Activity Based Costing - Report Example

In the business world information has always been a hot commodity for managers since provides them with additional input to improve the decision making process. In the finance and accounting field costs has always been important factor to consider in order to perform analyses about the effectiveness of the production of a firm. Accountants have always paid close attention to costs, since this variable provides a basis that is utilized throughout the entire accounting information system. In a manufacturing firm labor and materials have always been cost driver that are easily to trace and measure. In the other hand shared resources historically was a problematic grey area which caused problems in precisely determining its overall impact to the costs of an operation. A technique that is able to provide financial professionals and managers with better insight about the costs of an operation is called activity based costing (ABC). This purpose of this is to discuss activity based costing by covering the following five topics: history, features, implementation, evaluation and managerial applications. Activity based costing was first utilized in the 1980’s in order to understand the internal breakdown of costs associated with overhead drivers that serve as common resources. Robert Kaplan and Robin Cooper in 1987 for the first time introduced the concept as a chapter of its accounting textbook Accounting and Management: A Field Study Perspective (Weiner, 1995). The industry trend at the time was that overhead costs were rising, thus there was a need of a cost system with enhanced capabilities that enabled it to figure out the reason what this was occurring. In 1990 the first journal article on the subject came out in 1990 and it further revolutionized ABC because it provide a discussion of an application of ABC outside the manufacturing scenario by applying it service based business, financial institutions. The article appeared in the Journal of Bank Cost and Management Accounting and it was written by Richard Sapp, David Crawford, and Steven Robishke (Weiner, 1995). Activity based costing is a completely different accounting system that has its own unique methodology which does not follow the principles associated with traditional cost systems known as absorption costing. ABC just like any other costing system has a similar objective of providing information about corporate costs. One of the differences between ABC and absorption costing is that the systems provide information for different types of users. Absorption costing information is prepared for external users of financial information, while ABC focuses on internal users. The internal users of activity based costing are typically the managerial staff of a firm. Traditional accounting systems focus on inventory costs and cost of goods sold which serve a foundation of the preparation of financial statements. Activity based costing differs in that it focuses on profitability and corporate overhead. The utilization of the generally accepted accounting principles (GAAP) is mandatory when using traditional costing systems, but in ABC it is not a consideration. Due to the differences in objectives the functionality of activity based costing differs from traditional system in several ways, five of these differences are listed below: Nonmanufacturing costs can be included in the determination of product costs The system allows for the exclusion of some manufacturing costs Multiple overhead cost pools may be used and each of them can have their own unique measure of activity The allocation basis of ABC are different than in traditional costing systems Overhead rates are based on the level of activity at capacity rather than budgeted levels of activity (Garrison & Norreen, 2003, 317). Activity based costing provides extremely useful information for managers of corporations. In larger more sophisticated companies ABC can provide greater value because isimplifies and breaks down costs that would otherwise not be impossible to analyze. The reason the system utilized mostly in larger organization is the costs associated with implementing such as system. Two of the major benefits of activity based costing system is that it provides greater control over overhead costs and that it allows for better managerial decision making (Weygandt & Kieso & Kimmel, 927). Although activity based costing started out as system which was mainly utilized in the manufacturing sector, its use has become widespread in the service industry. Governmental institutions are large organization in the service sector. In 2000 the Texas government decided to implement activity based costing in order improve the efficiency of its operations. At the General Services Commission ABC allowed the governmental institution to identify that the location placement of its warehouses were costing them an extra $51,000 a year that could be saved if they move the warehousing activity elsewhere (Combs, 2001). In order for a company to implement activity based costing it must follow a simple algorithm. There are six steps that must be sequentially applied in order to apply activity based costing. The five steps associated with the implementation of ABC are enumerated below: 1. Define and identify activities and activity cost pools 2. Trace costs to activities and cost objects 3. Costs are assigned to an activity cost pool 4. Activity rates are calculated 5. Costs are assigned to costs objects based on activity rates and activity measures 6. Management reports are prepared (Garrison, et al. 2003, 322). The first two steps involves qualitative analysis, while in the latter three quantitative work must be perform. The last step of the implementation algorithm is the preparation of management reports. Activity based costing is a unique costing system that is universally recognized within the business community. It is a subject that has been taught to accounting students at the undergraduate and graduate level for over twenty years. It utilizes a scientific approach that can be replicated for implementation by any organization. Its