Activity Based Costing - Essay Example

Management Finance Introduction Activity Based Costing (ABC) is a comprehensive costing system in which a different costing system has been introduced. Under this costing mechanism, a separate cost allocation, identification and cost drivers and cost pools are certain important costing factors that are being considered. Currently, Berry Ltd is using the traditional absorption costing system in which the organization uses single allocation base (machine hours). However, this mechanism has failed to generate accurate costing information relating to the products. Based on this premise, it is reasonable to switch over to ABC in which separate but more accurate costing system has been given. In the following parts of this paper, first features of ABC have been provided in which entire ABC process has been included. Subsequently, comparison relating to selling price and selling volume with absorption costing has been included. After this step, budgeting and planning, budgeting and control, budgeting and performance evaluation and budgeting and motivation parts have been given before the conclusion. Part A Features of Activity Based Costing (ABC) Activity-Based Costing (ABC) refers to as “It is a technique which involves identification of cost with each cost-driving activity and making it the basis for apportionment/assignment of costs over different cost objects/jobs/products/customers/services” (Pandikumar, 2009, p. 414). The analysis of this definition further highlights that ABC is mainly based on three fundamental activities: cost identification, activities and apportionment basis. Fundamentally, ABC is based on a sequence of activities in which costing process is carried out. In the first step, the process of identifying the activities is carried out in which organizational activities are properly pointed out; in the second step, computation of the cost of each activity is conducted; in the last step, the process of identifying the activity cost driver takes place which concludes the entire sequence of ABC (Ryan, 2014). And the typical examples of cost activities are schedule production jobs, machine set up costs, number of orders and number of batches (Ryan, 2014). In addition, cost pool and cost activities are two different activities. In the cost pool, total attached costs are combined and the combined costs are further allocated to cost activities. However, before allocating costs to cost activities, identification of drivers is of paramount importance. In the Berry Ltd, the company has budgeted machine set up costs $280,000, material ordering costs ($316,000), machine running costs ($420,000), and general facility costs ($361,400) and these costs have been collectively identified as indirect production costs amounting to $1,377,400. In addition, the cost drivers, which have been identified as those which cause cost to incur, have also been appropriately identified. For example, number of batches, number of purchase orders, number of machine hours and number of machine hours are cost drivers which will consume costs of machine set ups, material ordering costs, machine running costs and general facility costs respectively. In this regard, it is important to highlight that ABC has inbuilt flaw in which centre managers are authorised to select their preferred cost drivers which will consume costs from cost pools. Under this situation, it will be very difficult to assess the credibility of such use of discretionary authority in which managers have been given full right to use their own information and delegated authority to choose the cost drivers. In this regard, it is also important to mention that there are no specific recommendations or any globally determined costing or allocation structure in which specific cost drivers use particular cost pools. As a result, the management accountants use this power and flaw in the structure of ABC costing and use their own method. ABC and Absorption Costing for Selling Prices and Selling Volumes Absorption costing puts distorted effect on selling price. Under the absorption costing strcutre, the managers are assigned to use one single costing base or allocation base which is uniformly applied to overall produced units. For example, Berry Ltd uses direct labour hours for allocating the total production overheads $ 1,377,400 and subsequently total hours of each products (X Y Z) will be totalled and which will be X (600,000 hours), Y (576000) and Z (528,000). And subsequently, they will be collected and will become (1704, 0000). After this step, total overheads will be allocated based on this structure in which 1,377,400*600,000/1704,000= $485,000 for X product, Y will receive $465,000, and Z will consume $426,800. Based on these results, it can be deduced that the higher production units consumed the higher production overheads and this has been proven by the fact that the product Y which consumes 36 hours for producing one unit and when this figure is compared with the total overhead absorbed by this product, which is $465,000 and this amount is second highest overhead consumption after the product X. Consequently, this allocation distorts the product cost and benefit analysis in which higher overheads is consumed by the higher units of production. At the same time, it is an inbuilt flaw to the absorption costing is that it includes fixed overheads to the product costing and subsequently, this further distorts the costing process; and it has arbitrary allocation of costs (Pandey, 1995). As a result, the sales price and sales volume fail to take into account the actual costs representing the costs attached with the production of the units. On the other hand, ABC does not take into account one single cost driver instead it uses different drivers for allocating the cost; and it is more accurate while apportioning overheads to products (Warren et al., 2014). In the company, overhead production has been further divided into cost pools, such as machine set up costs, material ordering costs, machine running costs, general facility costs and each one has been given separate cost by dividing the total iindirect production costs. Subsequently, cost drivers for different cost activities have been determined. For example, after deducting the direct cost, such as labour and material from the selling price, the remaining gross profit is further deducted from the machine costs, ordering cost, running cost and facility cost from each product separately and this separate allocation and deduction from the products will separately highlight the overall profitability of each product. As a result, this will reasonably highlight the product profitability. Part B Budgeting and Planning Budgeting and planning have strange relationship. Budget is a plan and quantified statement in which set of activities are budgeted (Finkler et al., 2008). On the other hand, planning has been defined as setting organizational goals and objectives (Hopkins and Massy, 1981). Both are highly important for Berry to use both approaches for carrying out managerial finance activities. For example, for developing the next year budget of products, the related managers must take into account all those factors, such as quantity and cost of products that will be produced in the next year and at the same time, planning should also be incorporated into this activity. In this regard, it is important to mention that managers working in different departments should take into account the objectives and goals of Berry Ltd while developing budgets for different products. For this objective, they should fully understand the organizational objectives and goals before going to devise their organizational budgets. Moreover, it is pertinent to mention that each department has different objectives and goals. For example, production department is