Financial Performance: the Activity Based Costing - Essay Example

?Accounting Dissertation Does the activity based costing play a vital part in financial performance? Introduction: Activity based costing is the assigning of expenses of the measures which is the actual causes of expenses. This costing is not the part of costs on the basis of machine hours as in the traditional method. In activity based costing, it allocates the expenditure of that action simply to the goods which are essentially challenging those actions. “To compete successfully, companies must change the way they report and manage costs. This means replacing old institutions of cost accounting and inventory valuation. Activity Based Costing (ABC) is a managerial accounting system which determines the cost of activities without distortion and provides management with relevant and timely information. It does not represent just a new set of overhead allocation rules or techniques to value inventory. ABC represents a way to look at operating costs and provides methods to dissect the underlying activities, which cause costs to exist” (Dunn 1891). The problem here, which is to be solved, is “Does the activity based costing play a vital part in financial performance”. For this purpose we have to know about the relevance of activity based costing. Here an example is given to know the difference about the activity based costing and conventional costing. E.g. Assume that Product A and Product B are manufactured by the same company. Product A is a low volume item and new one, it requires particular activities such as additional testing, special engineering, and some machine setups because it is ordered in less quantities. Product B is a big volume product produced constantly and needs little concentration and does not require the particular actions. “If this business makes use of conventional costing, they assign or assign every expense to goods on the basis of the amount of machine hours. This will effect in small expenses rate due to Product A, since it do not contain numerous machine hours. Though, it performs order loads of testing, engineering and setup actions. The Product B will be owed a huge quantity of expenses owing to every device hours, except it insist small expenses action and no special attention” (Emerging Issues in Cost and Management Accounting n.d). The result will create a serious miscalculation of both products’ real price of manufacturing expenses. This costing will raise above this situation by transferring expenses on above the one action that is., the machine hours will not only be the activity, all other activities are taken into consideration while costing the product. Background of the Study: Activity based costing will recognize the cost of additional testing, machine setups, special engineering and other activities that cause the costs. These activities consumed the resources of the company. So in activity based costing, they will calculate the cost of resources used in these activities and the product cost will be fixed accordingly. The cost of activity is assigned only to the product which demands the activities, which means the cost of special engineering, additional testing will not assign to the product B. Aims and Objectives: Here, the objective of the study is to understand “does the activity base costing play a vital part in financial performance”. Obviously, there are reasons to say that activity based costing plays a vital part in financial performance of organizations. But before stating it, we need to critically analyze the financial performances reports and compare the financial performance of activity based costing and conventional costing methods. From the above examples itself, we can understand how the activity based costing is an advantage for the organization. The real cause of costs is recognized and it is added to the product cost. This method eliminates the chances of miscalculations and hence gives additional profit to the organization. But activity based costing also have some problems like; some costs are complex to allocate during this technique of cost accounting. Indirect costs, for instance office staff salaries and management are sometimes complicated to assign to a specific product produced. Therefore, this technique has established its niche in the manufacturing division. Literature Review: Some study and researches have been done on the topic of ‘financial performance and Activity based costing. According to Douglass Cagwin, Assistant Professor of Accounting School of Business University of Texas at Brownsville in his paper on the topic ‘The Association between Activity Based Costing and Improvement in Financial Performance’ (Cagwin & Bouwman 2002) he mentioned that there is some indication that some enabling conditions may influence the effectiveness of ABC. The symbols of the coefficients of these non-significant allow variables are as probable; guiding one to believe that numerical authority may have been a problem. Even though it is complex to get both big the quantity of data and sample sizes required to sufficiently calculate the concept of attention, the problem is of major significance to follow. Additional research is too necessary to clarify the improved efficiency of ABC in lesser business. Lastly, there was some evidence that previously used measures of ABC success, approval with ABC, and economic benefit get from ABC is predictor of development of economic presentation. This is a crucial finding as it is significant step forward to complete the link between recognition of the circumstances which causes the success of ABC execution and documentation of ABC’s competence as a profit ornamental tool. “The main objective of ABC is to find the reason for the occurrence of the cost of indirect activities within a company and their relationship to the manufacture of specific products. This understanding can provide a basis for product costing and profitability analysis” (Greenwood 2002, p. 163). Peter Turney, the CEO of cost technology states in an article ‘Activity-Based Costing – An Emerging Foundation for Performance Management’ that developments of ABC are from time to time misunderstood, and this might lead to bewilderment and rejection.  