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Traditional costing method was introduced during the first part of the twentieth century. In fact during 1911 the first standard costing method was introduced by G. Charter Harrisson 1. The traditional costing employs a volume- based driver such as direct labour hours and machine hours for the assignment of all manufacturing overhead costs. In fact traditionally they tried to assign costs directly to the products.
During the initial stages of traditional costing the proportion of direct costs was inevitable to indirect costs and firms produced few products. However the situation changed due to the birth of technology throughout the 1980s. Thereby, firms now utilized less direct labour hours as there had been the introduction of machines leading to other expenses such as administrative and marketing costs. This had led to indirect costs to surpass direct costs, therefore direct labour hours no longer remained appropriate for Overhead Absorption Rate (OAR).
Subsequently there was the need of a new costing method. This led to the emergence of Activity Based Costing (ABC) which is a more accurate form to allocate costs. This new costing method was introduced in 1987 by Professor Robert Kaplan, Robin Cooper and H. Thomas Johnson. The main aim for such a method was to try to eliminate the deficiencies of traditional costing.
What is Activity-Based Costing?
Activity-Based Costing (ABC) is a costing system based on the concept that products consume activities, and activities consume resources. It identifies the various activities performed in a firm to produce a product/service, and uses multiple cost drivers to assign overhead costs to the different cost objects. The ABC technique has been developed to alleviate the problems of traditional costing previously identified, by refining the overhead allocation process and to reflect the actual portion of overheads consumed by the activities. This is done by first assigning the total overhead costs to the different activities using resource cost drivers, and then to the cost objects using activity cost drivers.
Changes introduced by the Activity-Based Costing technique
The major change brought about by the ABC technique developed by Robin Cooper and Robert S. Kaplan was that in the allocation and assignment of overhead costs to the different cost objects. In a traditional costing system overhead costs are assigned in an unsophisticated and arbitrary manner using arbitrary cost drivers / allocation bases, whereas in an activity- based costing system cause-and-effect cost drivers are used to assign overhead costs to the different cost objects.
Differences between Traditional Costing systems and Activity-Based Costing systems:
Overheads are allocated to activities rather than to cost centers / departments
Variety of volume and non-volume based cause-and-effect cost drivers are used to assign costs to different cost objects rather than a small range of volume-based arbitrary cost drivers
These changes in overhead cost allocation and assignment bring with them various implications on the management of an organization adopting such a costing system:
It can considerably reduce cost of errors and assist management in identifying unnecessary costs
More relevant information is produced to help the management team in the control and monitoring process
Assists management in identifying profitable and value-adding activities
In today's highly pressurized business environment, creating value is the number one priority for organizations. The key to achieving this is having a budget and accounting system that supports long-term goals. Increasingly, organizations are abandoning traditional methods that no longer meet their demands and implementing activity-based budgeting (ABB), an innovative approach that can help organizations become more competitive by linking the budgeting process to organization strategy.
Formally, ABB is defined by Antos and Brimson as;
"the process of planning and controlling the expected activities of the organization to derive a cost-effective budget that meets forecast workload and agreed strategic goals."1
Essentially, ABB focuses on understanding both the linkages between as well as the drivers behind the activities, in particular those activities that add value to the product or for the customer. Recognizing these relations and the flow between them is imperative in understanding cost behavior and performance improvement opportunities.
ABB is designed as a management process, operating at the activity level, with the aim of continuous improvement on performance and costs. Therefore, management control is directed towards those activities and business process that incur cost rather than the resources themselves.
In implementing ABB, the following steps should be followed;
The ABB process initiates by identifying who the organization's customers are, and what they want. Furthermore it also involves an analysis of its competitors.
Establishing planning guidelines
Each manager within the organization must establish his activity level targets in line with these planning guidelines. Every activity manager should seek to improve value adding activities and reduce the costs for the non-value adding ones.
Link strategy with budgeting
Strategic objectives and performance targets must be transformed into activity level targets. This transformation process initiates with customer demands and an analysis of competitive strategies. The price, time, quality and cost targets are determined and converted into activity level targets
Translate strategy to activities
A preliminary bill of activities is created. Management techniques are then used to modify these activities until comparison with strategic planning targets can be done. Subsequent to this comparison, a final budget can be created.
Finalize the budget
The management of each department should assess its budget to get a clear idea about the workload of the different business processes, the co-ordination between activities and the co-ordination of process improvement projects before the budget can be finalized.
Ultimately, once the budget has been finalized, it can be used for day-to-day operational control purposes.