Activity Based Costing - Essay Example

Activity Based Costing Activity Based Costing Introduction "Activity Based Costing (ABC) is a method for developing cost estimates in which the project is subdivided into discrete, quantifiable activities or a work unit" (Doe. G. 1997) Activity Based Costing (ABC) is a common procedure normally most of the organizations adopted to determine the price of their products or services. Both indirect and direct costs of manufacturing will be considered while calculating the unit price. This method proved to be an effective way to determine the true cost of a product or service. The manufacturers or service providers can avoid manufacturing of unprofitable products and also they can lower the price of their overpriced products or services using this method. But it is not necessarily that every time the ABC method will bring the positive results alone or in other words the success rate of activity based costing may not be 100% all the time. In this essay, the methodology of ABC, its positives and negatives are all discussed in a brief manner. Activity Based Costing. "Let's discuss activity based costing by looking at two products manufactured by the same company. Product 124 is a low volume item which requires certain activities such as special engineering, additional testing, and many machine setups because it is ordered in small quantities. A similar product, Product 366, is a high volume product-running continuously-and requires little attention and no special activities. If this Activity Based Costing 2 company used traditional costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product 124, because it did not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The result will be a miscalculation of each product's true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine" (Introduction to Activity Based Costing, 2004) Each manufacturing units will have often different products. The consumer demand for some of their products may be high while some other products of the same company may not be popular in the market. For example, a tire manufacturing company, most likely to manufacture tires, for passenger cars, trucks, aircrafts and motor bikes etc. It is not necessary for them to have all their products moving in the market equally well. Suppose the car tires manufactured by the company moving excellent, the truck tires moving good, the motor bike tire moving fair while aircraft tires moving poorly in the market. Because of the variations in demand the volume of the production of different tires will be adjusted by the company. The company will allocate more resources to the passenger car tire building compared to other types of tires. The technology and resources required to manufacture the aircraft tires is more complicated than the others. Lot of complicated processes is involved in the manufacturing of the aircraft tires though its movements in the market are dull. Mostly Activity Based Costing 3 because of the less movement in the market, only few machine activities will be allocated to the aircraft tire by the company. So if the company calculates the price of the tires based on the machine activity alone, the aircraft tire price must be less compared to others because of less machine activity. But since ABC considers all activities related to the manufacturing of a product, both direct and indirect, fixed cost and variable cost, etc, the company can determine the price of each product logically. If enough demand is there, mass production of product can effectively cut down the unit price of the product. China has successfully implemented such a strategy of mass production and thereby they are able to compete in the international market effectively by lowering the price of their products compared to their competitor's price. In the above example, most probably because of the less demand and higher technology and processes involved, the aircraft tires may be higher priced than their competitor's price based on the ABC. But since most tire manufacturing companies consider aircraft tire manufacturing as a prestigious project, the ABC method of cost calculation will definitely put them on the defensive in the market. In such cases the companies will be forced to neglect ABC and will put a competitive price for the aircraft tires based on the competition in the market to keep their reputation, even if such pricing may result in loss. "For our simple two-activity example, let's see how the rates for allocating the manufacturing overhead would look with activity based costing and without activity based costing:" Activity Based Costing 4 With ABC Without ABC Mfg overhead costs assigned to setups $200,000 $-0- Number of setups 400 Not applicable Mfg overhead cost per setup $500 $-0- Total manufacturing overhead costs $2,000,000 $2,000,000 Less: Cost traced to machine setups 200,000 -0- Mfg O/H costs allocated on machine hours $1,800,000 $2,000,000 Machine hours (MH) 100,000 100,000 Mfg overhead costs per MH $18 $20 Mfg Overhead Cost Allocations $500 setup cost per batch + $18 per MH $20 per MH (Introduction to Activity Based Costing, 2004) Activity Based Costing 