Performance Measurement And Control Activity Based Costing Accounting Essay

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Activity Based Casting (ABC)

Activity Based Casting is a casting model that identifies the activities in an organisation and assigns cost to the product based on the activities involved. In compare to traditional system , ABC system accumulate all the overheads involved and make a casting pool from where it assign cost to each individual products. Costs are assigning to individual activities like planning, engineering, or manufacturing and then activities are associated to different products or services. From this, an organization can precisely estimate the cost of individual products and services so they can identify and eliminate those that are unprofitable and lower the prices of those that are overpriced.(1) Generally, activity-based costing is most effective when used over a long period of time, as opposed to shorter-term solutions.

Apple is an electronic manufacturing company. It manufactures different electronic products from laptop to mobile phones. The uses of ABC system in apple help this company of accurately measure its cost to find suitable prices. Lean production is also achieved by using ABC system by removing non-value added activities. Value added activities are then assigning cost drivers which are chosen on the basis of activities. Cost pools are then created and assign cost on the basis of these cost drivers.

2. Stages involve in ABC system

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ABC technique is a complete accounting process which involves different steps .These steps are

Analysis of Activities

In this step, the activities that are to be analysed will be included. Experts recommend the analysis of at least half a dozen organizational units with a common functional orientation to start the program. These activities are important for assigning cost to the product or services. The analysis of each activity will include

Whether that activity is a value adding or non-value adding

Whether it is a primary or secondary

Whether it is important for the product or not

Value adding activity is important for the company because it add value to the product or service whereas non-value adding activities are not important. So this difference plays an important role in assigning cost to the product. Primary activities support company's missions while non-value adding activity support primary activity. Primary activities are always needs to be performed whereas secondary activities can be avoided.

Activity based costing definition :http://www.valuecreationgroup.com/activity_based_costing_definition.htm

For apple, the activities those add values to its products are the manufacturing process , labour , engineering technique , raw material etc.

Cost data gathering

Next step is cost data gathering. In this step the cost incurred for each activity is analysed. There are different cost those are associated with these activities. These costs are salaries of people performing these activities, material cost, equipment cost (fixed cost), and R&D cost. These costs are figured and if they are not available, they can be estimated.

Tracing of cost to activity

Next step is tracing of cost to activities. This step involve in determining where the total cost of each output comes from. Every output of an organization was produced by one or more activities, each of which incurred costs when that activity is done. This step aims to determine where the costs are being incurred in producing an output, by determining which activities are needed to produce that output and what costs are incurred in each of these activities. So the activity that are important are retain in this step.

Establishment of output metrics

The establishment of output metrics determine the total cost of producing an output. It consists of the calculation of the actual activity unit cost for each primary activity and the generation of the bill of activities.  The activity unit cost of an activity is the total input cost divided by the primary activity output volume.  The total input cost should include both the costs incurred by the primary activity and its associated secondary activities.  The bill of activities is the list of activities (and their corresponding consumed amounts) needed to produce the output. The total cost of the bill of activities is the sum of each activity unit cost multiplied by its corresponding activity amount consumed.  

Cost Analysis

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Last step is the cost analysis. In this step each activity's unit cost and bills of activities are analysed and then decided if the process need further improvement. In this step non-value adding activities are properly identified and remove from the process so that to find out accurate cost of the product or service. (2)

3. Importance of selecting the right cost drivers

Cost drivers for activities used in manufacturing products in Apple are important in the sense that if proper cost drivers are not used, then cost of the products will not be accurate. In implementing an activity-based costing (ABC) system, the selection of cost drivers is a major issue since accuracy must be traded off against the complexity of the ABC-system. On the one hand, a high accuracy in allocating overhead costs often requires a high number of cost drivers. On the other hand, a small number of cost drivers are desirable to achieve acceptable information cost and to make the ABC-system easier for management to understand. (3)

http://www.answers.com/topic/activity-based-costing

http://www.siliconfareast.com/abc2.htm

Activity Based Casting itself shows that it is based on activities. The selection of right cost drivers of each activity plays an important role as if the right driver is not selected that the distribution of cost on all activities will not be accurate. This is more complex system then the traditional costing system but this is more accurate system as it is based on all the activities involved.

