According to Bhimani, Horngren, Datar and Foster (2008), managers understand the need for a cost accumulation system in decision making to answer their questions about product selling price, profitability of the product, the quantity to make profit. Moreover, the problems which are many indirect cost are relevant for decision making, product decisions are not independent are also the main reasons (Drury, 2008). There are three typically cost system: direct cost systems; traditional absorption costing systems, activity-based costing systems.
Traditional costing systems versus ABC systems:
Drury (2008) indicated that both traditional and ABC systems use a two-stage allocation process. In the first stage, traditional costing systems allocate the overhead cost to all departments and then reallocate service department costs to production departments. In term of ABC systems, it assigns overheads to major activity rather than department. Consequently, many activity-based cost centres (or cost pools) are created and ABC systems will normally have more number of cost centres.
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In the second stage, overhead allocation rates are used to trace overheads to product by traditional costing systems whereas ABC systems use the term 'cost driver' (Soin, Seal and Cullen, 2002).
We can summarize the main difference of ABC to Traditional Systems are: ABC systems have greater number of cost centre and greater number and variety of second stage cost drivers. Thus, as a more advanced costing systems, ABC systems can measure the resources consumed by cost objects more accurately.
ABC systems and its design:
Drury (2008) proposed that ABC systems use both volume-based and non-volume-based cost drivers whereas traditional systems use only volume-based cost drivers. This idea is supported by Garrison and Noreen (1994), Volume-based cost drivers assume that the product's consumption overheads related directly to number of unit produced and it is only appropriate with activities which are performed each time a unit of the product or service is produced. Example of "number of set-ups and engineering orders" are non-volume-based cost drivers and they are also needed for cost allocation.
Bhimani, Horngren, Datar and Foster (2008) defined ABC systems is the costing systems focused on individual activities as the fundamental cost objects. ABC systems calculate the costs of individual activities and allocate costs to cost objects on the basic of activities undertaken to produce each product or service. An activity can be an event, task, or unit of work with a specific purpose. Another definition was given by Innes & Mitchell (1993); the fundamental principle of ABC is that overhead costs should be identified with cost objects as accurately as possible. Costs are caused or 'driven' by the various activities that take place within the business environment. Activities focused are divided into four categories: unit-level activities; batch-level activities; product-sustaining activities; and facilities-sustaining activities.
We are now going to look at ABC systems in more detail by looking at Drury's perspective and Garrison and Noreen's perspective about ABC systems design. Drury (2008) suggested that ABC systems are designed by four steps:
Identifying the major activities that take place in an organization;
Assigning costs to cost centres for each activity;
Determining the cost driver for each major activity;
Assigning the cost of activities to products according to the product's demand for activities.
He indicated that the first two steps are in the first stage and the final two steps relate to the second stage.
To begin with the first step, activities are composed of the aggregation of units of work or tasks and are described by verbs associated with tasks. Activities are identified by carrying out an activity analysis. Innes and Mitchell (1993) stated that organisations should star from examining a physical plan of the work place to indentify how all work space is being used and the payroll listings to ensure that all relevant personnel have been taken into account. A series of interviews with the staff involved or a time sheet for staff to complete explaining their time spent. Many detailed tasks are likely to be identified in the first instance, but after interviews, the main activity will appear. The activities chosen should be at a reasonable level of aggregation based on costs and benefits. The final choice of activities must be a matter of judgment but it is likely to be influenced by factors such as the total cost of activity centre and the ability of a single driver to provide a satisfactory determinant of the cost of activity. Activities with the same product consumption ratios can use the same cost driver to assign costs to products.
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Moving to second step, after activities have been indentified, the cost of resources consumed over a specific period must be assigned to each activity. The aim is to determine how much the organisation is spending on each of its activities. Many of the resources will be directly attributable to specific activity centres but others such as labour and lighting and heating costs may be indirect and jointly shared by several activities. These costs should be allocated to activities on the basic of 'resource cost drivers'. At this step, there is no reallocation of support costs.
In term of third step, in order to assign the costs of each activity cost centre to products, it is necessary to select a cost driver for each activity centre. These cost drivers are 'activity cost drivers'. The organisation should be able to explain costs in each activity cost pool. Moreover, a cost driver should be easily to measure, data should be easy to obtain and indentify with products. In 'activity cost driver', there are transaction and duration drivers. Transaction drivers count the number of times an activity is performed. However, if the amount of resources required by individual cost objects is not great, transaction drivers will measure accurately activity resources consumed. If this condition does not apply, duration cost drivers should be used. Duration drivers show the amount of time it takes for an activity.
The final step aims to apply the cost driver rates to product. Therefore the cost driver should be able to measure to be identified with each product. In addition, mechanism needed to monitor the use of one activity to the product, easier for transaction drivers and Duration drivers.
However, in a different point of view, Garrison and Noreen (1994) argued that four steps involved in the design of ABC systems are:
Process value Analysis (PVA);
Identifying activity centres;
Tracing costs to activity centres;
Selecting cost drivers.
Process Value Analysis (PVA) is systematic analyse in activities required to make a product or perform a service. It identifies all resource-consuming activities involved in a product or serving a customer and indicates these activities as either value-added or non-value-added in nature. To complete a PVA, the following actions should be taken. Firstly, managers should prepare a flowchart detailing each step to complete a product. Secondly, they should analyse each activity on the flowchart and determine whether it is value-added or non-value-added. Finally, they need to indentify how to eliminate the non-value-added activities documented on the flowchart.
Indentifying Activity Centres: The definition of Activity Centre is proposed by Garrison and Noreen (1994, p.194) as "a part of the production process for which management wants a separate reporting of the cost of activity involved". As we mentioned above, there are four general levels of activities: unit-level activities; batch-level activities; product-sustaining activities; and facilities-sustaining activities. Unit-level activities are those that arise as a result of total volume of production going through a facility. Some companies put all activities at the unit level into a single activity centre, while other use two or more unit-level activity centres (labour activity and machine activity). Batch-level activities are tasks such as the placement of purchase orders, setups of equipments, shipments and receipts. Costs of batch level are independent of the size of the batch. ABC systems recognise batch concept be the creation of a separate activity centre for each batch-level activity that can be identified. Product-level activities are activities relating to specific products. A spate activity centre is needed for each product-level activity that can be identified. Facility-level activities are usually combined into a single activity centre.
Tracing Costs to Activity Centres: where possible, organisations are likely to assign costs directly to activity centres to avoid any distortion in costing.
Selecting Cost Drivers: we should consider two factors when selecting a cost driver: the ease of obtaining data relating to the cost driver; the degree to which the cost driver measures actual consumption by products of the activity involved
Benefits and Limitations of ABC systems:
ABS systems help organisation to improve the costing systems which leads to more accurate product costs (Drury, 2008). ABC systems increase the number of cost pool to accumulate overhead costs. Moreover, ABC systems change the base used to assign overhead costs to products. ABC also changes a manager's perception of many overhead costs. To conclude, by having more accurate product costs, ABC leads to better costs control and more accurate decision making (Garrison & Noreen, 1994)
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However, ABC systems also have some limitations. Two recognised limitations of ABC systems are that it is necessary to make some arbitrary allocations based on volume and ABC systems are sometime costly with multiple activity centres and cost drivers.