Traditional Costing System versus ABC Costing Technique - Essay Example

Traditional Costing System versus ABC Costing Technique Contents Contents 2 Introduction 3 Traditional Costing System 3 Effectiveness of Traditional Cost Accounting 3 Failure of Traditional costing measures 4 Emergence of ABC costing technique 5 Activity Based Costing 6 Benefits of ABC Costing 7 Drawbacks of ABC Costing 7 Conclusion 7 Reference List 9 Bibliography 10 Introduction The method of costing helps in determination of product cost in relation to the amount of revenue it generates. The two most common and widely discussed costing techniques have been identified as, the traditional costing system and the activity based costing technique. Traditional costing technique is linked to the volume of production for forming the basis for determination of the cost driver. This could be the amount of labour hours that are put in the production process. The traditional costing system assigns overhead costs based on the volume of such cost drivers. The cost driver is that factor which causes the costs to occur in the first place. These include machine hours, direct labour and material hours. Activity based costing, on the other hand is a reflection of costs that have been allocated to a manufactured product based on the different activities that were undertaken in order to produce the item. The paper is an attempt to understand the use of these costing measures and also acknowledge the use of indirect cost as cost objects in each of the two costing measure. That paper is aimed at highlighting the difference in the approach taken in costing of these two costing method is measurement of such indirect costs. The paper also highlights the efficiencies and drawbacks of these two techniques and tries to explain the growing acceptance of the activity based costing measure over the traditional methods. Traditional Costing System Traditional or absorption costing measure refers to allocation of overhead costs to the manufactured products. This method assigns indirect cost of factories to manufactured items and bases this on volumes like quantity produced, amount of direct labour hours utilise and amount of machine hours utilised. Many of the manufacturing concerns use the traditional costing approach for the assignment of manufacturing overheads to the units produced. This is because the traditional costing measure within financial reporting because it helps to provide value to the cost of products sold. It has been argued that traditional costing measure fails to accommodate the non manufacturing costs like administrative expenses along with product cost. These costs also form an essential component of the manufacturing process and need to be incorporated for the purpose of price setting (Drury, 2005). The traditional costing measure allows only few components of indirect costs to be assigned to the responsible department or the entire production system. The traditional costing measure allows for indirect factory costs to be allocated to all items that have been based on volume. This includes machine hours, labour hours and the likes. Effectiveness of Traditional Cost Accounting Traditional Cost Accounting measure had been developed primarily with a view to assist businesses that were engaged in small scale production or those that used similar manufacturing techniques which involved direct labour as one of the primary inputs with measurement of product cost. Such production process was repeated and costs were kept within limits through high productivity and high levels of output. This resulted in huge inventory hold up and little idle time among the working staff. There was a growing need felt to develop a costing measure that was capable of assisting with the financial reporting needs for companies. The cost of goods sold figure was essential for developing the inventory maintenance and reporting the income statement. However, there was lack of awareness and desire for the cost accounting measure to serve the purpose of internal controls along with the reporting requirements The traditional costing method was relatively easy to use and apply within the organizational context. This is because mangers find it easy to track all kinds of direct costs that are associated with a particular product. Assignment of overhead costs associated with different products is far more difficult. In the traditional environment of the manufacturing business, direct labour was a simple way to measure the apportioned overhead costs. Direct labour was a major component of costing while other overheads enjoyed only a marginal component of the manufacturing process. The traditional costing measure is also well aligned with GAAP and it helps in allocating costs associated with the product in the financial statements. Non product costs are eliminated from the accounting presentation. Failure of Traditional costing measures The profitability of the company is crucially dependent on the product costs. The determination of product cost is critical for the setting of product prices and also the degree of marketing efforts required. Product costs are also essential for the determination of competitive ability and strength as against the competitors and thereby determine whether to beat or to meet the price reductions of the competitors. In the traditional costing measure, accountants assign a single percentage as direct cost expenses which also set the indirect cost component. The method is largely inaccurate because the overhead cost component has kept on increasing over time. Additionally each product cannot have the same percentage of indirect costs. An example of this can be cited as more machine time being taken by one product than the other. Also direct labour and material component