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While the world's attention is focused on the fight to increase productivity and develop new technologies, manufacturing managers - especially those in the electronics and mechanical equipment (machinery) industries - are quietly waging a different battle: the battle to conquer overhead costs (Miller and Vollman,1985,p.142);"Retrieved from URL:http://asbbs.org/files/2009/PDF/M/MyersJ.pdf on 14th October 2010.
The purpose of this essay is to compare and contrast the reasons for the use of traditional and activity based costing in modern organisation. Traditional costing (TC) is a product costing system in which direct material and labour are tracked down to products and manufacturing overheads are allocated to products based on volume based cost driver (Langfeild Smith, Helen, & Ronald, 2003). Activity based costing (ABC) means assigning overhead costs to specific activities performed in a manufacturing process with direct material and labour assigned to products in the same way as TC. The first section of the essay deals with explanation and basic difference between of ABC and TC. Remaining sections explain the need and reasons for adopting each type of these costing methods (ABC & TC) in modern organisations .These sections also emphasis on transformation from traditional costing method to ABC over the period.
Since the origin of Traditional cost accounting (Johnson and Kaplan 1987), it has been picked apart for its drawbacks such as cost distortion and not showing present organizational realities (Kim & Glenn, 2001). According to Miller, traditional costing reports what money is spent on and by whom, but fails to report the cost of activities and processes (Miller 1996). As a solution, a new costing method called Activity Based Costing (ABC) was formulated and has been encouraged as a mean for sweeping over the drawbacks of Traditional Costing to bring relevance back to Managerial Accounting (Kim & Glenn, 2001).
Basic differences between ABC and TC
In the traditional costing method, direct costs are related to each product and overhead costs are allocated to each product using volume based cost drivers. If the selection of allocation base is not correct then result will be an imprecise product cost. Many costs related to automated product line, diverse products, downstream costs etc are not driven entirely by volume based cost drivers. Comparing to TC, in ABC the overhead cost are allocated to specific activities performed so costs are traced more accurately to products or cost objects. The Following example about a workshop will illustrate the differences between the two types of costing methods. Consider material handling as an activity then cost of equipments used, such as conveyer belts, forklift etc can be traced down to pool of activity. While using TC in analysing the cost of workshop, a larger cost pool will be used and overhead cost will be allocated based on volume of products produced rather than complexity or time taken for each products. If the workshop produces uniform products with each using same composition of materials and same time for production, there will not be much difference between costing system based on TC and ABC.
Traditional costing and modern organisations.
Traditional costing methods are quiet adequate when the industries are not fully technologically advanced (with not much product differentiation) and major portion of total cost consist of direct cost component with indirect cost have no much effect on total cost. Traditional costing methods used for general purposes when the expense of determining the indirect cost is higher than direct cost (M C, Filho, Espozel, & Qassim, 1999) . This essay also uses information collected in a survey studies carried out in Australia. Conducted among 200 firms in 1997 the survey results suggesting that only 14% of firms use ABC and another 11 % have plan to use it in near future (Askarany, 2007).Reasons for the continuing use of TC are (1) simple and easily understandable, (2) less costly ,(3) still running good for certain firms for long period . So even with the introduction of ABC system, there are quite a number of firms using TC in the modern business environment.
Out of 231 companies surveyed in the Britain, 91% of them apply standard costing for cost control purposes (stated by David Lyall and Carol Graham). In U.K., out of 303 accountants's 76% of them and '73% of 85 finance and accounting specialists in New Zealand use standard costing'. (Marie, Attiea, & Rao, 2009).Study by Marie, Attiea and Anand Rao found that 39% of service sector firms and 75% of industrial firms use standard costing in Dubai (Marie, Attiea, & Rao, 2009)
Non-financial information about Small and medium enterprise (defect rate, through put rate) is not obtained while using traditional costing methods. In addition, factors like quality, service and information that matters to the consumers are out of the scope for traditional costing system .These disadvantages relating to traditional costing systems will prevent organisations from becoming competitive and world class in the modern economy (Gunasekaren, Marri, & Grieve, 1999). This has prompt SME's from reducing their dependency on traditional costing system and now they moved into ABC that resulted in improved profits for the organisation and helped managers in accessing more information for better performance. The main criticism for traditional costing system is that use of simple volume based allocation system will not reflect the actual cost of a complex manufacturing system in a modern organisation.
Use of traditional costing in a modern computer manufacturing firm is evaluated in this paragraph Consider the case if computer manufacturer who uses automated mechanism like robotic arms for manufacturing products. If there is, no system to find number of hours robotic arm work on each type of computer, then fixed overhead cost has to be allocated evenly to all products regardless of the number of hours machine works. This will result in complex products with more manufacturing time having understated costs and products with simple manufacturing procedure with overstated costs .The end result of all this being difficulty in evaluating performance , formulating pricing strategy
Activity Based costing and modern organisations.
"Understanding the steps and definitions of activity based costing will enable me to implement this strategy at Thompson." (Alan G. Dunn. (2001). Retrieved from URL: http://www.irc.caltech.edu/pdf/courses/Activity%20Based%20Costing.pdf on the 14th October 2010).
Activity Based Costing has given rise to revolutionary changes in cost management systems. It is not a method of costing, but rather a technique for better organizational management. The main purpose of activity based costing is to present cost distortion. Traditional based costing immixes all indirect costs into a single one. On the other hand, Activity Based Cost adopts multiple activity costs and cost drivers and thus prevent Cost distortion. Secondly, Activity Based Costing provides process view by reducing waste or unwanted activities. (Kim & Glenn, 2001). ABC bring forth fundamental shift in emphasis from traditional costing to activities, which requires resources. Thus, controlling activities, which is associated to the resource, allows the organisation to control costs at their source. Activity Based Costing allows the managers to segment customers and adapt process and pricing strategies to run the organisation more profitably while Traditional accounting completely hides this kind of data. (The Chartered Institute of Management Accountants, 2001)
Activity based costing is apt for organisations with a variety of products and services and are unable to know which products are profitable. Actually, the companies that are big enough and willing to adopt Activity based costing can benefit much out of it. This is because it can recognise high overhead costs occurred and provide solutions for bringing down the costs. It puzzles out any inaccurate allocation of costs and calculates profitability with impeccable accuracy than traditional costing that uses direct labour hours as the only cost driver. One of the main reasons modern organizations implement activity based costing method is that it could bring forth drastic advances in the quality of overhead cost allocation. Moreover, assign cost units to each individual activity such as packing, designing, and quality control at the beginning stage of activities. (Popesko2, 2010)
As modern business is become more complex and competitive, an accurate costing system is more than essential for aiding the managers for better decision making. Over the past two decades, some revolutionary occurring in business environment has prompted managers to choose an appropriate costing system, which suits the organisation's production system and product line. In our finding, certain organisations that follow a labour-based production system and have only limited product range adopt traditional costing system. While on the other hand, organisations with manufacturing overheads, which are not based on volume-based cost drivers, go for activity, based costing system. It suits for those organisations that have numerous products attached to their product line. Moreover, it helps in determine which products are profitable. To conclude, in most cases, companies cost accounting system, both traditional and activity based costing, effectively measures the direct costs of products and services, such as labour and material. However, it is up to the management to decide and choose which is the most appropriate costing system based on their production system and product range.