For instance, assessing the value of ABC in lean accounting will results in one answer if the appraisal concentrates on the first generation ABC costing method.  It will cause in a different reply if the focus is on ABC as a process-based source and ability preparation tool. As is true with any system or machinery, ABC has gained remarkable functionality over its life cycle. “Activity based costing (ABC) is an accounting procedure that allocates the costs of producing a product or service to the activities performed and the resources used” (Dubrin 2010, p. 566). ABC is the spirit of incorporated shows organization systems which sustaining measurement and analytic applications in many several settings. Possibly, cumulative practice and new techniques lowered the cost of implementing and maintaining ABC method. Accepting the cost-effectiveness of ABC is significant for assessing its value as a tactical tool in today’s highly aggressive and volatile global financial system.  Comparing yesterday’s ABC against today’s necessities is like assessing the power, safety, comfort, environmental impact, handling and fuel consumption of today’s vehicle, which is set up according to on a study of the Model T Ford. lastly I have to say it is time to take an additional look at ABC. An article titled ‘Integrating Activity-Based Costing and Economic Value-added in Manufacturing’ concludes that “the planned integrated ABC-and-EVA scheme will help managers and administrators in organizations appreciate that the capital venture of their company is a valuable reserve which has to be used effectively and efficiently. The planned capital accusation added to behavior and made to the goods and services effort to account for the capital uses and helps organization understand the capital cost linked with the developed process. Management can obtain an indistinct impression of prosperity if they look only at profit after tax in the conservative sense as opposite to economic profit as intended in the ABC and EVA system. The implemented integrated ABC-and-EVA system might be used as a manufacturing management tool to protect company best from making short-term decisions based on income alone that may obliterate economic value over the long-term. The planned incorporated ABC-and-EVA system by itself will not make it forward in the commerce procedure, also consider about providing management with in order which can direct development of efforts. Then Management should be dedicated to make these essential upgrading steps. These literature reviews will help us to understand the present situation of the problem and this will provide a better idea about the topic. Objective and Methodology: The purpose of this study is to analyze how the Activity Based Costing plays a vital role in the financial purpose of the company and to examine whether the cost system provides enhanced control over the cost in evaluation with the conventional costing system. The company requires cost information to develop the quality, timeliness, and effectiveness of the activities they carry out, and to recognize precisely the cost of the individual divisions in the company. “Activity-Based Costing (ABC) is an accounting technique initially developed for use in the private sector. With the push for program budgeting, ABC has also been used in the public sector of some countries” (Lienert 2008). The research methodology in this particular context is the combination of both descriptive and secondary research analysis. The Quantitative analyses mainly uses the Computation of Overhead rate and the Suggestion of New cost Model. “Lambert and Whitworth (1996) noted that the building block of an ABC system is the analysis of activities in order to identify the following: the activities within each department and why, and under what circumstances each activity is done; how often, and for whom, the activity is performed; resources consumed in doing the activity; and, what factors determine or “drive” the activity or resource” (Krishnan 2006). ABC Cost Model: In the ABC model, overhead cost category such as management, rent, shipping, and guarantee are identified. This price data can be attained simply from accounting. “The analysis of departmental activities is the first step of designing the system. Lambert and Whitworth (1996) noted that the building block of an ABC system is the analysis of activities in order to identify the following: the activities within each department and why, and under what circumstances each activity is done; how often, and for whom, the activity is performed; resources consumed in doing the activity; and, what factors determine or “drive” the activity or resource” (Krishnan 2006). The subsequently walk is to confirm the main actions that cut down the tracing of cost information. These know how to be attained by combine actions into activities and into movement midpoint using the ABC approach. Some figure of activities for a middle size manufacturing business are receiving a customer inquiry, client quotation marks, manufacture supervision, and carry products. Operating expenses are departing to be sending off to the previously explained activities through the primary segment cost drivers. Then, in the next stage, activity cost drivers are resolute to hand out overhead to entity products. “Due to the changing manufacturing environment, traditional cost accounting is rapidly disappearing. Traditional accounting systems were developed at a time when direct labor was a large percentage of the total product costs. Changes in manufacturing technologies, such as the just-in-time philosophy, robotics, and flexible manufacturing systems decreased the direct labor component of production and increased overhead costs” (Gurses 1999). The hierarchical associations are between expenditure categories, actions, and products. The intended methodology picture that the overhead cost and its categorization are available, usually from accounting. Cost categories contract with the conventional method in which a company separately