Activity Based Costing vs Traditional Costing Sober Public Limited Company - Case Study Example

Activity Based Costing vs. Traditional Costing Sober Public Limited Company Globalized market environments pose opportunities and challenges to organizations in equal measures. In order to adapt to the changing global market environments, firms and companies need to adjust through restructuring in many areas within the organizations, including, but not restricted to, change in accounting techniques. Financial information forms the basis for much of the decision-making for organizations, and the need for more accurate information continues to grow. Ignorance of the manufacturing realities may put an organization at risk of losing its competitive edge, which inevitably results in loss of profitability and crippling losses. Traditional volume based costing techniques present numerous challenges to organizations, especially in the modern manufacturing environments, where the overhead costs continue to rise. In addition, introduction of new technological advancements in the production processes invalidates traditional cost allocation mechanisms and articulates the need for organizations to switch to new and more market aware costing systems. This paper discusses traditional versus activity based costing with regard to a case on a global motorcycle company currently in a managerial stalemate over the most appropriate costing method. Introduction Traditional costing techniques can be highly misleading in their estimation costs of particular products, markets, or organization activities. Traditional approach to allocation of overheads is blind to the factors that drive costs, which are known as cost centres in activity based costing (Luehfing, 2005). Also, the traditional approach of using unit costing ignores the relevance of developing a number of cost drivers on which to allocate overheads. Therefore, one unit of production assumes the point upon which costing for overheads occur. This method conceals the real cost implications of producing a particular product and distorts profit figures attributable to each product, which can greatly hinder the growth in profitability for an organization (Daly, 2001). This paper discusses activity based costing versus traditional absorption costing for Sober limited, a motorcycle manufacturing company. Background to the Case The senior management staff at Sober Limited engages in a heated ideological standoff because of different viewpoints regarding the appropriate accounting policy for the company. The finance manager proposes adoption of a new costing system, which is activity based costing (ABC), and highlights the fact that the method can prove that the production of one of the company’s primary products, Fireball motorcycle, is no longer profitable, and in fact eats into the company’s profits from other segments. The chairman, critical of activity based costing and favourably predisposed towards traditional costing methodology, expresses his confidence in existing costing methodology, which shows that the production of Fireball is still a viable and profitable option. In addition, the chair claims that the use of activity based costing will only result in unnecessary cost overruns for the company. Analysis of labour hours and ABC in the context of Sober Public Limited Company Sober uses traditional volume based absorption costing to allocate overheads. The company allocates overheads according to the number of labour hours, although sweeping technological changes have put serious credibility as to the relevance of the use of labour hours to allocate costs. The company has had to reduce the size of the workforce due to the introduction of new manufacturing technology. New and more fitting cost drivers than labour hours are now available, and they include deliveries to retailers, set-up costs, and purchase orders. The company seriously considering and questioning the appropriateness of traditional cost allocation methods for overheads in the fundamentally altered manufacturing and market environments. The company sells the motorcycles globally, and the motorcycle market facing pressures from the global trends in the industry, hence necessitating the need to introduce a new costing methodology, which has sparked a heated dialogue within the echelons of the company management. The finance manager thinks the change shift to ABC costing is long overdue, while the chairman considers it unnecessary and expensive. Benefits of Activity Based Costing Activity based costing not only seeks to fill the gaps left by traditional accounting methods, but also to extend the scope of costing to beyond the limits feasible through the traditional accounting methodology. Activity based costing perpetuates a definitive agenda of replacing the traditional costing methods, and enhance the mandate of cost accounting in decision-making in organizations (Granof et. al, 2000). However, the activity based costing is not without its setbacks, and some people still debate the strength of one method of costing over the other, which defines the premise of the case under discussion in this paper in the case of Sober public limited company. There exists a strategic insight to adopting activity based costing, given the importance and robustness of the method in making sound management decisions (Wisner, 2008). Sober manufactures three different types of products, therefore, the verification of the commercial viability of each of them calls for detailed cost analysis. With traditional volume based costing, there is an implication that each of the three products returns a profit, although the use of activity based costing clearly suggests otherwise. According to activity based costing, Fireball is making the firm loses rather than profits, a situation, which requires swift management decision regarding its future manufacturing. Although the total profits remain the same, Fireball records a loss of 364,000 GBP. It follows that if the production of Fireball were to come to a halt, the company would cut up to 364,000 GBP more in profits. More profits would be possible for Sober with regard