Critical analysis of activity based costing and traditional costing system - Assignment Example

Critical Analysis of Activity Based Costing and Traditional Costing System Introduction In the efforts to implement the Strategic Management Accounting (SMA) approach in organizations, modern business enterprises find Activity-Based Costing (ABC) as an improved costing system by which the problem of large number of indirect costs and their allocation problem can be overcome. It has been observed that ABC method is the most sought after innovation in the field of management accounting in the last two decades. The method was originated in the Unites States of America during the 1980s as an improved system to enable better cost allocation by means of classification of more costs as direct (Cooper and Kaplan, 1988). The advocates of ABC method argue that the firms would be able to enhance their efficiency and cost control without having affected the customers' value, if ABC is successfully implemented and followed. However, its acceptance rate is still overwhelming across industries and countries despite the strong recommendation by Robin Cooper and Robert S Kaplan, the proponents of the method. The main problem associated with the low implementation rate may be attributed to the difficulties and complexities of the system. This paper discusses and analyses the ABS system as an improved cost control technique. The paper takes comparative and analytical approach; in which comparison is made between ABC and Traditional Costing System (TCS). The paper discusses the various aspects of ABC as a superior technique of cost control by assuming hypothetical examples. Every attempt is made to analyse the important characteristic of ABC with that of TCS in a critical manner. 2. Activity Based Costing- Meaning and Significance ABC as the name signifies is a system of costing based on activities involved in transformation process. ABC is the process of simplifying and clarifying decisions required to be made by the management using activity costs. It analyzes the cost and the benefits of various operational and business activities. According to Computer Aided Manufacturing International (CAM-I), "Activity-based costing is a methodology that measures the cost and performance of activities, resources, and cost objects. Resources are assigned to activities, then activities are assigned to cost objects based on their use. Activity-based costing recognizes the casual relationship of cost drivers to activities" (CAM-I). ABC, which was basically developed as an alternative to traditional costing system enhances the scope of performance management as a measure. This system was propounded by Robin Cooper and Robert S Kaplan as a superior tool to overcome the limitations of TCS. The main inefficiency with TCS is that it fails to accurately measure the actual cost of production and hence decisions are made out of inaccurate data. Therefore, the main logic behind the emergence of ABC system revolves around supplying accurate information regarding the cost of production, cost allocation; which are vital for cost and profit analysis. The main argument in favour of the ABC system is that it is against the traditional system of cost allocation on a percentage basis. ABC system, instead takes into account the cost effect relationship for cost allocation on a subjective basis. Whenever a cost is incurred and identified in relation to an activity, the cost is allocated to the extent the product has used the activity. Supports of ABC system strongly believe that supplying accurate information is the most important benefit of this system. In addition, ABC is justified from the benefits such as cost control, cost reduction, more accurate allocation of indirect costs, improved insight into cost causation and identification of activity costs and improvement of operational efficiency (Kaplan and Anderson 2004). It has also been justified for being able to supply accurate cost information which is necessary for fair pricing and thereby adds value to customers. 3. How Different ABC is from TCS TCS is criticized by experts from cost accounting field that it put emphasis more on direct labour hour, machine hours etc. to allocate indirect costs (overheads) to products. Therefore, it tries to correlate the volume of resources consumed with number of units produced for each product. It does not take care of the items/resources like material handling, material procurement, performing set-ups, production scheduling and inspection activities. Consequently, it leads to distorted product costs or under estimated cost (Brimson 1998). In fact, TCS was performed better when the firms had a limited number of products produced and as such direct material and labour constitute the major component costs. The proportion of overhead costs was very small that inappropriate allocation has not made significant impact. But, organizations of the present day engage in producing a wide range of products; which results in prime cost lost its importance as overheads outweigh the former in volume. Besides, the contemporary business management needs timely, reliable and accurate data for decision making. TCS is increasingly becoming a failure in this regard with its traditional concepts and approaches. It is further found that ABC focuses more on tracing the overheads than allocation. Of course, TCS has been advocated on being simple and economical for any organisation, however the present day competitive business setting has no room for old tools which may not be good enough to support strategic decision-making. Traditional costing system emphasizes the use of volume-related measures like direct labor hour or machine hours to