develop overheads. This information will carry the company in behavior the whole overhead calculated at the commence of the procedure contest the total attain when totaling the overhead that is assign to each person product via ABC. Measuring the Performance Monitor Methods in the ABC Method: “There are several specific tools that can be used as accessories, stimulating creativity and imagination in development of original ideas and that are working to highlight the achievement of enterprise-level performance. Among these tools we can mention: the dashboard, balanced scorecard, benchmarking, self-assessment, diagnostic analysis, cost-profit etc” (Briciu & Capusneanu 2010). The dashboard can be used for the framing, selection, arrangement and identification of the indicators for analyzing the entire trends and the developments in the various objectives in the management. The dashboard mainly aims in obtaining the analysis for the business strategies and in optimizing the functions of the various enterprises. The dashboard mainly operates under the various principles and those include mainly the consistency and the relevant information like where the information gives a dashboard, where they need to provide the dashboard, which should obey the hierarchy principles and they should have the proper establishment, etc. The Principle of Efficiency Provided Information: According to this principle, the information enclosed in the dashboard must be examined, understood and considered a sequence of remedial actions and procedures for their implementation. The Principle of Standardization Information: According to this standard the information refers to unchanging objectives, previous consequences and functioning hypotheses. On that basis it decides, analyze report and understand deviations attained at the department’s height. Identifying Actions or Cost Pools: In order to carry out ABC, the entire commerce procedure should be divided into a set down of activities .in order to begin the needed events for ABC; consistent processes ought to be accumulated together. In additional words, manufactured goods determined actions and purchaser driven actions must be separated in order to determine two being homogeneous activities. Examples of events in the manufacturing company are quote research, developed supervision and handling of the materials. Activities and First Stage Cost Drivers: Once the major activities have been specific, a complete cost of each action can be measured. First, the expenditure categories connected to each activity are documented. For illustration, the activity cost for “quote preparation” involve of costs from diverse expense category such as income, rent, efficiency, and office supplies. To properly copy the operating cost to every activity, cost driver, also explain as the first stage cost drivers, and have to be documented for each expenses category. Second Stage Cost Drivers: In the second stage, behaviors are recognized to products using subsequent stage price drivers. As with primary stage cost drivers, statistics necessary for second stage drivers may not be willingly available to represent the portion of cost pools that converse to the products. In the deficiency of tangible data there becomes a need to approximate the quantity of activity cost dedicated by every product. Information Gathering Procedures: Congregation of information is necessary in order to attain correctness of ultimate product expenses. A vital division of the essential data is the extent required in each phase of an ABC system. Equally, each product uses a section of an action. As conversed before, a fraction typically symbolize this portion. For example, the action “quote preparation” takes 0.1 (10%) of organization’s total operating cost. There is numerous ways to attain these scopes and the chosen process will shock the preferred exactness. Three level of data truth can be hired in approximation the various scopes like the cultured guess, systematic appraisal, and real data compilation. Educated Guess: In certain cases where the real data are difficult to retain or data collection is difficult to analyze, an educated guess is useful to make the proportions. This guess is done mainly by the administrators, management, financial organizers and employees in the operational wing, who have the interest in the costing side. The various teams can give a knowledgeable deduction of the size of costs owed in equal stages of an ABC costing method. The phase of accurateness attained is supported on an arrangement of the teams’ assortment and the information of the cost hub of interest. Systematic Appraisal: A new systematic way to accomplish the degree for tracing costs is by resources of a systematic scheme such as Analytic Hierarchical Process (AHP). An AHP is an appropriate tool for drawing biased beliefs into more diplomat information. A subsequent part in which AHP can be implicit is to allocate the expenses from the cost pool to each individual manufactured goods. At this step, it is important to choose a appropriate cost driver in sort to attain the chosen stage of accurateness. Discussion and Analysis: This paper investigated the problem of “Does the activity based costing play a vital part in financial performance”. For this reason, we have to recognize about the significance of activity based costing. As a financial performance in organization, activity-based costing (ABC) plays a very important role. “Internal auditors furnish information regarding company financial performance, extent of ABC usage, and enabling conditions that have been identified in the literature as affecting ABC efficacy” (Cagwin & Bouwman 2002). A firm can obtain one of three responsibilities in accounting system. Specifically financial based responsibility accounting and activity based responsibility accounting. Financial based responsibility accounting concentrates on organizational units for instance uses financial outcome measures, departments and plants, static standards and bench mark to assess performance; and highlights status of organizational stability. Activity based responsibility accounting