The Difference between the Traditional Cost Systems and Activity Based Costing - Essay Example

?Running Head: Management Accounting Management Accounting [Institute’s Management Accounting Product cost is the total of costs associated with direct materials, direct labor, and manufacturing overhead used in making a product. However, simple as they may sound, product costs are very important to make crucial decisions related to a product. As important as product cost is, it is quite difficult to calculate it because of the fact that they are not the only costs that the company incurs. Apart from these, a company incurs many indirect costs as well. Human resource, IT-support and other administrative and management costs are all examples of these (Broadbent et al., pp. 20-25, 2003). The type, number, or volume of the products does not directly drive these costs. Several costs even within a factory are questionable for the same reason. Moreover, substantial material vendors and customer also impel quite a few costs. “In fact there is no single correct (product) cost figure” (Walker, 22, 1999). Costs centers hold records of the financial transactions of the organizations, which they use to calculate their product costs. Several methods for this exist where different organizations may employ unique methods. The simplest of the aforementioned methods for product costing, employs only direct costs. Earlier, labor costs received greater importance. Companies carried out everything manually. The number of employees involved dictated the output volume. Then came the time when machines began to substitute labour in production. This progress posed a problem to the prevailing costing method because most of the machine costs are depreciation costs and are not comparable to direct labor costs (Fritzsch, pp. 83-89, 1997). Organizations and experts highlighted several more weaknesses of the traditional accounting system because it was not compatible with the development of the new business methods. To overcome the weaknesses of the simple product costing method, accounting experts introduced standard costing. Standard costing method uses Bill of Material (BOM) and the capacity demand of the product to calculate the product cost. To calculate direct costs, the accountant considers raw material costs and labor costs, as incurred per unit of production. Whereas, to calculate indirect costs, they use the product of multiplier factors (predetermined rates) and the direct costs (Broadbent et al., pp. 31-37, 2003). Although standard costing is an easy and appropriate way for actual cost follow-up, it may lead to inappropriate decisions when used erroneously in future planning. The basic issue with standard product costing is that it does not provide sufficient information to facilitate the user to control the overheads and other indirect costs related to the product. For instance, accounting experts express the production overheads multiplier as an additional percentage of the product direct cost. Recursive calculations from past accounting figures drive this value and it usually allows a rising trend for overheads when managers use it as a standard for a new product (Shank & Fisher, 77, 1999). Having seen the drawbacks of simple and standard costing systems, experts in the field have been attempting to formulate generic costing methods since decades. For example, traditional costing methods include only the manufacturing costs in the total unit cost of each product. However, the new concepts in cost management require the accountants to cross the usual limits of product costing methods by applying all organizational costs in a more applicable and informative way and attaching them to cost objects such as a process, product, customer etc (Broadbent et al., pp. 41-48, 2003). The design of such advance cost management system (ACMS) requires companies to integrate the new concepts practically in the business processes and operating systems (Schnoebelen, 52, 1993a). ‘Activity-based costing’ is one of such advance cost management systems. Activity based costing technique is a way of assigning product costs based on the activities that take place for the production. What accountants do is that they match the resources of business with the activities that the people perform. First, all the tasks are listed and then the required resources and personnel are identified to perform each task. Now to calculate product cost, accountants identify the extent of each activity that a product consumes and measure the cost accordingly (Garrison & Noreen, pp. 20-39, 1999). Different products consume different levels of each activity. For instance, a product that the company manufactures may require many trials before it is finally ready to be produced in bulk, and the same product may require a lower level of engineering based activities. The other product that company produces might not require many trials but may require lot of engineering activity. In scenarios like these, activity based costing traces the exact level of activity that each product utilizes and then it allocates only the cost that company incurs to get recourses needed to perform that exact level of activity. It emphasizes on controlling the activity i.e. the processes rather than the individual cost elements. Because controlling the activity will direct the way to improve the efficiency and effectiveness of the activities and these activities will lead to better product costs (Garrison & Noreen, pp. 20-39, 1999). A comparison between two business models can better highlight the problem that activity based costing offers to resolve. Consider two imaginary plants producing a simple product, cardboard sheets. The factories are of similar size having the same equipment. Every year, Plant A makes three million white cardboard sheets. Plant B also produces white cardboard sheets, but only 300,000 per year. Besides that, plant B produces a variety of similar products: 180,000 pink cardboard sheets, 36,000 blue cardboard sheets, 30,000 black cardboard sheets, etc to fill the plant, keep the work force busy, and absorb fixed costs. In a typical