5 "Next, let's see what impact different allocation techniques and overhead rates would have on the per unit cost of a specific unit of output. Assume that a company manufactures a batch of 5,000 units and it produces 50 units per machine hour, here is how the cost assigned to the units with activity based costing and without activity based costing compares:" With ABC Without ABC Mfg overhead for setting up machine $500 $-0- No. of units in batch 5,000 Not applicable Mfg O/H caused by Setup - Per Unit $0.10 Not applicable Mfg overhead costs per machine hour $18 $20 No. of units produced per machine hour 50 50 Mfg O/H caused by Production - Per Unit $0.36 $0.40 Total Mfg O/H Allocated - Per Unit $0.46 $0.40 "If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here is how the cost assigned to the units with ABC and without ABC compares:" Activity Based Costing 6 With ABC Without ABC Mfg overhead for setting up machine $500 $-0- No. of units in batch 50,000 Not applicable Mfg O/H caused by Setup - Per Unit $0.01 Not applicable Mfg overhead costs per machine hour $18 $20 No. of units produced per machine hour 50 50 Mfg O/H caused by Production - Per Unit $0.36 $0.40 Total Mfg O/H Allocated - Per Unit $0.37 $0.40 (Introduction to Activity Based Costing, 2004) From the above statistics it is clear that ABC can effectively reduce the unit price of the product by considering all the activities involved in the manufacturing process. Here the machine setup cost is spread over the units and deducted from the total manufacturing cost and hence the cost per machine hour (MH) is less compared to a cost calculation of MH without ABC. The less MH will result in less unit price of the product and hence the ABC calculation method can help the manufacturers to determine the actual price of their product and hence they can compete more vigorously in the market with less price for their product compared to a competitor whose price Activity Based Costing 7 analysis of the similar product is not on the basis of ABC. In the above example only two activities, production and setup are considered. Since a manufacturing process normally involves lot of other parameters, a more comprehensive analysis of such parameters based on the ABC may result in determining more accurate prices to the product. Such detailed analysis of the expenses of production will definitely help the managers in controlling the expensive parameters as far as possible to ensure the cost effective production. "Activity based costing has grown in importance in recent decades because (1) manufacturing overhead costs have increased significantly, (2) the manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours, (3) the diversity of products and the diversity in customers' demands have grown, and (4) some products are produced in large batches, while others are produced in small batches."(Introduction to Activity Based Costing, 2004). The cost of a product or service will normally be based on the supply demand theory of economics. The higher demand and less supply will result in higher price while less demand and higher supply will effectively reduce the price. Because of the advanced technologies and changing demands of consumers, the manufacturing overheads are increased a lot. The consumers are more quality conscious now compared to ancient customers. The old customers never bothered about the additional facilities or features of their product. For example the use of a mobile phone was simply to contact others just like the ordinary telephone. But for the new consumers it is more that. They are using mobile phones for taking photographs, for video recording, for surfing internet, etc. Since more and more Activity Based Costing 8 parameters have to be incorporated to a product, the overheads also will increase. Even the traditional packing methods are not acceptable to some consumers because of the changing trends. More and more advertisements are required nowadays to market the product well. All such parameters are the deciding factors of the actual price of the product based on the ABC. From the above discussion it is clear that the customer has to pay more than the real value of the product. They have to pay for the advertisements, unnecessary packing methods etc. Some manufacturers will use lot of unnecessary advertisements for their products and will add such costs to the unit price of the product. For example, the jewelers normally spent millions of dollars for the advertisements of their product using celebrity ads. Such huge expenditure on advertisements will finally result in either higher price or less quality of the ornaments. In either case the ABC method ultimately will result in damages to the consumers. The offers or complements offered to the purchase of a product also will result in ultimate loss for the customers since all such expenditure will be added to the unit price of the product as per the ABC. Most of the consumers may not be aware of the hidden agenda behind the slogan "buy one and get one free" Some manufacturers use attractive and expensive packing methods to attract the consumers. They believe that some segments of consumers