The activity-based cost system is a kind of costing system that provides decisions-makers with valuable information by supplying them a more accurate and equitable way of assigning indirect resources to products. Standing on the premise that activities consume costs, ABC system's main goal is to track the cost of a cost object, such as a product, by measuring and pricing out all resources used for the activities that go into making that cost object. (Drury, 2004)
This case study draw an hypothetic ABC system developed for the Microsoft Corporation, the multinational computer technology corporation.
The ABC system process involves seven main stages.
The first stage consists in the Activity Analysis: the identification and classification of the major activities that take place in the organization. This kind of analysis is usually carried out through an examination of a physical plan of the workplace and of a payroll listing, usually supported by a series of interviews with the staff involved. Due to the fact that each activity consists in the aggregation of different elements, the chosen activities should be at reasonable level of aggregation based on costs versus benefits criteria: if too many activities are defined, the cost of measurement for the ABC system grows disproportionately high. (Drury, 2008)
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The activities are often classified on the base of the level at which their costs are incurred, in an activity hierarchy.
Referring to Microsoft the main activities are the following:
UNIT LEVEL ACTIVITIES:
Customers orders and delivery: activities that ensure that the final products is shipped on time promptly upon receipt of purchase orders from customers. Â
Machine hours: machines are the primary equipment used in the production, fabrication and assembly of parts.
Maintenance :activities involved in maintaining machines in good working status
Purchase of raw materials: it is responsible for selecting vendors, inspecting materials, monitoring delivery time, verifying quantities received
Research and development: Microsoft's success is based on innovation: ability to initiate, to embrace new technology trends and to enter new markets
Product design: Microsoft has hundreds of design and human factors professionals work on designing products, creating great solution for costumers.
Testing: The quality control area is responsible for ensuring the final product quality
Warranty service : activities related to the relationship with the client such as the processing of complaints regarding product
Marketing: activities such as advertising and promotion.
Because the aim is to determine how much the organization is spending on each activity, after the activities have been identified, the cost of resources consumed over a specified period must be assigned to each activity, by creating Activity Cost Centers, or Cost Pools. While many resources can be directly attributable to specific activity, other may be indirect and jointly shared by several activities. ABC system designers typically estimate the resources consumed by each Activity Cost Pool by assigning these costs to activities on the basis of cause-and-effect drivers. The costs drivers used to allocate shared resources to individual activities are called RESOURCE COST DRIVERS, "factors that determine how much of a resource is used by an activity and therefore how much of the cost of the resource should be allocated to the activity" (Afuah, 2004, pp. 179-180).
The following step it to assign the cost of activities to the cost object by using ACTIVITY COST DRIVERS, "factors that determine how much of an activity goes into a product and therefore how much of the cost of the activity should be allocated to the product" (Afuan, 2004, pp. 179-180).Each activity should be matched with each own cost driver.
The next stage is to calculate the quantity in which each cost driver is totally put into action for each activity (usage). This is computed by summing the different quantities of cost driver that have been needed for each individual product. For example, for what concerns R&D the total quantity number of innovations in microprocessor technology has been calculated by summing the numbers of innovations undertaken for each of the launched products.
The fifth stage involves the identification of the Cost Driver Rate for each cost pool. To determine it, the estimated total overhead costs of each activity are divided by the total estimated usage of the respective cost driver. This represents a ratio that provides an estimate of the cost of using one unit of that particular cost driver.
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Since this moment, it is possible to assign the cost of activities to the products and so to calculate the unit overhead cost of each product .The cost driver rate is multiplied by the cost-driver usage of each product, that means by the quantity of that cost driver needed for the production of each item.
The last step in the ABC analysis is to compute the total product costs by summing the direct labor cost, direct material cost, and overhead cost of each product.
2. EXPLAIN WHY IT IS IMPORTANT TO GETH THE RIGHT SELECTION OF COST DRIVERS WHEN DESIGNING ABC SYSTEM. REFER TO THE CASE OF YOUR SELECTED COMPANY.
The selection of the cost driver must be really accurate: the cost driver should provide a good explanation of the costs sustained in each activity cost pools and it should be a satisfactory proxy that enables the quantitative measure of an output activity. First of all this choice should recognize whether the activity causes unit-level, batch-level, product-level or facility- level costs. Unit-level costs should have cost drivers that vary with the number of units, batch-level with the number of the batches and so far. (Drury 2008)
An important thing that firms should take in account in the selection of the cost driver is the subjective tradeoff between benefits of increased accuracy and cost of increased measurement (Atkinson , Kaplan and Young; 2004).
ABC system designers can choose essentially from three kinds of activity cost drivers: transaction, duration and intensity drivers. The first kind, counting the number of times an activity is performed, is cheaper but less accurate; this kind of cost drivers bases on the assumption that the more times a firm performs a particular activity adding value to a product, the larger the contribution of the activity to the costs . A transaction driver is fine in assigning activities expenses when the variation of quantity of resources used by each activity is small.
The second kind, representing the amount of time required to perform an activity, increases the measurement costs but are more accurate. The duration drivers base on the assumption that the longer the duration of an activity, the more costly the activity is likely to be (Atkinson, Kaplan and Young; 2004).