can be taken to be hypothetically same. Therefore in this case, machine hour calculation and cost appropriations cannot be done effectively is a particular percentage is made uniform for indirect costs for each product being produced. Hence, in this case, one product is subsidizing the cost for the other product. This is one of the major loopholes of traditional costing method. Inappropriate cost measurement and information can cause a whole host of problems. Some of these can be inappropriate product designs that raise cost unnecessarily, use of wrong equipments that raise cost of manufacturing, centralisation of functions that reduce quality and servicing along with costs (Kaplan and Johnson, 1987). With the use of machine hours alone for the allocation of overheads for manufacturing, the allocation implies that factory overheads are responsible for machine hour usage. This could have been true in the past when manufacturing was simpler and markets were far less competitive. However, in the recent times, manufacturing expenses have become far more integrated and there are many other components that affect overheads in the manufacturing process. Whenever the manufacturer wants to look for the true cost of products, traditional cost accounting method seems to be falling apart as for appearing adequate. This is because direct labour in this highly mechanised system is not the best way to measure cost drivers. The traditional costing measure also negates the identification of other significant cost drivers that contribute to the production of an item. Also associated with this is the bad management decision that might come forth with inappropriate cost drivers and elimination of other important non manufacturing cost drivers. Emergence of ABC costing technique In the 1950s, the traditional costing system saw widespread criticism for its limitations and this called the need for development of a new and improved costing measure that could overcome the drawbacks of the traditional costing measure. Goetz, 1949 was among the first proponents of the Activity Based costing measure. The cost factors that were dominant during the times when costing measures like traditional costing technique were existing and the ABC costing measure were being instrumentalised were direct labour and direct materials. The component of overheads was significantly small and any deviations that rose within such overheads were not so significant. The ratio of these costs with the overheads remained something around 100:20 but with globalisation and expansion of industries, the costs of overheads has increased and gained high importance. The ratio between direct costs and overheads has come to 100:800. This was one of the important factors that contributed towards the felt need for a new costing measure that increased focus on overhead costs (Cooper and Kaplan, 1988). Additionally, companies were becoming sellers in the market and there was a great degree of competition in the global context. The rise of global competition required correct costing techniques to be applied. Accurate costing techniques would in turn facilitate decision making process by establishing a proper cause and effect relationship. Another factor that adds on to the need for a new measure for costing was the fact that traditional costing measures were capable of measuring all costs that were related to volume alone. Costs pertaining to handling of material, setting up etc. could not be incorporated because they were not aligned to volumes. All of the above mentioned factors were responsible for the emergence of a new system of costing that would lay stress on the highly importance overheads components of cost and also measure costs for non volume linked activities. Activity Based Costing Activity Based Costing is an accounting measurement that by nature, assigns cost to activities instead of services or products. This very nature of activity based costing technique allows for a correct and accurate measurement of resources based as well as overhead costs. With a view to make a correct association of costs with each product and service, ABC technique tries to cost pertaining to each activity that is based on resource usage. These costs are then assigned to each of the cost objects which could be the customer or the product depending on the activity being used. ABC costing measure also facilitates to establish link between the activity flows within the different activities of the organization. This link is created by the assignment of each activity or resource consumption to the cost object. The flow between the ABC costing technique goes through four main areas of cost object, cost driver, resources cost of driver and activity cost driver (Horngres, 2008). The traditional costing measure relates overheads to the cost centres which are either the production centre or the service centre and this is followed by assignment to cost objects or the products. In the ABC costing technique, the overheads are first related to each activity and then grouped or classified into cost pools. It is only when cost pools have been designated that the assignment for products or cost objects are done. This presents the fact that the two costing measures are largely similar but difference arises in the first stage where ABC makes use of activities instead of functional departments or cost centres. The problem associated with incorporation of cost centres is that they tend to incorporate a whole host of activities that includes an entirely new set of costs which might behave in an altogether different fashion. It is quite possible that activities are spread across different functions. For example, the procurement function like raising a requirement note is done at the manufacturing or the stores department