Activate Based Costing's Competitive Edge - Case Study Example

Activate Based Costing’s Competitive Edge Introduction Cost reductions with the help of research-oriented manufacturing and other processes have created an atmosphere of fierce competition in arenas of business and commerce. Increasing global competition is causing upheaval in every area of industry and commerce. The use of advance technology is revolutionizing the way to do the business. These factors are exerting tremendous pressure on profit margins. The effect has been to substantially change cost structures with their traditional focus on direct labor and arbitrary allocation of overheads over products and services. Traditional arbitrary allocation of indirect costs often results into excessive costs being charged to high- volume products and insufficient cost allocation to low- volume products. This results into increased demand for the under costed (and thus under priced) products, and reduced demand for over costed (and thus over priced) products. Activity Based Costing (ABC) offers corrective measures to plug this limitation of traditional costing, so that unhealthy and artificial competition paves way for competition resulting from techno-advanced manufacturing and other processes. ABC does provide an extra dimension and approach with businesses to compete effectively and efficiently. Contents Introduction The ABC technique Decision making through ABC Improvement over traditional costing Conclusion The ABC technique Activity Based Costing (ABC) is primarily concerned with absorption of indirect costs in an organization having products that differ in volume and complexity of production. The crux of ABC is in accurately assigning the overhead costs to end products. The traditional costing does not serve effective purposes of product costing and pricing decisions. ‘Activity Based Costing is used to identify, describe, assign costs to, and report on agency operations. A more accurate cost system than traditional costing, ABC identifies opportunities to improve business process effectiveness by determining the “true” cost of a product or service.’1 ABC is a method of cost attribution to cost units based on benefits received from indirect activities. The reason for such a basis is that products themselves do not consume resources directly rather several activities are required to be performed for them, and these activities consume the resources of organization as driven by cost drivers (activities generating cost). Thus, overhead costs of organization are identified with each activity, which is acting as a cost driver, i.e., activity for incurrence of the overhead cost. After identifying the overhead cost with each cost center, the cost per unit of cost driver can be ascertained and cost assigned to jobs based on number of activities required for their accomplishment. Thus, ABC serves as a basis for product costing besides aiming for managing overhead cost. The characteristics of activity based costing can be summarized as follows: a) It identifies the cost centres or cost pools to accumulate overhead costs. The number of cost pools depends upon the cost driving activities. Thus, instead of accumulating overhead cost in a single company wise pool or departmental pools, the costs are accumulated by activities. b) It charges overhead costs to different jobs or products in proportion to the cost driving activities in place of a blanket rate based on direct labor cost or direct hours or machine cost. c) It improves the traceability of the overhead costs, which results in more accurate unit cost data for management. d) Identification of cost during activities and their causes not only help in computation of more accurate cost of a product or a job but also eliminate non- value added activities. The elimination of non- value added activities would drive down the cost of the product. This in fact is the essence of activity based costing. Decision making through ABC Competition forces businesses to seek awareness about the following facts that: 1. Business must be able to provide products or services at lower price than the prices of competitors. 2. The inflation-affected cost of product must continuously decrease through an in built costing process. 3. The knowledge about exact costing and profitability of each product or service establishes basis to plan strategies in face of stiff competitions. 4. Fixing competitive pricing enhances cash flow generation, so necessary for perpetual existence of the business. These facts involve strategic decision making about costing of each product or service. Cost cutting is often an area of decision-making that can start a cycle of decay if the correct decisions are not made. Cost cutting should create a competitive edge. Here the role of activity based costing is most important. Activity based costing is so resourceful that decision- making in face of competition is immensely assisted by its applications. Under noted examples will prove the point in this respect. a) Activity based costing system targets a more clear delineation. A B C provides the costs of resources used to perform activities or services in fulfillment of business function. ABC system models how activity usage and thus cost varies with changes in demand of the product or service, while traditional costing expresses only the relationship between so called fixed