concentrates on processes, uses both financial and operational actions, employs dynamic standards and emphasizes and supports continuous development. “Activity-Based Costing (ABC) is a method of allocating costs to products and services. It is generally used as a tool for planning and control. It was developed as an approach to address problems associated with traditional cost management systems that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. With these deficiencies managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services” (Activity-Based Costing 1999). The activity based costing method removes the chances of miscalculations and therefore provides extra profit to the company. Managers are then equal to generate data to make an enhanced budget and increase a greater on the whole understanding of the costs that are necessary to maintain to run the company efficiently. In general, activity-based costing is most efficient when utilized over a long period of time, as opposed to shorter-term explanations, for instance the theory of constraints. It requires correct planning and a commitment from higher management. If possible, it is better to do a trial test run on a section whose profitable arrangement is not living up to expectations. These kinds of conditions have a better chance of showing those in charge that ABC is a feasible method for the organization to save money. If no cost-saving procedures are resolute in this pilot study, either the ABC method has been improperly implemented, or it cannot be corrected for the organization. “The first thing a business must do when using ABC is set up a team that will be responsible for determining which activities are necessary for the product or service in question. This team should include experts from different areas of the company (including finance, technology, and human resources) and perhaps also an outside consultant” (Dankoob & Khozein 2011). ABC may assist to recognize value added activities and non value added activities, which will aid managers to organize their costs by reducing non-value added dealings or as a minimum reducing number of cost drivers of non-value added proceedings. There are two stages of activity accounting. First stage is called ABC, where it informs us how the competitiveness can get well by managing the resources more efficiently. It does not only give accurate costs, also it is a method for managing costs. Second stage is called Activity-Based Management (ABM) which is a significant instrument for attaining continuous development. ABC is a costing method that first recognizes the main activities that provide rise to overhead costs, then groups dealings having similar cost drivers into cost pools and lastly allocates total overhead costs to every service or product by computing combination rate for each cost group. Traditional methods often rely on changeable distributions of indirect costs; mainly they rely broadly on volume-based allocations. Volume based allocations are those which have elevated connection with number of units formed. It will guide to more than costing of high volume goods and under costing of small volume products, which will further provide mislead information. “Managers generally achieve improvements by managing activities in four ways: • Activity reduction – by reducing the time required to perform activity. • Activity elimination – by eliminating the entire activity. • Activity selection – by selecting the low-cost activity from set of activity alternatives. • Activity sharing – here managers make such changes that allow them to share activities with other products to achieve economies of scale” (Ahmed at al. 2011, p. 1). ABC cost system also helps to reduce non- valued added activities that consume organization’s possessions without any profits for the company. With this analysis, the service sector could concentrate its possessions on actions that add value to a consumer and give financial benefits. On the other hand, this does not mean that understanding the proceedings that drive cost and reduce non-value added procedures compromise the service quality rendered to its customers. The ABC system gives more perfect cost management and allows the organization’s managers to compute the ‘true’ cost of a product. ABC information system is commonly obtainable for an efficient use of ABC system in the business. This is particularly true if ABC replaces the available cost accounting system that has been usually used for supplying information for financial reporting purposes. So, special monitoring personnel are employed to administer the database. As well as this input, output controls and processing are recognized in order to control modifications and access. The ABC system obviously signifies that it can assist the organization to recognize where the costs are, what drives them to happen, and which costs possibly low value-added to the cost object. The method allows the section heads of organization to examine and see things, through the work activities and lens of costs. This absolutely will change their decision-making behavior during intuition and declaration to fact-based. Therefore, there are huge chances of ABC method predicting planning cost elimination and estimation of non-added value activities, which are helpful for operational planned decision. Limitations of Dissertation: Every dissertation has certain limitations.  In order to conduct the dissertation several limitations were faced like the limitation of time with respect to conducting the dissertation. Activity based costing is a process based activity. Therefore, it needs to investigate the process in an organization. To identify the processes in an organization, it is very significant to research for a longer period of time. In order to test the viability of the ABC costing in the financial performance, it is very important to understand the effect of ABC on the budgeting process of the firm. Therefore, at least a one year minimum period should be investigated in the organization after the adoption of the ABC costing. Financial performance implies that the financial position of a firm should be strong and should be generated positive results for the firm. The firm that is implying ABC costing should be able to generate profits at a high margin. ABC is the integration of traditional costing with the management strategies of the firm.   