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The last twenty years has been brought up a new type of accounting system, the activity based costing, and from year to year is being accepted by more businesses internationally, but some companies have not change their cost accounting systems and they using that which developed many years ago.
Activity based costing is modern costing method and is used as planning and control tool and identifies the relationship between costs, activities and goods, more accurately than traditional costing methods.
Traditional costing method is overhead absorption rate where containing all manufacturing costs incurred to produce those products, evaluate or valuing a business's total stock.
Activity Based Costing is a modern costing method where costs are owed to products and services and it is generally used as planning and control tool. It was developed as an approximation to solve the problems related with traditional cost management systems, which are likely to have the inability to precisely establish the production and service costs, or afford helpful information for operating decisions. Managers with these scarcities can be exposed to make decisions based on inexact data.
Activity Based Costing allows managers to attribute cost to activities and products more precise than traditional cost accounting methods. Furthermore, just activity costs are recognised, the cost of each activity is ascribed to each product to the extent that the product or service uses the activity. Activity Based Costing enables managers to recognize high overhead costs per unit and finding ways to reduce the costs.
Also can give detailed information to support annual budgets and define customer profitability. It also management can see how performance can be maximised and apprehend growth strategies. However, in applying activity based costing, where the customer demands that the costs are linked with the services, it revealed that the biggest expenses are driven by the ''profitable'' customer. It is significant to obtain that by identified costs drivers; the activities are computable and pertinent.
The activity has direct and indirect relationship to the cost of doing business and the portion attributable to the activities consumed are allot to each customer.
Activity based costing system is based on premise that activities make a product and also has been developed recently to overpower the drawbacks of traditional costing system which suffers from certain drawbacks.
Based on the activity needed for producing an item, activity based costing is the purpose of the item cost. To produce a product or the cost consume for service, required some activities. From the expenses consumed by all those activities which implemented for the making of finished goods and sale, the result is that is very important. Some research studies showed that the usage of activity based costing on overheads distribution and allocation for product cost is rising.
Activity based costing based on cost driver which needed for producing products or delivering services, determine the product cost. Furthermore, costing of multi-products manufactured by businesses and performing customers' orders effective more the activity based costing.
Also for determining and controlling the overhead cost, the activity based costing is an effective management approximation. By using activity based costing techniques, overhead analysis can be made more accurate for a large range of goods, for profitability analysis, for goods costing and for determining and control of the overheads suitability.
Businesses with activity based costing benefits can understand costs and reducing expenses. Businesses have to compare the product's price and selling record to see if it is worth to produce the item, and one of the benefits of activity based costing is the better analysis of good and bad products. A main problem with some items is overhead costs, but this method shows better those costs and helps to decrease overhead costs.
Furthermore, a more accurate product creation cost is another benefit of activity based costing. Analysts through this costing method can count the per-product cost and, thus, more practical measurements are used for evaluation.
However, businesses before create a product, will analyze overhead costs to find out if there are enough available budgets to make the product. Activity based costing as with the per-product price, is able to generate a lot of factors that straight influence cost, such as production costs, labour hours and part supplies. Businesses until the product made, can analyze these factors and find ways to reduce them to restrict the product's price when production does starts.
Finally, businesses after a product is created, analyze the product to find out if they are making a profit and make sure that they are not losing money. Also, better analysis of a product is another benefit of activity based costing, and helps businesses to see if it is worth to keep producing the item, because activity based costing method analyze better the product's price and uses a lot of factors when defining profitability.
Activity based costing system is a strong tool for decision making and therefore, helps managers to manage overhead and understand profitability of the items and customers. However, activity based costing has a numeral of drawbacks. These drawbacks are discussed briefly below:
Activity based costing most important disadvantage is that even though activity based costing is a scientific approximation; the method of execution is complex, time consuming, and costly. The procedure of data entry and data collection demands essential resources, and stays costly to maintain.
Another disadvantage is that reports of activity based costing do not comply to generally accepted accounting principles (GAAP), and from that, because businesses following activity based costing need to keep two cost systems and accounting books, one for inner usage and the other for outer reports, filings, and statutory compliance. This is a complicated covering of efforts.
