Critical discussion on the way ABC operates with regards to pools, drivers, and activity hierarchies
Activity Based Costing (ABC) is one of the costing techniques in accounting that business enterprises utilise to accumulate data concerning their various operational activities. Costing could be a simple exercise if only the direct and indirect costs are taken into consideration while calculating the price of a product, but all kinds of costs can not be added up to come up with the final price of a product. For example, salaries of managers and other executives can not be added up to come up with the price of a specific product especially when it is a large organisation producing several products.
Leitner (2004) asserts that in activity based costing; an enterprise identifies various activities and assigns each of the activity with a cost. This implies that the method allows business enterprises to allocate cost to products and services based on the actual resources consumed by each transaction or activity undertaken by the firm in the course of producing the service or the product.
According to Lal and Srivastava (2009), activity based costing involves a number of steps. The first step is to identify significant activities in the organisational operations that consume resources and assign the relevant costs associated with these activities. The activities for example may be purchasing of materials for a manufacturing firm, assembling, and material handling among many others. The activities are then assembled into activity cost pools. According to Wilks and Burke (2008), activity cost pools are normally a group of costs that an organisation incurs when it undertakes or performs similar operations. By grouping together costs that are related when performing organisational activities, this helps in assigning costs to relevant products hence helping in getting correct approximations of production costs. This is crucial in ascertaining the profitability or performance of a company’s products hence enabling managers to make balanced production assessments.
The second step in activity based costing involves identifying the factors that determine the costs of an activity known as cost drivers. A cost driver is an activity or a factor such as the level of an activity or volume that casually affects costs over a given time span. A cost driver normally creates a cause and effect correlation between the change in the activity’s level or the volume and a change in the level of the total costs of an object. The cost drivers serve as links. They link a pool of costs in an activity centre to the product thus facilitating the tracing of overhead costs to products. In this sense, the activity based costing enables an organisation to use multitude of cost drivers that relate costs more closely to the resources consumed.
It is clear from the foregoing discussion that ABC entails a two-stage procedure. In the first stage, the costs of resources are allocated to form cost pools. The cost pools are then allocated to cost objects on activity consumption basis. To differentiate between the two stages and avoid random allocation of costs, both the activities and the cost objects are put in a hierarchy where each level consists of unlike activities. The grouping of activities is done using different levels at which activities are performed for example unit level activities, batch level activities, product level activities and facility level activities in case of a manufacturing firm. Under ABC system, facility level activities and costs are treated as period cost, as they are found difficult to assign to different products. The costs associated with the first three categories unit level, batch level and product level are assigned to products, using cost drivers that reflect the cause and effect relationship between consumption and cost
Kinds of firms/products that can use ABC
Browning (2012) asserts that although ABC is commonly used by manufacturing organisations, any company in converting resources and capital into services and products can actually utilize the method. The technique can be used in government entities, services firms and other non-manufacturing companies. The most important fact that any firm should take into consideration before employing the method is its ability to identify and quantify the costs of all its process and activities. The philosophy of ABC emphasizes that the resources of an organisation are usually consumed by the activities it engages in. Therefore, organisations that make use of ABC are those ones with a large amount of overhead costs related to diverse activities that they engage in in order to provide goods and services to the customers with different demands as well.
According to Krumwiede (1998), there are four factors that determine the users and the non-users of activity based costing. First is the potential cost of distortions. A firm with a high amount of distortion cost is motivated more to utilize ABC compared with the one with low distortion costs. This is attributed to the fact that cost distortions have a very big influence on the firm’s many significant decisions such as the analysis on profitability. The second factor according to the author is decision usefulness of cost information. Implementing and maintaining ABC systems is costly, unless a firm uses the information from ABC for better decision-making process ABC cannot be implemented. The third factor is lack of system initiatives. Without a good system, it will be impossible for any firm to implement and utilize ABC. The fourth factor that determines the kind of a firm can use ABC is the size of the organisation. Larger organisations that deal in several products and service resulting in complex operations would make use of ABC as opposed to small-sized enterprises.
Evaluation of the extra commercial value of using ABC in comparison with standard absorption costing
To manage business costs properly, one must have a fully understanding of all the activities that are utilized by the business in creating its products and services. Activity based costing provides a mechanism through which the business enterprise can effectively analyze and understand all its business costs as opposed to absorption costing. This is because the method enables the firm to measure accurately all the cost as well as the performance of the activities, objects and the resources that use them thus enabling the generation of correct information required for decision making process. The modern business is very complex, dynamic and turbulent and thus presuming that overhead costs can be allocated only on volume basis can result to generation of inappropriate information. Most business has many cost drivers a number of which are based on every day transactions than just the volume of activities. Therefore, all relevant cost that can be traceable to a product should be calculated and considered in pricing the firm’s products and not just total direct costs and overheads related to manufacturing costs, as is the case of absorption standard costing. Determination of product costs based on activity based costing is reliable and correct since it enables a firm to focus on the effect and association of activities and cost in pricing its products. The method also enables an organisation to develop proper mechanisms in determination of the selling price for multiple products.
The main developments in ABC theory from 1988 to date
Activity bases costing has come a long way from being a costing methodology to a management style that aims to reduce waste. The evolution of activity based costing can be studies in 4 different phases. The first phase was in 1980 when the characteristics of this costing system were present in some systems, however the approach was not identified and given its name. These systems were just considered sophisticated and were used for financial purposes and not for strategic purposes.
The phase 2 of the evolution of this system was between 1980-1985 when the approach was identified and it got an identity. The difference between ABC and the traditional costing was highlighted. However, the method still did not have a structure yet. The method got acceptance as a method that provides good insight, but is still used for financial reporting.
The third phase which started after 1985 accepted that ABC could be a very important business decision making tool that provided important strategic insights. This phase also witnessed database technology being used to make the approach practical.
The last phase of ABC was after 2000 when it was integrated with performance management. The approach was studied in depth and both, similarities and differences were recognised between factors responsible for performance and the main cost drivers. The phases provided a way to link costing, performance management and investment rationale.
Currently, the method has gained notoriety and is employed both in private and public organisations. This is because of today’s competitive, dynamic and turbulent business environment that requires relevant and reliable cost allocating systems among various organisations. In such an error, the vital cost factors have significantly changed from costs such as material costs or labor costs into indirect costs such as administration and set-up costs. This has necessitated the need for ABC systems, which provides the mechanism through which business enterprises break their various overheads in order to allocate them to the products or services that incur them. The ABC system enables an organisation to create a greater number of cost centers with different cost drivers that are accumulated to products in the percentage of usage of an activity hence avoiding distortion.
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