Effect of Value-Added Activity Based Costing and Economic Value Measure and their impact on Process Improvement & Business Profitability Business’ profitability and processes can be greatly improved by implementing a value-added activity based costing (ABC) and economic value measure system. The effects can save a company exponentially with the additional detail ABC information provides. ABC information provides much more accurate information about the costs of existing products and the cost of implementing future products as well.
This costing method first assigns costs to activities and then to goods and services based on how much each good or service uses the activities (Hilton pg 147). ABC is common among companies looking to improve upon their more traditional costing systems. The break down of costs in ABC information is quintessential to managers for decision-making purposes. Managers can precisely estimate the cost of individual products and services so they can identify and eliminate those that are unprofitable and lower the prices of those that are overpriced (Wikipedia).
The specific detail associated with ABC information allows one to pinpoint these areas. There are 4 critical steps to determine the costs of goods and services using ABC (Hilton pg 147-158). Step 1: Identify and classify the activities related to the company’s products. Step 2: Estimate the cost of activities identified in Step 1 Step 3: Calculate a cost-driver rate for each activity Step 4: Assign activity costs to products Step 1 involves identifying the activities performed to produce goods and services.
There is a five-level hierarchy of resources and activities used to address this issue. 1)Unit-level resources and activities- resources acquired and activities performed specifically for individual units 2)Batch-level resources and activities- resources acquired and the activities performed to make a group, or batch, of similar products. 3)Product-level resources and activities- resources acquired and the activities performed to produce and sell a specific good or service. )Customer-level resources and activities- resources acquired and the activities performed to serve specific customers 5)Facility-level resources and activities- resources and activities acquired and the activities performed to provide the general capacity to produce goods and services. Traditional cost systems have high indirect, or overhead costs. The problem with this is that larger companies, which have a broad range of products and services, will have varying overhead costs for different products.
In order to reduce costs, managers are required to analyze the costs associated with products and services and see where changes can be made. By lumping all overhead costs for all products together, traditional costing systems may be “undercosting” and “overcosting” products and services. Product A may require expensive materials in order to produce the good; however, product B may require inexpensive materials for production. Traditional cost systems may put all material costs under one category, thus, painting a very inaccurate picture of material costs.
Furthermore, perhaps product B requires expensive, highly skilled labor to create the good, while product A does requires has only average labor costs associated with the production of the good. ABC systems will sort all of this data out. ABC information breaks down the specific steps with specific costs associated to each step, and moves the indirect or overhead costs into direct costs. In doing so one can now properly see the distinction of costs associated with specific products. So now when cheaper labor for product B comes along, the decision can be made accurately, whether or not to lower labor costs.
Without the proper costs aligned to the proper goods and services, the aforementioned “cheaper” labor may appear to be more expensive or the same rate as currently being used. Cost-driver rate is the estimated cost of resource consumption per unit of the cost driver for each activity (Hilton pg 153). The cost driver is a factor that creates or drives the cost of the activity (Wikipedia). Since it is more difficult to associate indirect costs to products, using a cost-driver rate can simplify the process. For example, in manufacturing machines are often used to complete tasks.
The hours in which that machine operates is the cost-driver. Once the cost-driver rate is established, assigning activity costs to specific goods and services is possible (Hilton pg 148). By assigning manufacturing overhead costs to products in a more logical manner then the traditional approach of simply allocating costs on the basis of machine hours (accountingcoach. com), ABC information is superior for cost calculations. ABC systems due have high costs for implementation though. Many companies have never switched from their traditional cost systems to ABC because of the implementation costs.
American Airlines, Hewlett-Packard, John Deere, DaimlerChrysler, Ford, IBM, and U. S. Postal Service, are among some companies that have made the transition (Hilton pg 147). In the case of the U. S. Postal Service, used ABC to decide whether to use debit cards, credit cards, checks, cash, or a combination as payment for postal transactions. ABC results indicated that for the same transaction size, debit cards were slightly less costly, and credit cards were only slightly more costly than cash (Hilton pg 161). Implementation of an ABC system allowed the U. S.
Postal Service to properly analyze costs associated with payment, and in so doing improved processes and business profitability. ABC systems add much value to a company’s profitability and improve processes tremendously. The detailed information is important for so many reasons. Appropriate costs can be associated with goods and services, which increases productivity and profitability. Even though the implementation of the ABC system can be costly, in the long run it will save money by cutting costs, and allowing managers to make better-informed decisions.
Works Cited 1. http://jobfunctions. bnet. com/abstract. aspx? docid=82444 2. http://site. ebrary. com. library. esc. edu/lib/empire/docDetail. action? docID=10046824 3. http://en. wikipedia. org/wiki/Activity-based_costing 4. http://www. accountingcoach. com/online-accounting-course/35Xpg02. html 5. http://www. answers. com/topic/activity-based-costing 6. Hilton, Maher and Selto. “Cost Management: Strategies for Business Decisions. ” 4th edition. McGraw-Hill Irwin. 2008