The management of costs remains pertinent to the successful operation of any company. To achieve a competitive edge a company must consistently improve their service or product quality, lower their service or product costs, and eliminate services or products that incur profit losses. Using a traditional costing system the portion of overhead costs allocated to the production of a service or product is determined by the total of direct labor hours used in production of the service or product. Companies implement refined cost allocation systems such as the activity based costing method with the intention of helping management strategically plan because these systems provide quality information to help management make informed decisions.
In this essay, I will examine the use of cost allocations, the activity based costing method, and how companies can implement and benefit from activity based costing.
The allocation of costs serves four primary purposes throughout a company. The first is to present the information management needs to make an informed decision.
The second is the reduction of non-essential uses of common company resources. The third is to encourage management to assess the efficiency of services provided internally. Finally, the fourth reason is the calculation of the “full cost” of a service or product to be used in price determination and financial reporting (Jiambalvo, 2009).
Cost allocation consists of three steps. The first step is the identification of the cost objective. Here it is established which service, product, or individual department needs costs allocated to it. The second step is the formation of individual cost pools. A cost pool is a collection of similar costs that is assigned to an individual allocation base. Finally, the third step is to select an allocation base that relates each cost pool to a cost objective. Ideally, each allocation base should share a common characteristic with all of the cost objectives, and should correlate each cost with the individual cost objective that produced the costs (Jiambalvo, 2009).
According to Jiambalvo, when indirect costs are fixed or a cause and effect correlation is not feasible the following approaches are used: the relative benefits approach, the ability to bear costs approach, and the equity cost to allocation approach (2009). The relative benefits approach states that the allocation base should result in more costs being allocated to the cost objectives that benefit the most from incurring the cost (Jiambalvo, 2009). The ability to bear costs approach states that the allocation base should result in more costs being allocated to products which are more profitable (Jiambalvo, 2009). Finally, the equity cost approach states that the allocation base should result in allocations which are fair and equitable (Jiambalvo, 2009).
Three main approaches are used for cost allocation: the direct method, the reciprocal method, and the sequential method. The direct method is the most commonly used method. Additionally, the direct method is the simplest method because it ignores service department costs that are provided to another service department. For instance, the janitorial department would not allocate costs to other departments for their services. Interdepartmental expenses would be bypassed as all costs would be allocated directly to each operating department. The sequential method distributes interdepartmental costs to other service departments in a chronological manner always moving forward never backwards. Typically, the “sequence” begins with the service department that is responsible for the largest quantity of services to the other departments and continues to the department that has provided the smallest amount of services to the other departments. However, the sequential method only partially accounts for interdepartmental services. Finally, the reciprocal method fully accounts for interdepartmental services. Using this method the actual cost of individual services is calculated and then dispersed to each department based on the percentage of usage.
The use of cost allocations can present several problems. The problems are incurred when cost allocations are not controllable, when arbitrary allocations are present, the fixed cost allocations make the fixed costs look as if they are variable costs, when manufacturing overhead allocations to products employ insufficient overhead cost pools, and when only volume related allocation bases are used (Jiambalvo, 2009).
The activity based costing method categorizes the foremost activities responsible for the production of overhead costs. Each individual resource cost expended during the execution of these activities is categorized into a cost pool. Each of these costs is allocated to an individual product using a cost driver that is a measure of the activity (Jiambalvo, 2009). A cost driver can be defined as “units that are used to causally assign and trace indirect and shared resource expenses related to activities” (Cokins & Capusneanu, 2010). The appropriate selection of a cost driver offers several benefits for a company such as cost control and the reduction of activities that do not add value.
The major overhead activities such as assembly, machining, and inspections are individually identified and traced to the service or product using a cost driver like the quantity of parts, machine hours, or quantity of inspections. The quantity of the overhead costs that is allocated to a service or product is dependent upon the quantity of parts, quantity of machine hours, or quantity of inspections. Selected activities can be associated with production volume; however, not all costs are associated production volume. The four steps used in activity based costing are: (1) the identification of major activities, (2) the grouping of activity costs into cost pools, (3) the identification of cost drivers, and (4) the relation of costs to products using the cost drivers (Jiambalvo, 2009).
