This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.
This essay will discuss how small service-sector business might use ABC to produce product cost for service and to evaluate the internal efficiency, quality and profitability per product or service line. It will also aim to analyse both the benefits and drawback of ABC for the small service sector. I will be using K. C. Supermarket as a case study for this essay. Below are the topics that will be discussed.
Definition of ABC
Using ABC for small service-sector business
How small service business sector might use ABC:
to produce product cost for service
to evaluate internal efficiency, quality and profitability per product or service line
Discussion on benefits and drawbacks
Overview of Activity Base Costing
Activity Based Costing was first introduced by Cooper and Kaplan in 1998. They both conceptualised the facts behind these systems and invent the word ABC. ABC was established as a problem solving tool linked with traditional costing management according to G. Cokins, (1999). He also stressed that the use of ABC does not necessarily replace traditional general ledger accounting. Instead, it transforms data in the general ledger into costing information. Since the change of business environment and activities, this has resulted in the tools and techniques used for developing management accounting. Although the old technique of management accounting has some limitations attached to them for example, the use of absorption costing method is said to be in appropriate in the modern world. It is also noted that the old ways of measuring management accounting performance can also produce an inaccurate result. As a result of this, ABC has gained a unique reputation.
Meaning of Activity Base Costing
Generally, Activity Based Costing by C. Drury, (2008) can be defined as "an accounting technique that allows an organisation to determine the actual cost associated with each product and service produced by the organisation without regard to the organisational structure". ABC requires adequate planning and commitments from the top management and for a small business like, K.C Supermarket to use ABC to produce product costs for services; it is advisable to do a test run on the department that is underperforming. In this situation, there is a better chance that the business will succeed and a way of proving that a business can save money by implementing ABC. On the other hand, if no saving measure of activity cost is determined, it means either the cost system was wrongly implemented or is not suitable for the business.
Robert S, (2003) pointed out that "the old ABC model has been complex for many businesses to execute because of the high costs expended to interview and study people for the preliminary ABC model, the use of biased time allocations, and the complexity of maintaining the model as (i) resource spending changes, (ii) fresh activities are added, and (iii) enhancement arises in the range and density of individual orders, channel and customers".
Using ABC to produce product costs for services, benefits and drawbacks:
ABC does not need a massive attempt to execute and that it is useful for any size business said, D. Hicks, (1999). He also stated that some managers of an organisation suffered themselves unnecessarily because they lack the understanding of what ABC really is. However, most small businesses are now starting to see how ABC can work successfully in their favour as it worked for large organisation. He also highlighted that businesses has to carry out certain activities to supply the products and services it sells which could be expensive or costly. The cost of each of those activities is considered and allocated only to those products and service needing the activity, using suitable assignment bases (called drivers). Following this method will help small business to obtain a correct picture of the actual cost of producing each product or providing each service. The following are the steps a company is required to take in order to use ABC to produce product costs for services:
Firstly, there is a need to set up a team in charge of deciding the activities necessary for the product cost or service. The team must cover departmental areas such as human resources, finance and an external consultant if possible.
Secondly, after assembling the team, data on materials and utilities is needed in order to ascertain which of the activities really cost money to the business with a high level of attention to details and concentration is requires as some of the costs may not be obvious. As soon as all the costs are noted, the result must be entered into ABC software which will help the business to analyse and get facts on what is needed to boost their profit margin and make the activity more resourceful.
Thirdly, after analysing the data collected via ABC and cost effective activities has been determined, the next step is to choose the methods that can be taken to boost profit. Any activities that are deemed to be too expensive can then be outsourced in an attempt to enable them more cost-effective.
Drawbacks and Benefits
However, businesses that apply ABC run the possibility of wasting too much time, effort and money on collating data that is gathered. Too many details can sometimes be provoking for managers and inadequate detail can also result to unsatisfactory data. An additional cause of ABC downfall is failing to take action on the results supplied by the data. This occurs especially in businesses where ABC model is not welcomed. G. Cokins, (1999) cited that ABC repeatedly fails because project managers overlook the fundamental rule: It is better to be roughly accurate than to be specifically inaccurate. He also cited that the application of average cost rates and disconnecting information to action can also hamper ABC projects.