In apple, the best way of selecting activity drives is dividing the costs into value-added and non-value-added components, with cost drivers separated into volume-related and transaction-related categories. This will result in approaching cost drivers as a way to manage and control expenses.

When selecting an activity driver, care should be taken as not all cost drivers are volume related and sometimes the drivers associated with transactions have a greater cost than the cost drivers associated with volume. For example to making a mother board for a laptop, activities involve labour time, raw material finishing, machine handling. If proper drivers are not used like raw material finishing is used on the basis of labour instead of machine hours then it will not result accurately.

Activity drivers merge the requirements that cost objects places on activities. The importance of selecting activity drivers accurately cannot be over emphasised. This will impact on the accuracy of the costing of cost objects. (4)

4. ABC oil well cementing company

ABC Oil Well Cementing Company, a cost centre affiliated with a Chinese State-owned Oil Conglomerate, specializes in cementing oil wells and gas wells. In petroleum well construction, cementing is the process used to make sure that oil or a gas well is firmly protected for the later oil or gas exploration work. This company use ABC system in its process to calculate the true cost of product. In this company team responsible for implementing ABC (Activity Based system) identifies six activity centres of lime storage, well drillings, transportation, repair and maintenance, laboratory testing, and administrative coordination. In these six activities, the ABC team finds that the transportation activity overhead cost is the most important cost for company management to control. The transportation activity includes packing, loading, and transporting the direct materials and the equipment needed for well drillings from the company office to the oil well field. Cement trucks, tank trucks, water-tank Lorries, and pressure cars are needed for the transportation activity. Cement trucks are viewed by the ABC Company as transportation equipment, while tank trucks, water-tank Lorries, and pressure cars are viewed as transportation and cementing equipment.

The resource consumption or overhead cost for the transportation activity includes labour cost, equipment related cost, facility related cost such as parking or renting fees, and other motor vehicle cost. Considering that driving the tank trucks, water-tank Lorries, and pressure cars from the company office to the oil field are needed both for the transportation purpose and the well drilling purpose, it is difficult to decide on the proportion of labour cost and equipment cost that should be assigned to the "transportation" activity pool and the "well drillings" activity pool.

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If these cost drivers are not selected rightly based on the activities performed then the cost of finding oil of a certain reign will not be accurately measured. If for example transportation activity pools 'cost drivers (number of trucks involved in transportation, number of drivers etc.) are not accurately used and instead drivers of well drilling pools are used then the cost incurred in transportation cannot be accurately measured which in result of favourable or adverse variance. (5)

5. Importance of classifying cost hierarchy

A cost hierarchy is a categorization of costs into different cost pools. Cost drivers are associated to each activity on the bases (cost-allocation bases) of activity.ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases:

5.1 Output unit-level costs

5. 2 Batch-level costs

5.3 Product-sustaining costs

5. 4 Facility-sustaining costs

The importance of these cost hierarchy is that they allocate cost to all the activities that are involved. The cost drivers included all the costs those are to be incurred in doing that activity. In the hierarchy, first one is output unit-level costs.

5.1 Output Unit-Level Costs

These are resources sacrificed on activities performed on each individual unit of product or service.

Energy

Machine

Depreciation

Repairs

As these costs directly related to the individual product, so as the number of product increases, this cost is also increases. As the number of ram card increases, the cost is also increase. But as this is directly related to the product, there is no extra cost incurred in the production of the product.

http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6WMY-456JPDV-B&_user=10&_coverDate=06%2F30%2F2001&_rdoc=1&_fmt=high&_orig=gateway&_origin=gateway&_sort=d&_docanchor=&view=c&_searchStrId=1666852401&_rerunOrigin=google&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=288770a231d542f7722e5deb6648f488&searchtype=a

5.2 Batch-Level Costs

These are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service.

