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When traditional costing methods were introduced few decades back companies marketed a relatively narrow range of products. Direct labour was often the biggest cost of production and overhead costs were therefore smaller; the distortions that resulted from inappropriate overhead allocation were not evident. Direct labour was therefore used as a proxy to allocate overheads; managers would simply allocate a higher portion of overheads to products with higher direct labour hours. Information processing costs were high back then therefore the use of more sophisticated costing methods was uncommon. (Drury, 153) For businesses that manufacture a large quantity of only a few types of products, traditional costing is able to provide a rather accurate value of costs for manufacturing the products. However, since diversity in output is becoming more common, absorption costing becomes less relevant for users nowadays. (Pondent) The limitations of traditional costing methods have been widely publicized during the 1980s. (Drury, 153) Firms having a large amount of overheads need a more precise and reliable method to allocate their costs. A business that uses the incorrect costing method might affect its competitive position. For example, a company might price its products wrongly or choose to produce certain goods that were mistakenly seemed profitable under the wrong costing method. Moreover, machines and computers are used more intensely than ever before. Technological developments have led to a huge drop in demand for labour in manufacturing processes which means that a system that uses direct labour as a proxy for allocating overheads is outdated. (Pondent)
Furthermore, the rise in global competition during the 1980s has resulted in decision errors caused by poor cost information more probable and more costly. (Drury, 153) A new and more sophisticated type of costing system known as the activity-based costing (ABC) emerged afterwards. A clear distinction of the ABC from the traditional costing methods is that traditional costing allocate indirect expenses to products based on characteristics of a single allocation factor and that is often not causally related to the type and level of work consumed. Traditional costing considers factors such as the number of direct labour hours required to produce a unit, the cost of that direct labour, the purchase cost of goods to be resold or the number of days occupied. These are however broad averages that do not appropriately reflect causality for the indirect expenses. The weakness of these allocation methods is that it results in allocations that vary with changes in the allocation basis. The ABC however recognizes the fact that individual products do not consume indirect expenses in those proportions. They focus on specifically the work activities of people and equipment required to produce each product and their consumption on each of the activities. (Cokins, 3) ABC traces overheads to products, services and customers by identifying the resources and the costs associated, the consumption of these resources by different activities and the performance of activities in producing output. Examples of the resources are wages, operating supplies, depreciation on machinery, utility expenses and so on. They represent the capacity to perform each task. ABC gives visibility to work activities in the manufacturing process and the costs associated. The activities performed under the ABC are identified using activity analysis which involves determining the types of activities done within a department, the amount of labour needed plus the time required in performing these activities, the resources required and the value that these activities bring to the organization. Resources will be allocated to activities using resource drivers which are used to determine costs of resources that will be consumed by each activity. Nevertheless activity costs are traced using activity drivers to each product that consumes a particular activity. The management determines the amount of activity output each cost object consumed during a specific period of time. (Cokins, 4)
Figure 1 and 2 further illustrates the major differences between traditional costing and activity-based costing. Both costing systems involved the two-stage allocation process. As shown in Figure 1, the first stage of a traditional system is to allocate overhead costs to the production departments then reallocate service department costs to the production departments. Rather than assigning indirect costs to departments, the ABC system assigns them to each major activity. Under the ABC system, a number of activity-based cost centres are established. On the other hand, overheads tend to be pooled according to departments with the traditional system, though they are often described as cost centres. (Drury, 156) In general, ABC systems typically have a greater number of cost centres. The second stage of the costing process allocates costs from cost centres to the products. Traditional costing trace overheads to products with a smaller number of second stage allocation bases, which changes accordingly to the volume produced. In contrast, ABC uses cost drivers instead of allocation bases. (Drury, 156) In addition, traditional systems normally allocate service costs to production centres. The costs are then merged with those of the production centre thus included within the production centre overheads. The ABC systems establish separate cost driver rates under service centres and then allocate the cost of service activities directly to cost objects. (Drury, 158) By using an increased amount of cost centres and cost drivers, ABC has the potential to more accurately measure the resources consumed by cost objects. Conversely traditional cost systems report costs that are relatively inaccurate because the cost drivers used have no cause-and-effect relationship to help assign service costs to cost objects. (Drury, 158)