Advantages of using Activity Based Costing
Several benefits exist with the use of activity based costing. According to Jiambalvo, the primary advantage of using activity based costing is that it “is less likely than traditional costing systems to under cost complex, low-volume products and over cost simple, high-volume products” (2009). The cause of this benefit is that activity based costing employs additional cost drivers in the assignment of costs, and these cost drivers aren’t always associated with production volume. Using activity based costing may also
lead to “improvements in cost control” (Jiambalvo, 2009). The cost improvement can be attributed to the specific information on production costs available to managers when activity based costing is utilized. Activity based costing provides a breakdown of company costs allowing management to prioritize cost management strategies. A study performed by Stratton, Desroches, Lawson, & Hatch observed that respondents found several benefits using an activity based costing system (2009). Among these benefits is that an activity based costing system delivers “greater support for financial, operational, and strategic decisions”, and that activity-based costing systems “alleviate managers’ concerns regarding the accuracy of cost allocations, the cause-effect relationship between allocations and resources consumed, the timeliness of cost/profit information, and the capability to update systems” (Stratton et al., 2009).
Disadvantages of using Activity Based Costing
A leading drawback of using activity based costing is the expense incurred to properly implement the system when compared to the cost to implement a traditional costing system. Additionally, the set-up is time consuming and hard to make adjustments to. When compared to traditional costing systems activity based costing is also more costly to maintain and develop (Jiambalvo, 2009). Furthermore, using activity based costing can be limited because it is used in the development of full product cost. Jiambalvo asserts that “because full cost includes allocations of costs that are fixed, the cost per unit generated by the activity based costing system does not measure the incremental costs needed to produce an item” (2009). Moreover, Wegmann asserts that “a lot of failures have been compiled, especially in the service industries” and that “a lot of people think that the ABC method is too complex” (2009).
Steps for Successful Implementation of Activity Based Costing
According to Velmurugan & Nahar, nine steps are needed to successfully implement activity based costing that will vary slightly dependent upon the type of software the company has chosen (2010). Step one is to identify and assess activity-based costing needs by determining if it is feasible for use within the organization by addressing issues like the accuracy of the
current system in place. Step two is to fulfill any training requirements for team members who will be implementing the new system. The use of courses or workshops is needed to ensure a firm understanding for employees. Step three is to define the scope of the project. Team members and management should evaluate the objectives of the mission and bring together all of the needed elements. Step four is to identify the individual activities and drivers. Careful consideration should be taken to locate what drives a specific process or activity. Step five is the creation of operational and cost flow diagram that summarizes the use of resources in the performance of activities, how the process produces the good or service. Step six is the collection of data such as man hours or machine usage. Step seven is to enter the data and the relationships obtained into activity-based costing software. Step eight is to interpret the results into meaningful information usable to management and employees. Finally, step nine is to integrate the results so as to allow management to make use of the results in the future.
In conclusion, earlier cost allocation methods such as the direct method, the sequential method, and the reciprocal method are not as effective at measuring the true cost of production. Activity based costing results in the precise determination of product or service costs, and is a useful tool for the management of costs and performance improvement. When properly used activity based costing provides valuable information to management to make informed decisions on product costing and the discontinuance of unprofitable products or services. However, to be successful the system in place must be flexible because rigid rules for allocation will most likely not be beneficial. The assignment of costs to factors that were previously unmeasured will help in the identification of which company goals and objectives are unprofitable.
Cokins, G., & Capusneanu, S. (2010). Cost drivers. Evolution and benefits. Theoretical & Applied Economics, 17(8), 7-16. Retrieved from
http://www.ectap.ro/?ver=en&id=73&rid= Jiambalvo, J. (2009). Managerial Accounting. Hoboken, NJ: John Wiley & Sons, Inc. Stratton, W. O., Desroches, D., Lawson, R. A., & Hatch, T. (2009, Spring). Activity-based costing: Is it still relevant?. Management Accounting Quarterly, 10(3), 31-40. Retrieved from http://www.imanet.org/resources_and_publications/management_accounting_quarterly.aspx The Activity Based Costing Portal. (2002). http://offtech.com.au/abc/Home.asp Velmurugan, M., & Nahar, W. (2010, September/October). Factors determining the success or failure of ABC implementation. Cost Management, 24(5), 35-46. doi: 2160357261 Wegmann, G. (2009, January). The activity-based costing method: Development and applications. ICFAI Journal of Accounting Research, 8(1), 7-22. Retrieved from http://www.iupindia.org/ijar.asp
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