required to develop budget for units that will be produced by the department. For this objective, the department is required to interact with other departments. And the purpose of this interaction is to bring uniformity in their budget and planning process. Also, this uniformity is mainly required as all units of organizations collectively and individually work to obtain the organizational objectives and goals. Budgeting and Control Managers use budgeting process as a way to control activities so as to attain the organizational objectives and goals (Jackson et al., 2009). For this purpose, the control activities encompass attaching actual activities with the budgeted objectives and goals. For example, two types of activities are mostly developed by organizations: budget and actual performance or production of units. In this process, the organizations are required to manage their production by ensuring that the daily, weekly, monthly and annual budget production of units remain closely attached with the budgeted targets and this is only done through ensuring the actual production units achieve their intended budget target. And this whole process is known as the control process in which budget targets are compared with the actual targets. However, it has been seen that control has largely been subjective in which the department managers prefer to manage and control the actual performance as they want to. For example, if it is in their favour that over production is needed, they will ensure that actual production should outnumber the budgeted target. Consequently, this production strategy increases the chances of wastage of resources which is done at the cost of organizational objectives. Keeping this view in mind, it is highly essential that the managers working in Berry Ltd should ensure that actual output should achieve the budgeted target and this policy will have positive effect on their performance as it will enable the senior management to appropriately evaluate the department and the role and performance of managers Budgeting and Performance Evaluation Both have strange relationship. Performance evaluation is process in which performance of departmental manager is evaluated by taking into account the budgeted targets and actual performance. From the organizational perspective, it is highly essential that the department managers should fully understand their annual budgets and ensure that they are achieved on time. In this regard, it has been observed that the department managers are given authority to generate and provide budget. Sometimes, managers try to give low budgets in which it becomes easy for them to set easy and attainable budget targets and this type of budget works at the cost of organization as such departments do not work at their maximum capacity and use minimum resources and maximum time. On the other hand, this type of low budget only benefits to the department manager as it makes the work easier through achieving the budget targets very easily. Budget control is used by top senior management (McCaffery and Jones, 2001). The senior management of Berry ltd should ensure that the department managers are not allowed to receive approval of low budget. For this objective, the senior management should work closely with the department managers and should discourage them to developing such low budget instead they should be encouraged to make those budget which use maximum capacity and resources of departments and medium level budget targets for the department managers. This will have a win-win situation in which both organization and the department managers will be in a better position. At the same time, this policy will facilitate the process of performance evaluation in which hard working departmental managers will be rewarded and lazy managers will be pinpointed. Budgeting and Motivation Budgets are compulsory by nature (Hinka, 2005). Budget should always motivate managers to attain the budget targets. Motivation refers to an action that is taken in a particular direction for attaining certain objectives. In this regard, it is important to highlight that the department managers can be easily motivated for attaining the medium level budget targets through providing both intrinsic and extrinsic rewards as they encourage managers to put their maximum efforts for attaining the budget targets. And for this objective, Berry ltd should ensure that they provide both intrinsic and extrinsic rewards to the department managers. And this is important because some managers prefer to receive intrinsic rewards in which appreciation is the most important reward type whereas others prefer to receive bonus and other related incentives for maintaining motivation for attaining the organizational objectives. However, it is highly essential that the company should not tolerate any concession to underperformance of the department managers as the cost of underperformance will also be paid by the company. Also, Conclusion ABC has replaced the traditional absorption costing system. The fundamental positive point of ABC is that it has distinctive costing structure in which cost drivers, cost activities and cost pools are those activities that are considered. More importantly, this mechanism individually highlights the cost and profit of products. And this important difference is mainly contributed by the fact that it uses different allocation bases which clearly highlight the difference of fixed cost from the product cost. In the traditional absorption costing structure, only single absorption costing base is used which distorts the profitability of product. At the same time, this mechanism has inbuilt flaw as it takes into account fixed cost as the product cost. As a result, which do not allow the actual and reasonable assessment of actual costs that directly contributed to the production overheads. At the same time, Berry ltd should use planning, motivation, performance evaluation, control for carrying out the budgeting process. For example, planning enables the mangers to take into account the organizational objectives and goals while developing budgets for the organization. At the same time, motivation is also needed as it encourages and enables the managers to remain motivated and put their maximum efforts for ensuring obtaining the objectives of organization. At the same time, the department managers should be allowed and encouraged to develop medium level budget targets as this type of budgeting supports the objectives of both organization and managers as well. However, while evaluating performance of managers, Berry should take into account the budgeted targets and the actual performance of the managers. References Finkler, S.A., Kovner, C.T., Jones, C.B. (2008). Financial Management for Nurse Managers and Executives. 3rd ed. Missouri: Elsevier. Hinka, R. (2005). Budgeting: Approaches and Shortcomings. Norderstedt: GRIN. Hopkins, D.S., & Massy, W.F. (1981). Planning Models for Colleges and Universities. Stanford: Stanford University. Jackson, S.R., Sawyers, R.B., Jenkins, J.G. (2009). Managerial Accounting: A Focus on Ethical Decision Making. 5th ed. Ohio: South-western. McCaffery, J.L., & Jones, L.R. (2001). Budgeting and Financial Management in the Federal Government. Greenwich: Information Age Publishing. Pandey, I.M. (1995). Finance: A Management Guide for Managing Company Funds and Profits. New Delhi: Prentice-Hall. PandiKumar, M.P. (2009). Management Accounting theory and practice. New Delhi: Excel Books. Ryan, N. (2014). Activity-Based Management. Available: http://www.accaglobal.com/us/en/student/acca-qual-student-journey/qual-resource/acca-qualification/p5/technical-articles/activity-based-management.html Accessed: 19 December, 2014. Warren, C.S., Reeve, J., & Duchac, J. (2014). Financial and Managerial Accounting. 12th ed. Ohio: South-western. Read More