biggest weakness is the high costs associated with running and maintaining the system. A basic principle in the accounting profession is that information adds value to a company as long as its benefits outweigh the costs of producing the information. Activity based costing can also lead to information overload that can distort reality and give managers a wrong sense its real cost base. An industry that has seen multiple failures in implementing activity based costing is the printing industry. Printing companies have had a difficult time with the costs estimate outputs derived from activity based costing because activities do not properly match cost pools. The unique nature of graphic design companies is more suited form individualistic estimates based on customer profiles, than the possible cost pools within an activity based costing system (Gorelick, 2007). The fact that activity based costing produces different outputs concerning the profitability of a firm panics many managers. Managers experience symptoms associated with resistance to change when an ABC system is proposed in firms that have always solely utilized absorption costing systems. Activity based costing requires the full commitment of the organizational hierarchy, especially of those executive and managers at the top of the chain of command. This limitation is a risk factor that increases the possibility of failure. Activity based costing has the peculiarity of being more effective if economies of scale are present in the business. In a company with large volume purchasing and complex logistical system with many processes ABC can become a very important analytic for the enterprise. For example Wal-Mart is the world leading retailing company who also happens to be the largest employer with over one million employees. Such a large workforce involved a high overhead costs associated with administrative expenses. In fiscal year 2008 the administrative expense account in the income statement of the company equaled $70,288 million (Msn, 2009). If the company can find ways to reduce waste in the administrative processes of the firm there Wal-Mart could save millions of dollars. A 0.5% cost reduction in overall administrative expenses equals a savings of over $344 million dollars. This type of application of ABC is an example of activity based management. The effectiveness of activity based costing at creating valuable data and information for managers has led to the surge of activity based management (ABM). Activity based management describes managerial decisions that use activity based costing information in order to satisfy customers and improve the profitability of a company (Horngren & Foster & Datar, 2000). It application includes pricing and product mixed decisions, costs reduction, process improvements, design decisions and planning activities. Managers can utilize the output of its ABC system to determine how to become more effective in specific such as designing decisions. The manufacturing layout of a company can be optimized to achieve a greater production from the equipment and machinery. Internal processes such as setup and maintenance costs are specific activities that managers can be deeply analyze with the help of their ABC system. There are many organizations in the business world seeking an edge in order to get ahead of the competition. Accounting information is a key source of information that can help the managers of a company determine the root cause of inefficiencies within a firm. In order for a manager to be to get information that goes beyond the capabilities of a traditional costing system they must adopt activity based costing. ABC does not interfere in any way with the normal function of a firm’s accounting information system because it is a supplementary system whose information output is used for internal decision making. It enhances the capability of an accounting information system because it allows for greater control over the overhead variable of total costs. In the 21st century activity based costing has evolved from a basic costing system into a managerial tool that led to the surge of activity based management. ABM applies activity based costing information in conjunction with other managerial tools such as total quality management to achieve greater operating efficiency that help companies reduce costs and provide a higher quality product or service to its customer base. Firms in both the manufacturing and service industry can benefit from ABC. Due to the high costs of maintaining an ABC system its utilization is more commonly seen in medium to large companies. The changes in the marketplace that have accelerated all facets of the business require for more proactive managerial styles. The utilization of ABM techniques are necessary in order to keep up with other firms in the current business environment. A properly implemented activity based costing system is an investment that will reap great benefit for a business in the long term. References Combs, S. (2001). Activity-Based Costing and Management: The Texas Pilot Project. Available from < http://www.window.state.tx.us/specialrpt/abc/costmgmt.html>[Accessed 1 February 2009]. Garrison, R, and Eric, N. (2003). Managerial Accounting (10th ed.). Boston: McGraw-Hil Companies. Gorelick, D. (2007). The Price of ‘Average’ Estimating. American Printer, 124(1). p46. Avaliable from [Accessed 1 February 2009] Horngren, C. and George, F. and Sriknant, D. (2003). Cost Accounting: A Managerial Emphasis (10th ed.). New Jersey: Prentice Hall. Msn.com (2009). Wal-Mart Store Inc.: Financial Statements. MSN Money. Available from < http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?symbol=wmt> [Accessed 1 February 2009] Weiner, J. (1995). Activity based costing for financial institutions. Journal of Bank Cost & Management Accounting. Availalble from < http://findarticles.com/p/articles/mi_qa3682/is_199501/ai_n8717516>[Accessed 1 February 2009] Weygantd, J. and Donald, K. and Paul, K. (2002). Accounting Principles (10th ed.). New York: John Wiley & Sons. 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