are more concerned about the packing methods. For example, the packing of ornaments in small attractive boxes with velvets inside, vacuum extruded packing materials, etc; all will result in the increased unit price of the product. The packing of perfumes in expensive bottles which Activity Based Costing 9 are exclusively designed to keep the brand images is another example where the poor consumers forced to pay for the useless items. A consumer will use only the perfume inside the box and he will never use the bottle in any way. Thus the consumers are forced to pay for the useless packing materials because of the activity based costing method. A country where the labor cost is high, the product cost also will go on the higher side as per the ABC compared to other countries where the labor cost is less. Countries like India and china have ample labor forces in both skilled and unskilled sector and hence the wages or labor cost will be less compared to other countries like US or UK. Most of the major corporate companies have now targeting India and china for their operations simply because of the ample labor force and infrastructure facilities there. For example the unit price of a NOKIA mobile phone will definitely come down if it is produced in India or China compared to the US or UK. So ABC method is hugely dependent on parameters like infrastructure and labor availability. The price of the same product can vary based on ABC, if it is produced in different countries "The drawback of implementing ABC is that it requires time and resources to implement it properly. ABC entails the complex task of identifying discrete activities and identifying the measure of output for each of these activities. Each activity also needs to be classified as either 'value-added' or 'non-value-added.'' Value-added activities are activities that add value to the product or service that the customer is willing to pay for.' Thus, all steps required to manufacture a product or enhance its quality or reliability are value-added activities.' On the other hand, non-value-added Activity Based Costing 10 activities are activities that do not contribute any value to the final product, and are other activities that the customer doesn't really want to pay for.' Staging of products and unnecessary inspection are examples of non-value-added activities. Non-value added activities, in general, must be eliminated if possible. (Activity-Based Costing (ABC), 2005) The main drawback of activity based costing is it's over dependence of non value added activities. The customers are forced to pay for the items which are not relevant or useful to them as per the activity based costing method. Unnecessary inspections of the product which again will result in increased unit price will also considered in the final calculations of ABC. The utility of the product remains in the elimination of non value added elements while in the production and marketing, as far as the average consumers are concerned. 'The other criticisms against ABC are; More time consuming to collect data, Cost of buying, implementing and maintaining activity based system, Makes waste visible which some executives and managers don't want their boss to see' (Activity Based Costing'Advantages & Disadvantages, 1984) The process of ABC is more complex and hence its implementation is time consuming. Since it is an activity based system, the cost is directly proportional to all the activities in the process of manufacturing. The scrap or waste coming out of the manufacturing process is also accountable as per this method which is actually not an impressive factor for the managers. Activity Based Costing 11 Conclusion Activity based costing gives better understandings of overheads, easily understandable, accounts for all the materials used and unused and hence supports performance management etc. The ABC can effectively raise the competing capacity of a manufacturer or service provider in the market since it calculates the real cost of the product. The main criticism against ABC is the involvement of non value added parameters in the calculation of the price. The consumer has to pay even for the lack of resources such as lack of infrastructure and labour power. They are also forced to pay for the expensive advertisements and packing methods. Irrespective of all such criticisms, ABC is believed to be the most reliable method of determining the actual price of a product to compete in the market. Activity Based Costing 12 References 1. Introduction to Activity Based Costing (2004), Retrieved on 19/1/2009, http://www.accountingcoach.com/online-accounting-course/35Xpg01.html 2. Doe. G. (1997), Activity Based Costing, Chapter 24, Retrieved on 19/1/2009, http://72.14.235.132/search'q=cache:6LIVm_MZ1X0J:www.directives.doe.gov/pdfs/doe/doetext/neword/430/g4301-1chp24.pdf+activity+based+costing+example&hl=en&ct=clnk&cd=2 3. Activity-Based Costing (ABC)(2005), Retrieved on 19/1/2009, http://www.siliconfareast.com/abc.htm 4. Activity Based Costing'Advantages & Disadvantages (1984), Retrieved on 19/1/2009, http://www.valuecreationgroup.com/activity_based_costing_advantage_disadvantage.htm Read More