As indicated in the previous paragraphs, ABC systems rely on a greater number and variety of cost drivers. This refers to the fact that ABC systems use both volume-based and non-volume based cost drivers. However traditional costing systems only use volume-based cost drivers. (Drury, 159) Volume-based cost driver assume that the allocation of product overheads is highly interrelated with the number of units produced. These cost drivers are suitable only where activities are performed each time a unit of product is produced. As for those activities which are not performed each time a unit is produced require non volume-based cost drivers. An example of non volume related activities is the set-up of a machine. Set-up costs emerge each time a machine produces a different type of product from before. It costs the same to set up a machine that was meant for 1 or even 1000 items. (Drury, 159) In this case the number of set-ups rather than the unit produced is a better standard for measuring consumption of the activity. Using only volume-based cost driver to allocate non volume-based overheads would therefore result in a distorted cost figure. Nonetheless if non volume-based overheads only constitute a small proportion of an organizationâ€™s total overhead costs, traditional costing systems would more likely be accepted.
ABC systems are as important to companies in the service sectors as to manufacturing companies. In fact, while the ABC was originated for the purpose of manufacturing companies in the 1980s, hospitals back then were already allocating overheads to departments and then to patients using methods that seemed to be ABC. Hospitals were required to employ the use of relatively sophisticated allocation processes in order to comply with Medicare reimbursement rules. After its inception in the 1960s, Medicare established a set of detailed rules regarding overhead costs allocation. This includes how they should be grouped into cost centres, and the ideal choices of allocation bases for allocating overheads to departments and then to patients. (Caplan) Having a clearer idea of the cost structure of different activities, managements were able to maximize revenues by shifting costs from one activity to another.
The following is an illustrative example of the ABC system used in a hospital: Suppose that a hospital is carrying out an ABC system study to determine the nursing cost for various types of cardiology patients. The interview with the unit supervisor included a list of questions that may be used to represent a sample of what type of costs could occur.
The first question would be to describe what the nurses do for patients in the cardiology unit. (Zoiner, 147) The second question is to find out if the patients require any type of equipment. These questions are constructed upon the purpose of activity identification.
Question 3 would be to identify the resources required for the nursing care activities.
Question 4 is regarding resources driver identification: How much time do nurses spend on each activity? How much equipment time does each activity consumes? This information is needed to assign labour costs and equipment costs to individual activities.
Question 5 is to identify potential activity drivers: What are the outputs of each activity?
The final question is used to recognize cost objects: Ultimately, who or what consumes the activity output? (Zoiner, 148)
The same set of questions would still be used dealing with organizations from different fields. If the hospital used traditional costing instead, these questions would be irrelevant since all they have to do is just allocate the overheads directly to the activity outputs.
Despite enjoying all the advantages as mentioned before, implementing ABC can be a challenging task for any organization. Firstly, Setting up an ABC system is expensive and time-consuming. Business activities must be broken down into individual components; the whole process can take up a lot of resources. Businesses may also need a consultant who specializes in that field to provide training on its use. The software itself also acts as an extra expense to the organization. Results produced by an ABC system contain information such as profit margins that vary from those produced by a traditional costing system. It might possible that some activity-based costs may be irrelevant in certain decision making situations since ABC does not conform to GAAP and should not be used for external reporting. (Rojas) However in overall ABC improves business processes in a way that it allocates overheads based on a productâ€™s cost driver. As costs are appropriately allocated on products, which business processes are doing well and which are not becomes visible to the management. This therefore helps the management in choosing to allocate resources to efficient and profitable activities. Lastly the ABC method allows an organization to have a better understanding on where the overhead costs are going. This data can help identify wasteful products and avoidable costs, so that the resources can be allocated more efficiently. The ABC also aids the management in product pricing. (Rojas)