year, Plant B produces up to 3,000 product variations with volumes ranging between 1500 and 300,000 units. The total yearly output is the same amount as the three million units produced by Plant A, and the plant produces it using the same quantities of material, labor and machine hours. Regardless of the similarities in product and total output, anyone would be able to notice the dramatic difference between the two plants. Plant A would have a much lesser production support staff compared to plant B. Plant B will have more people to perform tasks related to setups. These include scheduling the machines, performing setups, as well as the follow up work such as inspecting items as well as incoming materials (Hansen & Mowen, pp. 20-22, 2006). This is still not inclusive of the several other jobs in the company. Even the seemingly insignificant things like shifting inventory, assembling and shipping orders, negotiating with vendors, are subsequently part of the product cost. These are all indirect costs associated with the products and these costs increase as the variation in product line increases. In addition, the company with plant B will operate with considerably higher levels of idle time, overtime, inventory, rework, and scrap. The widespread factory support resources and production inefficiencies of plant B produce cost-system distortions. Most companies allocate factory support costs in a two-step process. First, they collect the costs into groups that match to responsibility centers (production control, quality assurance, receiving) and assign these costs to operating departments. Most companies perform this first thoroughly. Nevertheless, they lack in performing the second step. The process they use to trace costs from the operating departments to determine unit product costs is simplistic, as it employs labor hours as an allocation base. An alternate practice is recognizing the declining role of direct labor, using two additional allocation bases (Kaplan & Anderson, pp. 56-60, 2007). Materials-related expenses now receive higher importance, as accountants allocate them directly to products as a percentage increase to their product cost. Moreover, in technology intensive places, the accountant uses machine hours or processing time as the allocation base (Kaplan & Anderson, pp. 56-60, 2007). The cost system of Plant B will report production costs invariably and mistakenly for the high-volume product (white cardboard sheets) that greatly exceed the costs for the same product in Plant A, no matter which cost approach it uses. It is not difficult to understand that company will allocate only 10% of the factory costs to the white cardboard sheets because it represents only 10% of the output of plant B. Similarly, the company will allocate only 1% factory cost to black cardboard sheet because it represents only 1% of the output. This way the company uses standard output per unit of direct labor hours, machine hours, and materials quantities that are same for white cardboard sheets as for black cardboard sheets. Hence, the company reports identical costs for both types of cardboard sheets even though black cardboard sheets consume far more overhead per unit because company orders, packages and ships them in much lower quantities. This in turn has several consequences. In long run, companies producing cardboard sheets with plant A will determine the market price of white cardboard sheets, as for most high-volume products. Managers of Plant B will notice that their profit margin on white cardboard sheets is lower than on their specialty products. The price for white cardboard sheets is lower than for black cardboard sheets. The cost system inaccurately reports that the white cardboard sheets are as expensive to make as the black cardboard sheets. Company will be dissatisfied with the low margins on white cardboard sheets, but will be pleased that they are a full-line producer. Customers will be willing to pay premiums for specialty products like black cardboard sheets. Company will think that black cardboard sheets are apparently no more expensive to make than commodity-type white cardboard sheets. The wrong cost data will lead to de-emphasis of white cardboard sheets. Company will start offering an expanded line of differentiated products with unique features and options. This strategy will be devastating in reality (Lindahl, pp. 62-66, 1997). White cardboard sheets in Plant B are cheaper to make than black cardboard sheers, no matter what the cost system reports. Decreasing the production of white cardboard sheets and replacing the lost output by adding new models will further increase overhead. The rising total costs will irritate Plant B's manager because the profitability goals will become hard to pin down. If the company had implemented an activity-based cost system to generate the cost data, it would not have got the distorted information that misguided strategic signals of this sort (Schnoebelen, pp. 50-54, 1993a). In such a scenario, activity based costing (ABC) starts off with identifying and defining activity and activity pools and then directly tracing the cost to these activities. Then accountants assign the costs to activity cost pools and calculate the activity rates of each product. Then they assign the costs to cost objects using the activity rates (Garrison and Noreen, 180, 1999). Following this process, accountants can allocate all the costs to activities and then allocate activities to product according to their level. This way, they measure all the costs related to product appropriately and because no costs are left unmeasured, accountants do not need to make any adjustments, which may distort the cost data (Shank & Fisher, pp. 73-82, 1999). In addition, it avoids the concept of allocating the indirect costs and overheads as a percentage of direct costs to all the products in a similar manner, which is another reason of inaccuracy in cost information. Accounting experts (Turney, pp. 58-64, 1996) believe that activity based costing more correctly represents real product costs because it drives the costs down to products based on the actual