Furthermore, a main disadvantage of activity based costing is that it is not probable to separate some overhead costs such as the chief executive's salary on a per-product basis usage. Similarly, employees rarely dedicate 100% of their working hours to productive actions; and not all productive actions or the procedure of the business that increase the value of the product. For example, for the time employee participate in awareness campaign, leading to essential 'cost leaks'; the activity based costing method fails to account. There is no significant way to delegate such 'business sustaining' costs to products on a commensurate basis, and products and services share such costs equally.
Finally, immensely attention to detail and control might shade the larger picture or make the business lose view of strategic objectives in a pursuit for small savings, making the business "penny wise and pound foolish." For example, one distribution channel might identify from activity based costing as non-profitable, or an inspection as non-value adding. To achieve some other strategic objectives, channeling or processes might be non-remunerative, but placed in the first place.
Overhead Absorption Rate
Overhead absorption costing is a traditional costing method by containing all manufacturing costs incurred to produce those products, evaluate or valuing a business's total stock. These manufacturing costs are the direct materials, direct labor, fixed manufacturing overhead and variable manufacturing overhead.
Overhead absorption rate is the procedure of distributing the overhead costs by all the goods of a specific department. Also overheads are applied in each production facility. Furthermore, overhead absorption is the procedure of ascertaining the total overhead costs in each production facility by using overhead rate. Thus the allocation of the overhead expenses distributed to a specific department over the units of produced in that department is absorption of overheads.
Overhead absorption rate should be determined, in order to absorb the overheads by each production facility of a specific department. Overhead absorption rate has two main methods which are the labor hour rate and the machine hour rate. For the calculation of overhead absorption rate under these two methods the formula is:
Labor hour rate = Total Overheads/Total Labor Hours
Machine hour rate = Total Overheads/ Total Machine Hours
Advantages & Disadvantages
Overhead absorption rate has a lot of benefits which are going to be discussed below.
Identify fixed cost in product cost, as it is appropriate for defining price of the product. Based on overhead absorption rate the price obtains that all costs are covered.
Overhead absorption rate will show the calculation of profit correctly that variable costing, where production is done to have sales in future.
Matching costs with revenue for a specific accounting period required to complied absorption costing with accrual and matching accounting concepts.
For stock valuation purposes and for the purposes to prepare external reports has been identified the absorption costing.
Absorption costing evades separating costs into fixed and variable data.
Managers from the allocation of fixed overheads factory to cost centers, have been more aware and responsible for the cost and services applied to others.
Overhead absorption rate except from benefits has more drawbacks which are:
For decision making absorption costing is not helpful. It examines fixed manufacturing overhead as goods cost which raise the cost of production. This does not help managers to receive special offers for the goods price. Variable costing method can be solve the managerial problems which concern to decision making.
Absorption costing is not useful in planning and control of cost and functions, and in fixing the liability for incurrence of costs. Also for managers it is not practical to be responsible for the costs where they have not control.
Some product costs by producing for stock can be removed from the income statement. By raising production, managers can temporarily improve profitability.
An example of a company that used activity based costing is DHL. DHL was formed in 1969 and is the creator of the air express industry and specializing in cargo and parcel delivery, and today has the leadership in its sector.
DHL used activity based costing firstly in 1988 and later in the late nineties to reposition it as the base for the business to move forward to improve the efficiency.
A review of the organization's largest international customer accounts is the result of that the activity based costing model let costs to become real. From this review the company finds out the main areas for development and led it to improve profitability.
The result of using activity based costing is that DHL has the basis to dialogue with their whole customer base and their customer profitability programme is one of the keystone of the company. DHL created a set of tools, which can find from this the pricing of international tenders. Also, they create a costing system which is efficient and trustable and is based around a standard cost model, which used worldwide to count the profitability of their customers.
As we can see above activity based costing system and generally modern costing methods are more accurately than traditional costing methods. This explained in the example of DHL, where the company used activity based costing in late nineties to improve their profitability and they did it successfully.