allocate overheads to products. The traditional system correlates resources consumed with the units produced. The resources consumed are measured in relation to the units produced for each product. The most basic drawback of this system is that it does not take into consideration the non-volume related activities. These include activities like material handling, material procurement, performing set-ups, production scheduling and inspection activities. Since resources are related to their production volumes, it results in distorted product costs or under estimated cost. The traditional costing systems were formulated years ago, when most organizations had a narrow range of manufactured products and as a result, the direct labor and material expenses were the dominant factory cost. The volume of overhead cost was very small and even if there was some inappropriate allocation, the variations were insignificant. Organizations of the contemporary era produce a wide range of products and as a result, the Prime Costs (Direct expense) lost its importance and overhead costs become more prominent. The intense global competition made correct cost information vital which resulted in the genesis of ABC. 4. Three Dimensions of Cost in ABC ABC System has been viewed from three perspectives depending on the user. The three views of cost can be thought of as financial, operational, and strategic. These three views of cost focus on different variables, the understanding of which is the key to harnessing the power of ABC system. 4.1 Financial The financial view of cost can be compared to a man facing backwards, because of its adherence to the historical cost concept. The financial controller, tax manager, and treasury department use this type of cost information to value inventory and report to shareholders, lenders, and tax authorities. Auditors and accountants use the financial view to address periodic reporting requirements. Although this view receives the most attention, it is usually ineffective for operational and strategic uses. 4.2 Operational The operational view of cost is used for internal analysis. The operational view of cost focuses on the cost information needed to manage on a day-to-day basis. Line managers, process improvement teams, quality teams, and day-to-day managers use operational cost information as an indicator of performance, and to determine if activities are adding value. Interestingly, operational managers are most comfortable with, and often use, physical measures rather than financial measures. 4.3 Strategic The strategic view of cost differs from the financial and operational views in that it is the forward looking view of cost. The users are concerned with improving tomorrow's results; yesterday and today are important only to explain how to improve tomorrow. Investment justification, target costing, life cycle costing, and make/buy decisions benefit from the strategic view. The strategic planner, cost engineer, and people doing product sourcing use this view to determine how to change future costs and improve future profitability. 5. Cost Reduction through ABC As mentioned already, ABC looks forward to reduce cost, improve cost effectiveness and enables strategic decision-making. These are achieved by following certain stages such as selection, sharing, elimination or reduction of activities. Selection implies the effort to choose an alternative, which has least cost for its performance. Sharing aims at resources and activities sharing in order to accomplish economies of scale. It is meant for utilization of resources to its maximum. The process of reduction here represents reduction either in the number of times an activity occurs or the volume of resources used for production during a particular period. Elimination is complete avoidance of an activity, which has become useless on account of one reason or other. Therefore, it can be concluded that ABC facilitates cost reduction through these stages by identifying the various underperforming or non-performing activities. 6. Activity Based Management (ABM) ABC provides a closer approximation of the cost of product than that provided by the traditional volume-based costing method. The use of ABC in itself will not lead to better profitability, but managements use information provided by ABC to decide upon the course of action that will lead organization into improved results. On the other hand, Activity-based Management (ABM) is the next step in the evolution of ABC (Peter Tumey). The change in the name indicates that we need to manage our businesses based upon this new found understanding of what it really takes to run the business. ABM is the process of understanding, reengineering, measuring, and making decisions about activities to put the enterprise on the road to continuous improvement and excellence (Burch, 1994). The information gathered during the activity-analysis stage, can be used to make the activities more efficient and productive. Activity-based Cost System is the primary source of information for ABM. Activities are the building blocks of any organization. Organizations are constantly involved in numerous activities and produce certain outputs. So, to change an organization, the changes will have to be made at the activity level. 