Another limitation which was faced was that in order to implement the ABC costing in a firm, it requires a lot of substantial resources and again once it is implemented it is more costly to maintain rather than the traditional costing system.  Therefore most of the firms are apprehend to implement such a system even though the ABC costing system can cater to them better costing and financial management in the future. Firms are apprehensive to take the present risks associated with ABC. Therefore it was difficult to convince firms to adopt the ABC costing system and to check how far the new costing system of ABC has been helpful in maintaining the financial performance of the firm. ABC has different costing techniques and “ABC produces numbers, such as product margins, that are at odds with the numbers produced by traditional costing systems” (Garrison et al. 2009, p. 338). The costing procedures are completely different from the traditional method therefore managers who use the traditional method do not show an interest in using the ABC costing system. Therefore, the data available from the firms with respect to the implementation of ABC was less. In spite of the above limitations, the dissertation was conducted as the research methodology used was secondary in nature. The qualitative research points out that ABC system of costing is very vital in improving the financial performance of the firm and the disadvantages of the system come way below the advantages. Recommendations: Understanding the true cost is to be considered as a significant function in strategic decision-making. The ABC system should offer more correct cost management and facilitate the managers to compute the ‘true’ cost of a product. ABC information system must be extensively accessible for an effective use of ABC system in the organization. The internal control must be placed in order to circumvent any illegal users to make alteration to data in the system. This is particularly true if ABC replaces the accessible cost accounting system that has been conventionally used for supplying information for financial reporting purposes. Unique monitoring personnel should be hired to manage the database. In adding together the input, process and output control should be well established to monitor the changes. “Dependencies among the different flexibility options should also be considered while conducting the future research” (Gurses 1999, p. 125). Conclusion: This study aims to the problem of “Does the activity based costing play a vital part in financial performance”. The study improves the improvement in financial performance in ABC in three methods. One, it employs internal auditors who include an objective and well-informed source of ABC performance. Second, this study investigates a detailed measure of development in financial performance, rather than unobservable general construct for instance perception of satisfaction, success or financial advantage. Finally it tests a structural form synthesized from prior hypothetical research, describing the circumstances under which ABC should be successful. When we apply ABC in any association, a modify in the executive arrangement should happen. Managers can adjust ABM by utilizing the information given by ABC to attain necessary profits. Application of ABC is a team work and it requires many manpower training. The activity based form bridge the space among the financial system and the different operational system of the organization. It can give better information for business improvement and decision making than moreover of those methods as it contain both financial and operational data that make into a model that imitate how the business really operate. Reference List Activity-Based Costing. 1999. RCG University. Rockford Consulting Group, Ltd. [Online] Available at < http://rockfordconsulting.com/activity-based-costing%20%28ABC%29.htm> [Accessed on 23 January, 2012]. Ahmed at al. 2011. Activity – Based Costing: Is It from Pain to Joy? International Conference on Economics and Finance Research. Vol. 4. IACSIT Press, Singapore. Available at [Accessed on 23 January, 2012]. Briciu, S & Capusneanu, S 2010. Effective Cost Analysis Tools of the Activity-Based Costing (ABC) Method. Annales Universitatis Apulensis Series Oeconomica. 12(1). Print. Cagwin, D & Bouwman, MJ 2002. The Association between Activity-Based Costing and Improvement in Financial Performance. Mendeley. [Online] Available at [Accessed on 23 January, 2012]. Dankoob, M & Khozein, A 2011. Activity Based Costing System and its Succeed Implementing in Organizations. Australian Journal of Basic and Applied Sciences. Available at [Accessed on 20 January, 2012]. Dubrin, AJ 2010. Essentials of Management. Cengage Learning. Print. Dunn, AG 1891. An Executive Program: Activity Based Costing: A Step-by-Step, Proven Path for Rapid Implementation. California Institute of Technology. Available at [Accessed on 22 January, 2012]. Emerging Issues in Cost and Management Accounting. n.d. Scribd.com. [Online] Available at < http://www.scribd.com/doc/44536303/Ankita-Emerging-Concepts-in-Cost-Mngt-Acing> [Accessed on 23 January, 2012]. Garrison et al. 2009. Managerial Accounting. 11th Edn. Tata McGraw-Hill. Available at [Accessed on 23 January, 2012]. Greenwood, RP 2002. Handbook of Financial Planning and Control. 3rd Edn. Gower Publishing Group. Available at [Accessed on 23 January, 2012]. Gurses, AP 1999. An Activity-Based Costing and Theory of Constraints Model for Product-Mix Decisions. Blacksburg, Virginia. Print. Krishnan, A 2006. An Application of Activity Based Costing in Higher Learning Institution: A Local Case Study. Curtin University of Technology. Contemporary Management Research. Print. Lienert, I 2008. Activity-Based Costing: Is it Applicable in Governments? Public Financial Management Blog. [Online] Available at [Accessed on 23 January, 2012]. Read More