Setup-hours

Procurement costs

Importance of this cost is that it divided to the whole group of the homogeneous products. As each batch is produced, this cost is occurred once and when the batch is produced, this cost is finished. Setup-hours and procurements costs are the two examples of this cost and these are just related to that particular batch.

In Apple , the supervisor's salary will stay same whether Apple produce 10 mother board or 100 mother boards.

5.3 Product-Sustaining Costs

These are often called service-sustaining costs and are resources sacrificed on activities undertaken to support individual products or services.

(1)Design costs (2)Engineering costs

Designing of Apple's products and its engineering are the product sustaining cost.Importance of these costs is that they are directly involved to the product regardless of number of units or batch produces. These costs are always there and they support to produce individual product or service.

5.4 Facility-Sustaining Costs

These are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole.

General administration

- rent

- building security

These costs are also important for that individual product or batches as these are the basic facilities to produce product.

Cost pools and cost drivers are the basic theme of ABC system. In cost hierarchy if cost pools are not design properly then right cost drivers cannot be assign to the activity. So designing a cost pool is the first fundamental step in using ABC system. Cost pools will show all the cost that can possible incurred in making the product.(6)

http://findarticles.com/p/articles/mi_qa5440/is_201008/ai_n55069232/pg_3/?tag=content;col1

6. Example of Activity based coting system of Apple

Following is the example of ABC method which shows the implementation process of ABC system.

The following information provides details of the costs, volume and transaction cost drivers for a period in respect of Apple Pvt. Ltd:

 

Products

 

A

B

C

Sales and production (units)

90,000

30,000

15,000

Raw materials usage (units)

10

7

14

Direct materials cost (£)

30

40

15

Direct labour hours

2.5

3

1.5

Machine hours

5

3

7.5

Direct labour cost (£)

20

30

10

Number of production runs

5

10

50

Number of deliveries

18

7

50

Number of receipts

50

70

700

Number of production orders

45

25

60

Overhead costs

£

Set up

75,000

Machines

1,000,000

Receiving

900,000

Packing

650,000

Engineering

750,000

Total

3,375,000

To apply the ABC method to the above example, we need to identify cost drivers for two stages:

1 cost drivers tracing the costs of inputs into cost pools; and

2 cost drivers tracing the cost pools into product costs

The calculations for each of the rates to be used are:

The machine hour rate is the only rate that is what we might call a traditional rate. All of the other rates we are about to use involve a two stage process. We will see the elements of these two stages as we get to them.

Machine hour overhead rate

£1,000,000 =

£1.5326

652,500 machine hours

 

This rate is used as normal.

For the set up costs, we first devise a rate to tell us the cost per set up: total set up overheads divided by the number of set ups: in this case, this is

£75,000 =

£1,153.85

65 production runs

 

We will return to this rate shortly.

All of the other rates are calculated similarly. Hence they will be presented now without further comment.

Receiving rate

£900,000

= £1,097.56

 

820 receipts

 

Packing rate

£650,000

= £8,666.67

 

75 deliveries

 

Engineering rate

£750,000

= £5,769.23

 

130 production orders

 

All of this information can now be put together into a cost per unit statement as follows.

The final stage in the whole ABC procedure, as far as product cost determination is concerned is to find out the costs per unit. The cost per unit statement follows, and then we will work through the calculations.

Unit costs

A

B

C

 

£

£

£

Direct materials

30.0000

40.0000

15.000

Direct labour

20.000

30.000

10.000

Machine overheads

7.6628

4.5977

11.4943

Set up costs

0.0641

0.3846

3.8462

Receiving costs

0.6098

2.5610

51.2195

Packing costs

1.7333

2.0222

28.8889

Engineering costs

2.8846

4.8077

23.0769

Total Costs

£62.9546

£84.3732

£143.5257

Workings:

Machine overheads are found by multiplying the machine hour rate by the number of machine hours per product per unit:

Machine hour rate £1.5326 x

machine hours

5

3

7.5

gives

£7.6628

4.5977

11.4943

The set up costs rate we have already is the rate per machine set up, the cost per unit is calculated by multiplying the rate per set up by the number of set up per product and then dividing the results by the total number of units per product:

Set up cost per set up £1153.85 x

No of set ups

5

10

50

gives

£0.0010

0.0059

0.0592

Set up cost per set up £1,153.85 x

No of set ups

5

10

50

gives

£5,769.25

11,538.50

57,692.50

These values are then divided by the number of units per product to give us the cost per unit:

 

£0.0641

0.3846

3.8462

The receiving, packing and engineering costs are all calculated in the same way as the set up costs. There is no need to repeat these calculations, but check that they are understood.