7. Why ABC and ABM ABC can supply useful information; but what a company does with that information is what counts. In ABM, managers apply the information gathered, using ABC to make better decisions. In the broadest terms, ABM aims "to improve the value received by customers" and "to improve profits by providing this value" (According to Foster). ABM offer better results by focusing on managing the activities including the elimination of non value-added activities, and by making sure that needed activities are carried out efficiently. Of course, each organization has its own set of activities. To improve operations, management must find out unnecessary or inefficient activities, determine the cost drivers for the activities, and change those cost drivers. For example, moving a partly finished product from the end of one production process to the start of another provides no value to the customer, but it is a necessary step. The distance between the processes drives this particular cost. By decreasing the distance, the cost can be reduced, if not eliminated. 8. Limitations of ABC Despite the many superiorities of ABC system, it cannot overcome all the deficiencies of TCS. It is not a panacea for all deficiencies of TCS. Under ABC, costs such as production-sustaining costs are found untraceable in many occasions. In addition, ABC needs to segregate activities to the root level, its specialized treatment and involvement and commitment from the part of the accounting staff. Also, it is impossible to segregate all the tasks into clearly defined activities. Though it is useful for cost estimation, ascertainment, allocation and apportioning, the use is limited in case of inadequate knowledge. 9. Case Studies 9.1 Wings Plastics Limited (WPL) WPL is producing plastic castings for toys and wrist watch. The firm has been following TCS and has observed that wrist watch is highly profitable. At the same time the firm is incurring losses in producing plastic castings for toys. Under the present system machine hour is the basis for cost allocation. WPL allocates 90% of its production overheads of 2, 00,000 to toys and 10% to wrist watch. The firm allocates the corporate expenses of 1, 25,000 in similar proportion between toys and wrist watch. As an alternative to the present system the firm is contemplating about implementing ABC system for analyzing its operating profit statement. As seen in the Operating Income Statement (Appendix 1, Table No.1), after the implementation, ABC observes that direct overheads of 2, 00,000 include 50,000 as engineers' salaries and also that engineers spend 80% of their time for wrist watch. ABC allocated remaining 1, 50,000 on 90:10 ratios between toys and wrist watch taking machine hours as the cost driver. ABC allocated the corporate expenses in a ratio of 82:18 taking sales as the basis of allocation. The table below exhibits how profit is calculated under ABC system It is clear from the Table No. 2 (Appendix 2) that gross and operating profit margin is 20.82% and 3.70% respectively for both products in common. But gross profit margin for toys is 16.36% under TCS and 22.20% under ABC. Further, under TCS toys are showing operating losses while under ABC toys show 5.09% of operating margin. Wrist watch is exhibiting 41.22% of gross profit margin and 31.68% operating profit margin under TCS while ABC is showing a different picture where gross profit margin for wrist watch is only 14.51% showing operating losses of 2.67%. Thus it is observed that after applying ABC system the results can be different. It is only because the accurate allocation of overheads that ABC provides is of strategic importance. 9.2 Galaxy Ltd 9.2.1 Calculation of Total Cost per Unit under TCS and ABC The company Galaxy Ltd. is manufacturing two products, X and Y. Product X needs 2 units of direct material, 3 direct labour hours and 2 labour hour overheads. Product Y needs 3 units of direct material, 4 direct labour hours and 3 labour hour overheads. It is also informed that material cost per unit is 50. Labour rate is 20 per hour. Labour overheads are 1, 00,000 for 1,000 hours. Number of units produced is 200 for each product. As per TCS, labour hour overhead rate is . 100 per hour (. 100, 000/1,000 hours) and thus 200 are allocated to product A and 300 to product B. As per ABC system, there are four different for labour overheads and the proportion in which the product X and Y use overheads is also different. The calculation of labour overhead under ABC system is illustrated in Appendix 3. It is evident from Appendix 4 that the unit cost under TCS comes to 360 for product X and 530 for Y. After the implementation of ABC system, it is found that the product cost is increased and decreased to 375 and 515 for product X and Y respectively. It signifies that . 15 incurred in relation to product X is inaccurately allocated to that of product Y, under TCS. 9.2.2 Calculation of Total Production Overhead The Star Ltd. is a manufacturing enterprise. Its production consists of two activities, namely setting up of machine and actual production in batches. The annual manufacturing overhead cost amounts to 10, 00,000 out of which 10% has been incurred for machine set-ups. Machine needs to be set up before every batch. Star Ltd. assumes 200 set-ups in a year. There is 1, 00,000 machine hours available and 25 units per hour can be produced. The management of Star Ltd., is interested in knowing the manufacturing overhead per unit, for different batch sizes. As per TCS the total production overhead amounts to 10, 00,000 and machine hours are 1, 00,000. This means production overhead allocation rate is calculated as 10 per machine hour. It is calculated to be Re. 0.40 per unit (. 