to reduction in labour hours and cost of materials. In addition, the production of just two products would change some key cost driving processes such as regular set ups, which would result in less costs and further increases in the company’s profits. The extra production capacity left would allow the company to produce more of the more profitable brands of motorcycles, which have greater profitability, and hence increase the company’s profits. Possible setbacks with the use of ABC costing for Sober The chair’s concerns about the cost implications of the proposed costing method are not unfounded. Activity based costing is relatively more data intensive than the traditional volume based costing (Bharara & Lee, 1996). For instance, the company may have to invest in new technology to collect and analyse the data, and possibly hire new staff to run and manage the new system. Other huddles may result from the lack of acceptance of the accounting technique by accounting standards bodies such as GAAP, which further implies that the company should consider running two consecutive accounting systems, the traditional method for legal reasons and the ABC system for performance evaluation purposes. The use of two cost accounting systems would result in extra costs for the company (Roztocki, 1999). Relevance of ABC in modern manufacturing environments Activity based costing helps in creation of better estimates and allocation mechanisms for overheads with regard to each product in a company’s production line. In addition, the use of ABC supports decision-making processes and offers better insight into underlying cost behaviours of products (Kim & Ballard, 2001). On the other hand, traditional costing techniques are appropriate in manufacturing environments with just one product, while activity based costing is more appropriate for manufacturing in environments with more than one product, as is the case with Sober Plc. As such, activity based costing provides a more realistic cost of producing a product, and is more suitable for decision-making purposes. Activity based costing is therefore a powerful tool for decision-making, and helps identify the production units which are making profits or losses (Kaplan & Steven, 2007). For instance, Fireball is making losses while Sunshine and Roadster are making good profit returns for the company. Conclusion From the above analysis, it is apparent that the use of traditional costing techniques, which disregards one of the primary principles of ABC costing, cost centres, is hugely failing in its role as a decision-making tool. According to traditional unit based costing, all motorcycle models return a profit, however, with the use of the more appropriate ABC costing, it becomes indisputable that Fireball motorcycles are actually reducing the company’s profit margins. From the analysis, the best way forward for Sober Limited is to adopt activity based costing. Among its many advantages, ABC costing will enable the company identify the most profitable areas in its production chain, or make adjustments to the current system as appropriate. The information supports the opinion of the financial manager, and backs his opinion that Fireball is no longer profitable for the company. Although the chairman opposes activity based costing, and criticises it on numerous levels, his concern about the cost implications for the use of the method are tenable; activity based costing requires more robust information collection mechanisms, which may require additional costs for the company for the initial setting up of the system and the recurrent maintenance costs for the systems. References Bharara, A, and Lee, C, 1996, ‘Implementation of an Activity-Based costing system in a small manufacturing company’, International Journal of Production Research, 34(4), 1109-1130 Daly, J, 2001, Pricing for Profitability: activity based pricing for competitive advantage, Wiley, New York, Granof, M, Platt, D, and Vaysman, 2000, ‘Using activity based cost to manage more effectively’, PriceWaterhouseCoopers, Last accessed on April 13, 2012 from Kaplan, R, and Steven, A, 2007, ‘Time-driven activity-based costing: A simpler and more powerful path to higher profits’, Harvard Business School Press, Boston, Kim, Y, and Ballard, G, 2001, ‘Activity based costing and its application to lean construction’, University of Singapore, last accessed on April 13, 2012 from Luehfing, M, 2005, ‘Activity-based costing’, Encyclopaedia of Management, Last accessed on April 13, 2012, Roztocki, N, 1999, ‘A procedure for smooth implementation of ABC costing in Small companies’, State University of New York, New York, Last accessed on April 13, 2012 from < http://www.offtech.com.au/abc/ABC_PDF/virginia99.pdf> Wisner, P, 2008, ‘Profitability analysis using activity based costing’, QFinance, Last accessed on April 13, 2012 from A. Profits on each of Sober Plc Motorbike Models 1. Profits Using the existing method based upon labour hours Motor Bike Labour Costs Cost of Raw Materials Overheads Total Costs Total Sales Profit Sunshine 2,000,000 1,600,000 9,600,000 13,200,000 16,000,000 2,800,000 Roadster 2,200,000 1,920,000 10,560,000 14,680,000 19,200,000 4,520,000 Fireball 800,000 720,000 3,840,000 5,360,000 6,400,000 1,040,000 Total 5,000,000 4,240,000 24,000,000 33,240,000 41,600,000 8,360,000 2. Profits Using Activity Based Costing i) Overhead cost allocations using activity based costing Motor Bike Deliveries Overheads Set-Ups Overheads Purchase Orders Overheads Total Overheads Sunshine 1,920,000 4,200,000 3,600,000 9,720,000 Roadster 1,536,000 4,800,000 2,700,000 9,036,000 Fireball 1,344,000 3,000,000 900,000 5,244,000 Total 4,800,000 12,000,000 7,200,000 24,000,000 ii) Profit for each motorbike model with the use of activity based costing Motor Bikes Labour Costs Cost of Raw Materials Total Overheads Total Costs Total Sales Profit Sunshine 2,000,000 1,600,000 9,720,000 13,320,000 16,000,000 2,680,000 Roadster 2,200,000 1,920,000 9,036,000 13,156,000 19,200,000 6,044,000 Fireball 800,000 720,000 5,244,000 6,764,000 6,400,000 -364,000 Total 5,500,000 4,240,000 24,000,000 33,240,000 41,600,000 8,360,000 Read More