The choice of a cost driver for each activity bases on the balance between the cost and the accuracy of this. For example for the SETTING MACHINE, the cost determinant could be both the number of setting up undertaken and the set-up hours. In the case of Microsoft, if a software requires a short set-up time and a hardware requires a long time then using set-up hours as the cost driver will more accurately measure activity resources consumption than the transaction driver which assumes that an equal amount of resources are consumed by both products (Drury, 2008).. In order to offset the measurement costs, for the manufacturing activities have been chosen Duration drivers, while cheaper Transaction drivers have been preferred for the other activities. The choice to spend more for the cost drivers of manufacturing activities rests on the risk that the rapid change in the PC's industry and the fast drop in prices can result in very high cost in manufacturing operations ; thus a firm like Microsoft has to develop a cost system that provides an analysis as possible as precise on these operations.
Intensity drivers are the most accurate and expensive cost drivers, that charges directly for the resources used each time an activity is performed. Finally in the selection of cost divers in an ABC system it is fundamental the difference between volume-based cost drivers and no-volume based cost drivers, in order to avoid the over-costing or the under-costing of the product.
3. PROVIDE SUPPORTING CALCULATIONS FOR THE USE OF ABC SYSTEM IN THE CASE OF YOUR SELECTED COMPANY.
The supported calculations are justified by the seize of Microsoft Corporation: looking at the income statement of year 2010, the total operating expenses were about $38,000 million. Firstly it has been assumed that at least $18,000 million were direct costs, thus just the remaining part has been allocated among the activities as overhead costs. Secondly, it has been assumed that in the considered financial period Microsoft has produced JUST two products:
4. EXPLAIN WHY ABC SYSTEM PROVIDE VALUE TO FIRM MANAGERS.
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In the strategic management process, manager needs to control current activities in order to ensure that only profitable products and services are being launched. This kind of need could be reached only by using particular techniques that provide accurate information about the sustained costs. One of these techniques is just the ABC system that furnishes a significant aid in strategic decision: it allows to study the profitability of each cost objects, such as products and costumers, and gives the opportunity to rank them on the basis of their profitability, and to transform the unprofitable into profitable, through actions such as process improvements or pricing activities.
As already explained, ABC system, by tracing the cost of all activities and overhead to a particular product rather than spreading them across all product lines, enables resources and overhead costs to be more accurately and equitably assigned to the cost object that consumes them. In this way ABC system gives visibility to how effectively resources are being used , so how costs are actually consumed and how all activities contribute to the cost of a product or service.
Therefore the main value added by the use of ABC system lays on the possibility that , using the ABC system, a manager could evaluate the costs for each activity and may decide to combine some of the steps in order to lower costs. Thus ABC system provides accurate data that may serve either to justify some company's activities and investments, or to identify the need to withdraw or modify others.
ABC system adds more value to a manager than a traditional system because it uses a greater number of cost drivers, including differ types that traditional system does not use: the no-volume based drivers. Indeed traditional cost system uses only volume-based cost drivers , such as direct labor and machine hours, where no cause-effect-relations exist to assign support costs to cost objects. Using only volume-based cost drivers to assign no-volume related overhead can result in the reporting of distorted product costs: such as in the over-costing of high volume product and in the under-costing of low volume products..
Referring to the Microsoft case, it could happen that the full cost of a software unit computed by using the ABC system is higher than it computed with a traditional costing system. With the selling price remaining constant, this provides an essential information suggesting manager that the product should be reviewed and the activities should be reassess in order to increase the selling price (to cover the additional costs that with the traditional system were not released) or to lowering overhead costs, by eliminating non valued added activities, activities that require time and use resources but add no value to the customer.
5.EVALUATE SOME OF THE LIMITATIONS OF INFORMATION PRODUCED BU ABC SYSTEMS
Although ABC system provides really valuable information to managers, some company have experienced difficulties and pitfalls to build and use it. First of all, companies considering using ABC should keep in mind that while it can be a very powerful management tool, it can be very expensive to start and run: itÂ requires substantial resources and costs to be maintained. As it has been pointed out, the decision of designing and running an ABC system should be based on the trade-off between the additional cost of implementing it and the mistakes in management decisions that can result in the traditional systems a cause of the distorted costs.
Secondly, activity based costing data must be used with care when implemented in making decisions: before making any significant decision, managers have to identify which costs are really relevant for the decisions at hand . Indeed , backing to the Microsoft case, the fact that the full cost computed with the ABC system is higher can lead to a loss, does not legitimate the manager to immediately abandon the product: it does not mean that this kind of action would represent a cost saving. Cost assigned to cost objects are only potentially relevant: manager should complement them with other kind of information such as data about the general market and the forecasted moves of competitors.
Thirdly , even if ABC system can be used for almost each kind of business, service industries may not benefit as much from it as other industries because their costs can be difficult to assign as they may not have an identifiable cause and effect relationship. Finally ABC does not always conform to GAAP, the generally accepted accounting principles. That means that a company using ABC system have to keep a separate system to track costs in a manner that conform to them.