but the division where most of the procurements are done, the purchase department, does not raise any procurement note. The activity based costing measure tends to behave in a similar fashion by incorporating the activity where it occurs. Hence the ABC measure provides a more realistic picture for behaviour of costs. Another reason for the adoption of traditional costing measure over the ABC costing technique is that the cost rates under the ABC costing measure are taken in advance for the entire year. The same rate is used all along the year at a particular time. The advantage associated with this is that any seasonal variation that shall temporarily increase or decrease costs shall get spread out during the year providing with the average costs. In the absence of such measure, if actual costs were being sued, as in the absorption costing, the costs would provide highly varied figures. This would imply that in the event when output became high, overhead rates would be shown to be quite low and vice versa. Also, when prices have been based on cost, seasonal variations in prices would come in through seasonal fluctuation of input prices. It is important to make a cost benefit analysis of the activity based costing measure because the cost of activity based costing technique is higher. Benefits of ABC Costing ABC costing lays focus on activities rather than on products which provides a more scientific approach to cost measurement. Costs that have been identified within each activity are allocated within cost pools and then assigned to product and services. Such assignment is based on suitable cost drivers. This provides a larger and a far more precise. Managers are responsible for the management of activities rather than products. Any changes within the activity impacts the cost. Hence when activities are measure and managed efficiently, cost can be brought under control (Cohen, Venieris and Kaimenaki, 2005). With a view to make more efficient and stronger economic analysis and decisions for the company, managers have to identify the link between different activities and this is provided in a more accurate fashion by the ABC costing technique (Maiga and Jacobs, 2003). ABC helps in identification of areas of problems which need a detailed analysis and a more efficient management system. Drawbacks of ABC Costing ABC costing provides accurate measures at activity level but fails to encourage managers to change processes and hence activities for enhancing the efficiency of business. Activity based costing does not provide a comparative measure for cost estimation that might provoke the need for better cost management ABC costing measure fails to confirm with the GAAP principals. This is evident from the allocation of non product cost like research expenses into cost measurement while eliminating the product cost like depreciation of factory being eliminated from such measurement. Short term decisions taken based on the ABC costing technique can prove to be dangerous for the long run. For example, small order elimination for cost minimization might affect long run profitability (Coulter, McGrath and Wall, 2011). ABC costing system can create delays by eliminating the identification of constrain removals. Conclusion The activity based costing technique is a definite improvement over the traditional costing technique but it is not a perfect science in the sense of the term. This is to explain that traditional costing is losing its importance and applicability with growing business needs and increasing competition. The activity based costing technique overcomes the drawbacks in overhead cost measurement inherent within the traditional technique. The rise in importance of the overheads component has increased the relevance of giving more focus to the component rather than direct expenses. Activity based costing puts more focus on these non product related overheads and brings a more scientific approach to the costing technique in the modern day. Activity based costing has been criticised on grounds of being impractical and including waste costs that do not add value and bureaucratic costs of secondary and support activities into the cost component. However, it is also a measure for reducing costs through laying increased focus on processes and re-engineering methods. The measure benchmarks performance and activity links highlight areas of improvement and hence cost saving. Both the costing techniques can be considered as a replacement for each other. The main difference lies in the linkages that are important and the extent to which activity data needs to be collected. Reference List Cohen, S., Venieris, G. and Kaimenaki, E. 2005. ABC: adopters, supporters, deniers and unawares. Managerial Auditing Journal, 20, pp. 981-1000. Cooper, R. and Kaplan, G. S., 1988. Measure costs right: make the right decision. Harvard Business Review, 88(5), pp. 96-103. Coulter, D., McGrath, G. and Wall, A., 2011. Time Driven Activity Based Costing. Accountancy Ireland, 43(5), pp. 12-15. Drury, C., 2005. Management Accounting for Business. Los Angeles: Thompson. Horngres, C. T., 2008. Introduction to Management Accounting. New Delhi: Pearson Education. Kaplan, R. S. and Johnson, T. H., 1987. Relevance Lost. London: Harvard Business School Press. Maiga, A. S. and Jacobs, F. A., 2003. Balanced Scorecard, Activity-Based Costing and Company Performance: An Empirical Analysis. Journal of Management Issues, 15(3), pp. 283-301. Bibliography Cokins, G., 2002. Activity Based Cost Management: An Executives guide. New York: John Wiley and Sons. Kaplan, R. and Anderson, S. R., 2013. Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits. London: Harvard Business Press. Marsh, C., 2012. Financial Management for Non-Financial Managers. London: Kogan Page. Read More