Summary 1: Total costs per unit using each of the three methods

 

Product

 

A

B

ABC

62.9546

84.3732

Summary 2: Overheads per unit using each of the three methods

 

Product

 

A

B

ABC

12.9546

14.3732

Summary 3: Overheads as a percentage of total costs

 

Product

 

A

B

ABC

20.58%

17.04%

http://business.fortunecity.com/discount/29/abcworkex.htm

http://www.scribd.com/doc/9589335/Cost-Accounting-chapter-5-ABC-

7. Limitation of ABC system

Although ABC system is a very powerful system in assigning cost to the product or services. But there are also some limitations in using this system.

Implementing an ABC system is a major project that requires substantial resources. Once implemented, an activity based costing system is costly to maintain. Data concerning numerous activity measures must be collected, checked, and entered into the system. This is very challenging and hard to cope with.

ABC produces numbers such as product margins that are odds with the numbers produced by traditional costing systems. But managers are accustomed to using traditional costing systems to run their operations and traditional costing systems are often used in performance evaluations.So traditional system attract managers most then ABC system and due to agency problem , managers prefer traditional system then ABC system.

 Activity based costing data can be easily mis-interpreted and must be used with care when used in making decisions. Costs assigned to products, customers and other cost objects are only relevant. Before making any decision using activity based costing data, managers must identify which costs are relevant for the decisions at hand.

Reports generated by these systems do not generally accepted accounting principles (GAAP). Consequently, an organization involved in activity based costing should have two cost systems - one for internal use and one for preparing external reports.

External reports are less detailed than internal reports prepared for decision making. On the external reports, Individual product costs are not reported. Cost of goods sold and inventory valuations are disclosed, but there is no breakdown of these accounts by product. If some products are under-costed and some are over-costed, the errors tend to cancel each other when the product costs are added together.

It is often very difficult to make changes in a company's accounting system. The official cost accounting system in most large companies are usually embedded in complex computer programs that have been modified in-house over the course of many years. It is extremely difficult to make changes in such computer programs without causing numerous bugs.

The auditors are likely to be uncomfortable with allocation that are based on interviews with the company's personnel. Such objective data can be easily manipulated by management to make earnings and other key variables look more favourable.(8)

http://www.accountingformanagement.com/activity_based_costing_external_reports.htm

http://www.articlebin.info/finance/finance/news_2009-05-18-19-30-03-965.html

References

http://www.valuecreationgroup.com/activity_based_costing_definition.htm

http://www.answers.com/topic/activity-based-costing

http://www.siliconfareast.com/abc2.htm

http://www.scribd.com/doc/9589335/Cost-Accounting-chapter-5-ABC-

http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6WMY-456JPDV-B&_user=10&_coverDate=06%2F30%2F2001&_rdoc=1&_fmt=high&_orig=gateway&_origin=gateway&_sort=d&_docanchor=&view=c&_searchStrId=1666852401&_rerunOrigin=google&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=288770a231d542f7722e5deb6648f488&searchtype=a

http://findarticles.com/p/articles/mi_qa5440/is_201008/ai_n55069232/pg_3/?tag=content;col1

http://business.fortunecity.com/discount/29/abcworkex.htm

http://www.scribd.com/doc/9589335/Cost-Accounting-chapter-5-ABC-

http://www.accountingformanagement.com/activity_based_costing_external_reports.htm

http://www.articlebin.info/finance/finance/news_2009-05-18-19-30-03-965.html