Another restraining factor is that ABC software can be too expensive. M Henricks, (1999) stated that most Activity Based Costing Practitioners find the software very efficient in managing tasks. He also said that time can be a crucial cause for businesses looking for an instant result. He said some businesses see results immediately but in reality, it may last up to three months for some companies to see the profitability of ABC and depending on the type of product phase, it could last much longer.
J. Cullen, (2001), cited that "costing concentrates on processes relatively than functions. He also said that managers can only administer costs by overseeing the activities that cause the costs. The principal facet is to recognise cost drivers and to apportion costs to an activity on the basis of that cost driver. An example is K. C. Supermarket' use of activity based costing for producing product cost for services and to evaluate internal efficiency, quality and profitability per service line.
The benchmark method for estimating a simple ABC model begins with identifying a compilation of resources that carry out a range of activities. For example, K. C. Supermarket customer service division that performs three activities:
Process customer complaints
Handle customer order
Perform customer credit checks
The total cost for performing these activities is £12,500 per quarter according to K. C. Supermarket report, (2010). The percentages of time exhausted by employees on these three activities are 15%, 60% and 25% respectively. The actual quantities of work for the quarter in these three activities are:
5 customer complaints
150 customer enquiry
120 customer credit checks
Allocating £12,500 supply cost to activities, by means of time percentage, and calculating activity cost driver rates as revealed below:
The above activity cost driver rates can then be used by the project team to apportion the expenses of the set of activities performed to each customer.
If an in-house process is found not to be adding value to the business or company, organisation could possibly get rid of the process completely which as a result would decrease its overall costs.
ABC also help management to try-out in recuperating the present practices of production by monitoring the adjustment in costs related to the process or even considering a wholly fresh practice. The capability to sight which changes decrease costs and increase production enables management to make more efficient an organization's production process. Efficiency is significant in staying competitive, and with ABC giving room for process excellence costs are capable to be decreased while production remains constant or even enhances.
However, there are several problems that arise when businesses try to size up the straightforward method and maintaining the model to enable it reveal the change in activities, products, processes and customers. The first problem is the process to survey and interview employees in order to get their time apportionment is expensive and time consuming. Also, due to the high cost involved in updating ABC model consistently, many of the systems are only updated infrequently which then results in outdated activity cost driver rates, and incorrect estimation of customer, process, and product costs.
Using product cost to evaluate profitability and drawbacks
ABC will engage proper planning and devotion to execute which can also put into practice a trial run on a department whose profitability is very low and under-performing. In this situation, there is a greater chance of convincing the manager that ABC is a practicable way for the company to save money. Costs of helping a customer can be derived individually since ABC is now based on activities. We can ascertain profitability by subtracting product cost from the cost expended in serving each customer. This method helps to identify the profitability of individual customer and putting the products and services in proper shape respectively. The execution of ABC will also enable small business to determine the various cost involved by allowing them to examine the cost and to recognise the activities that is both valuable and not valuable. Based on this, benefit and improvement can be executed and accomplished. With ABC, small businesses are capable of improving their effectiveness and limit cost without giving up the worth for the customer.
In conclusion, small businesses require dependable and exact cost information to continue to exist in which ABC can supply accurate costing information for tactical judgment. D. Hicks (1999), discussed that every small or medium size business can develop an ABC system as the system does not require a vast level of time dedication or monetary resources nor does it call for the execution of particular software incorporated into the general ledger. According to G. Cokins, (1999) he pointed out that whenever an ABC project fails, the only main reason it fails is that managers planned the ABC system to be excessively outsized and entail a vast amount of detail. Therefore, this essay has realised and concluded that managers are not only focusing on cost but also concentrating on the activities that are driving cost.