cost (overheads) and associated product activity. b) In decision-making process, all costs should be considered product costs. Fixed cost need be viewed either as bedrock fixed cost or manageable fixed cost. The management does not have control over first category of fixed costs; but manageable fixed costs has the ability to influence cost patterns over an extended period once the structure of cost is understood. The application of ABC assists the management to restructure the manageable fixed cost because ABC identifies unused resources and capacities. On basis of this information through ABC, the management can decide to either optimize the use of a resource, reduce cost or eliminates it. c) ABC is useful in analyzing specific segments of an organization. This might include a market line, a group of products (even a single product), a customer or an employee. The management can work out on any of the inefficiencies of such segments and thereby an effective cost management can bring an extra competitive edge. d) Introduction of new products might add to the variance of overheads. For example, the need for an additional storage capacity or the need of new handling equipment will increase overall operational costs. These costs when spread over the product line, using traditional costing system, will not only reduce margins on existing products but also reduce the cost impact of the new items. Such disparity can be corrected by using activity based costing system. ABC correctly reflects the cost burden created by the new products. This allows the existing products to retain their merits; and allows new products to justify their introduction. e) The decisions about relocation or opening of new distribution centres can be highly facilitated when activity based costing system is in operation. For example, the extra rental overheads of new establishments can be offset by reduction in freight or other logistics costs. f) Decisions about human resources can also be facilitated a lot by activity based costing. Adding or deleting human resources can be determined based on costs of activities. Activity costing provided through ABC can present a number of options like outsourcing, productivity improvements through automation, and determination of employee/ revenue ratios. Improvement over traditional costing ‘Activity based costing (ABC) addresses internal operating concerns and is an augmentation to the traditional General ledger based cost management system. It is not replacement for traditional accounting, but use of source documents provided from standard job costing system’2.The extra competitive advantage of ABC over traditional costing is evident from its competitive features described hereunder: a) Effectiveness of purpose: The objectives of product costing and pricing decisions are more effectively served by adopting ABC system. ‘ABC is a powerful tool for industrial marketers in three ways: yielding cost estimates to use in pricing that reflect significant differences among product specifications; providing the industrial marketer as to which product specification may be adjusted in negotiations to yield significant cost reductions; and indicating areas in which to change company operations to yield cost reductions that will allow the company to satisfy customer wishes better’3 b) Basis of identification: Under ABC system, overhead costs are identified to each major activity instead of the department as under traditional costing system. It results into greater number of cost centres, which provide more flexibility and accuracy in cost absorption to a product or service. c) ABC system uses separate rates for support centres and there is no reallocation to production centres, as is the case under traditional costing system. This is primarily because cause and effect relationship is considered under ABC system to identify support cost objects. Conclusion Activity based costing is a management tool that structure costing data fundamentally different from traditional costing system. By associating cost to the activity, a relationship between the costs and related source activity is established. This association of costs and source activity enables the management to prepare strategies to face available marketing competition. The management can evaluate the production, distribution, and marketing costs with reference to generated revenue. ABC system is definitely more scientific because it produces more accurate product cost, so necessary to establish competitive pricing. ABC is more appropriate when competition is fierce, enterprise produces varied products, and when overhead cost assume a large proportion of total cost. Costing analyzed through activity based costing system provides numerous opportunities to improve upon the product or service cost and presents the organization in high esteem in competitive market. References 1 Activity- Based Costing (ABC) Accounting For Operational Readiness, page 2, A Concept Paper From OSD Comptroller I Center, http://www.defenselink.mil/comptroller/icenter/learn/abconcept.pdf 2 Activity Based Costing: A concept whose time has come, page 1, by Simon Decker, Barry A. Knight, and Sandy Zingo, http://www.dekkerltd.com/library/ABC02AAAfinal.pdf 3 Activity- Based Costing: a powerful tool for pricing, Lere J.C., http://www.ingentaconnect.com/content/mcb/080/2000/00000015/00000001/art00002 Read More