consumption of activities and resources by each product. Activity based costs better reveal the accurate cost behavior or profile of a product. Ideal calculations and cost behaviors usually exist in books but accountants strive to know the product costs as close to ideal as possible because these costs are a very significant part of decision-making process. People often refer to ABC as not only an accounting system, but also an instrument of ‘corporate strategy’. The manager makes several important decisions, with regard to pricing, product design, and mix. In addition, for each of these, they require adequate and proper information about the product costs (Cooper and Kaplan, 97, 1988). If asked, how Activity Based Costing (Walker, pp. 18-27, 1999) provides more accurate product cost information, the answer is very simple and that is because it overcomes the flaws of other cost systems that still rely on previous accounting methods even though the business models have changed drastically over the years. In earlier days, companies manufactured fewer of products and as mentioned earlier, they could easily trace down most of the costs directly to products. At that time, materials and labors were the major parts of the costs (Cooper & Kaplan, pp. 130-135, 1991). As the businesses have grown the nature of costs have changed. Now the direct labor costs represent a small portion of total costs. The new costs that have emerged are factory support operations, marketing, distribution, engineering, and other overhead functions and following prior costing practices that heavily rely on direct costs distorts the cost data, giving rise to wrong corporate decisions. Activity based costing (Cooper, pp. 78-81, 1990) provides such companies with an alternate costing system that allows them to calculate more accurate product costs enabling them to compete in this intensified global arena where such cost information is crucial to their success. Activity based costing is based on the concept that all the activities of the company exist for the production whether it be manufacturing the product or delivering it. Hence, accountants should consider all the costs related to the activities as product costs. It is possible to separate all most all the factory and corporate costs and trace them to individual products. There are several examples of such costs, like information resources, technology, marketing and sales, logistics, general and financial administration, amongst several others (Cooper, pp. 78-81, 1990). Activity Based Costing reclassifies these indirect costs as direct costs. This reclassification actually leads to accuracy. Another important reason why Activity based costing provides more accurate information is that it de-emphasizes the difference between fixed and variable costs. It always looks at the costs from a long-run perspective whereas the methodology of traditional costs systems emphasizes the short run perspective. Activity based costing considers that all the costs are variable in the end. The designers of Activity based costing system (Cooper, pp. 78-81, 1990) have attempted to know demand drivers of output of each of the company’s main activities. The concept of fixed cost stays only until an activity uses only one unit of a resource such as a person or machine. However, when the activity uses more than one unit of a resource, accountants using Activity based costing do not classify that as a fixed cost because doing so will not be beneficial for the product costing purposes. Something caused the demand of the resource to rise and identifying that ‘something’ will help trace the costs more accurately to the product that ultimately consumes the resources through activities. Cost of some activities tends to be fixed because they do not respond to short run increase or decrease in volume. However, there has to be a reason behind that behavior too and that could be some commitment from management towards past, present or future activity level. In general, there is a reason behind each cost, which may at times appear inactive. At times, the costs increase without the revenues actually increasing and this may have happened due to some idle capacity or unused resource. Knowing the reasons that increase the costs will definitely help identify such a case and this surely will lead to more accurate cost information (Weygandt et al., pp. 67-79, 2009). This is only possible when a company implements the activity based costing and not any other costing methods that apply the overhead costs as per the percentage rate of direct costs. In conclusion, the key difference between the traditional cost systems and Activity based costing is the key to the accuracy of Activity Based Costing. This key difference is that Activity based costing uses all the activities whether directly related to production or not, to trace costs to products. This accurate cost information (Weygandt et al., pp. 67-79, 2009) leads to several strategic benefits for the company. If, the company using plant B to produce cardboard sheets uses Activity Based Costing, it will have accurate cost information. It can use that to decide if it wants to lower down the price of white cardboard sheets because it actually costs lesser than black cardboard sheet. It may also decide on charging a higher premium on specialty products because they cost more. These are just two options. Any company that uses Activity based costing will have so many more option to choose from and make the best possible decision only because it now has information that is more accurate. References Bradford, T. 2008. “Activity-Based Costing.” Suite101.com. Retrieved on January 29, 2011: http://www.suite101.com/content/activitybased-costing-abc-a52148 Broadbent, M., Broadbent, M. and Cullen, J. 2003. Managing Financial Resource. Butterworth-Heinemann. Cooper, R. 1990. “Five steps to ABC system design.” Accountancy, Volume 106, nr 1167, p 78-81. Cooper, R., and Kaplan, R. S. 1988. “Measure costs right: Make the right decisions.” Harvard Business Review. Sep-Oct, p. 96-103. Cooper, R., and Kaplan, R. 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