10/25 units). It will remain constant at all levels of production. But, as per ABC system, 10% of 10, 00,000 i.e. 1, 00,000 has been treated as batch-level cost. The balance of 9, 00,000 of the productions overhead is traced to the machine hours and 9 per machine hour is allocated. The per unit production overhead is for different batch sizes, which are calculated in Appendix5. Considering the information in Appendix 5, the total production overhead cost per unit for various batch sizes can be ascertained with the help of the following model: Y (in ) = 0.36 + ( 500/X) Where, Y represents the total production overhead cost per unit and X stands for the number of units to be produced. It is very well observed from the above table that the production overhead cost per unit remains the same for all batch sizes under TCS, whereas the production overhead cost per unit comes down with increase in the batch size Under ABC system. Thus, after calculating under ABC, there is inverse relation observed between total manufacturing overhead cost per unit and the batch size. 10. Conclusion Cost control and Cost Management has become vital facet of contemporary liberal and competitive business environment. ABC was evolved with specific objectives of cost control and within a short span of time; ABC has succeeded in becoming a popular cost accounting tool. Innovation and development are essential components of success relating to any concept and the same is the case regarding ABC. Its increased popularity and use has helped in refining its core concept. The limitations which surfaced during the use have motivated the experts to prune and purify the concept and TDABC is a result of that. This new concept has successfully eliminated some of the fundamentals of pitfalls that existed in the contemporary ABC methodology. ABC allows business concerns to assess the possibilities of product in the market to flourish the as it helps producing better quality products at competitive prices. ABC system facilitates better managerial decision making by analyzing the product profitability and customer profitability, ABC system argues that firms would be able to enhance their efficiency and cost control without having affected the customers' value. In short, ABC can become a competitive cost advantage and can continuously add value to its stakeholders as well as customers. However, implementation of ABC system is often accompanied by difficulties. Many adopters of ABC have reported that during the implementation of ABC, they faced the doubts expressed by employees or managers regarding the usefulness of the new system, difficulties in identifying and selecting activities or cost drivers, problems in accumulating cost data for the new system or lack of resources. It has also found that in many cases, the time schedule of the adoption process has been stretched, cost budgets have been exceeded or even the computer software has been proved inadequate. Many times, ABC adopters seem to have encountered difficulties because the process of implementing ABC is often time and resource consuming. Appendices 1. Statement of Operating Income under TCS Table No. 1 Statement of Operating Income under TCS Particulars (All Figures in ) WPL Toys Wrist watch Sales 7,30,000 5,99,000 1,31,000 Less: Direct Expenses 86,000 61,000 25,000 Material 2,92,000 2,60,000 32,000 Labor Direct Overheads 2,00,000 1,80,000 20,000 Cost of Goods Sold 5,78,000 5,01,000 77,000 Gross Profit 1,52,000 98,000 54,000 Gross Profit Margin 20.82% 16.36% 41.22% Less: Corporate Expenses 1,25,000 1,12,500 12,500 Operating Profit/Loss 27,000 14,500 41,500 Operating Profit Margin 3.70% 2.42% 31.68% 2. Statement of Operating Income under ABC Table No. 2 Statement of Operating Income under ABC Particulars (All Figures in ) WPL Toys Wrist watch Sales 7,40,000 5,99,000 1,31,000 Less: Direct Expenses 86,000 61,000 25,000 Material Labor Overheads: 2,92,000 2,60,000 32,000 Engineers' salaries (20:80) 50,000 10,000 40,000 Remaining overheads (90:10) 1,50,000 1,35,000 15,000 Cost of Goods Sold 5,78,000 4,66,000 1,12,000 Gross Profit 1,52,000 1,33,000 19,000 Gross Profit Margin 20.82% 22.20% 14.51% Less: Corporate Expenses (82:18) 1,25,000 1,02,500 22,500 Operating Profit/Loss 27,000 30,500 -3,500 Operating Profit Margin 3.70% 5.09% -2.67% 3. Calculation of Labour Overhead Using ABC Calculation of Labour Overhead Using ABC Activity (.) Cost Product X Product Y Act 1 20,000 1 5,000 3 15,000 Act 2 30,000 1 10,000 2 20,000 Act 3 10,000 2 4,000 3 6,000 Act 4 40,000 3 24,000 2 16,000 Total 1,00,000 43,000 57,000 Units Produced (No.) 200 200 Overhead per unit 215 285 4. Calculation of Total Cost per Unit under TCS and ABC Calculation of Total Cost per Unit under TCS and ABC Particulars (.) Product X Product Y TCS ABC TCS ABC Direct Material 100 150 Direct Labor 60 80 Labor Overhead 200 215 300 285 Unit Cost 360 375 530 515 5. Calculation of Total Production Overhead Cost per Unit under ABC Calculation of Total Production Overhead Cost per Unit under ABC No. of Units Manufactured /Particulars 500 1,000 5,000 10,000 12,500 25,000 Setting up Cost (.) 500 500 500 500 500 500 OH per unit for setting up (.) (A) 1 0.5 0.1 0.05 0.04 0.02 OH per machine hour (.) 9 9 9 9 9 9 No. of units produced per hour 25 25 25 25 25 25 OH per unit for production () (B) 0.36 0.36 0.36 0.36 0.36 0.36 Total production overhead cost per unit (A + B) (.) 1.36 0.86 0.46 0.41 0.4 0.38 References Antos J and Brimson J A (1999), Driving Value Using Activity-Based Budgeting, John Wiley & Sons, New York Argyris Ch and Schn D A (1978), Organizational Learning, Readings, Addison-Wesley Publishing Company Brimson J A (1998), "Feature Costing: Beyond ABC", Journal of Cost Management, January-February, pp. 6-12 Burch JG,(1994) Cost and Management Accounting: A Modem Approach, West Publishing, House Cooper R and Kaplan R S (1988), "Measure Costs Right: Make the Right Decisions", Harvard Business Review, September-October, pp. 96-103 Foster G, Activity Based Management - Theory and Application, VHS Cassettes by Center for Business & Economic Research, Somona State University. 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