Activity Based Costing - Case Study Example

Management Finance Activity Based Costing Introduction An activity based costing system (ABC) is the system of costing that assigns costs to activities first and then it traces the costs from the activities to the products. This system of costing assumes that activities use resources while the products and other costs objects on the other side consume activities (Otley, 2000). For the management to make this costing system possible, there is a need to identify activities with their costs and the use of cost drivers. The costing system is considered to be more accurate and that it better reflects the overhead consumption pattern. A feature of the ABC that mostly makes it distinct from other costing systems is the fact that the cost objectives upon which the costs are accumulated is the specific activities. The costs of the activities are then allocated to other cost objects like customers, products and services (Kaplan & Norton, 2006). The activity based costing is a costing system that underpins the job and process costing through the provision of an alternative way of ascertaining the accuracy of costs. It, therefore, should not be considered as an alternative to job and process costing. In ABC, therefore, the process begins by defining the activities that contribute to the production. An activity cost pool is then used to collect the costs of each activity. These costs represent the cost of undertaking each activity for a year. The costs are mostly classified into support activities and those of production process activities (Keef & Roush, 2002). The support activities cost costs such as inspection and costs of purchase order. The production process activities costs include costs such as assembly, machining, and finishing costs. In the ABC system of costing, the costs of support activities stand alone and are allocated separately as product costs. The ABC costing system uses different cost drivers for absorbing overheads. These are the factors responsible for the increase of cost activities. In other words, they make the cost activities to increase. Examples of cost drivers in the case study are as illustrated below: Cost pools £ Cost drivers Machine set up costs 280,000 Number of batches Material ordering costs 316,000 Number of purchase orders Machine running costs 420,000 Number of machine hours General facility costs 361,400 Number of machine hours –––––––––– 1,377,400 –––––––––– For each cost driver, there should be a cost driver rate that is associated to it and this is used in determining the amount of activity pool resource cost to be charged to each product line. This cost driver rate is calculated as followed: Cost of activity cost pool / Number of Cost drivers for the activity Cost drivers are, therefore, found from cost pools. A company is usually faced with a hard time when it produces several products and would like to calculate the per-unit cost for the products. It is not enough to just add the raw materials and the labor costs and the absorbing production overheads on the direct labor hours or machine hours as this is not a good way to calculate the per-unit cost. There exist many activities where the company will incur costs in order to achieve the production objectives (Burns, 2000). Such activities are what are known as the cost drivers. Some of the cost drivers commonly experienced in most companies include the number of purchase orders, number of set up machines, number of machine hours, number of parts of weights of material handled, number of tests or inspections, number of batches and materials, number of number of machine operators, number of direct labor hours. In the case of Berry Ltd. Manufacturers, the main cost drivers include the number of batches from the machine set up costs, number of purchase orders from the material ordering department, number of machine hours from the machine running costs and the number of machine hours from the general facility costs. Number of batches of materials is used by the company to calculate the storage cost per batch. The number of direct labor hours becomes a cost driver that the company uses to calculate the supervising cost per unit. The company also uses a number of machine hours to calculate the different machine hour rate that concern depreciation, maintenance and repair of the machines. It is also a common practice to issue the number of products we would like to make (Collin, et al., 2000). The cost of that number of products that we would want to make is calculated through the use of a number of purchase orders. The traditional absorption costing impacts the selling prices and sales volume in the following ways. One, it was very hard to know exactly the sales volume that was particular for a specific product. This is because, cost was aggregately applied across the board without distinguishing that cost drivers are involved in allocating the costs to the specific activities. This resulted to the selling prices of products being estimated, which could either be overestimation or underestimation (Coombs & Evans, 2000). When this system is to be applied by the company, then there would be a lot of assumptions on the basis of the sales volume as well as the selling prices of each product X, Y and Z produced. On the other hand, using the ABC system of costing entails allocating costs for the activities depending on the cost drivers that are associated with those particular activities. This is a very direct and easy way to know the particular amount of cost that would be allocated to each product to be produced. It, therefore, translates to a known and quantifiable amount of costs that are allocated in the production of each product (Coombs & Jenkins, 2002). This will then go a long way to determining the resulting sales volume that will be as a result of the quantity of costs applied on each product. It is the cost allocated using the cost drivers that are involved in the production of each product that will be used to determine the selling price of each product produced. As we can see, the cost drivers for product Y are higher than the cost drivers for other products X and Z. This shows that product Y will receive the highest allocation of costs that will result in its production in high numbers. Depending on other factors, its selling price may become higher or lower, but it is expected to be relatively lower. Part B A budget is commonly referred to as a plan that is expressed in financial terms. It is always prepared prior to the defined period to be able to achieve particular set objectives. In most cases, budgets are prepared for short periods that are not normally exceeding one year (Coombs, et al., 2000). Budgets are normally prepared for various purposes including controlling, planning, coordination, resource allocation, motivation, performance evaluation, and communication. Here, we will discuss the implications of some of the budget purposes as they apply to Berry Ltd. Planning This budgetary function involves the preparation of detailed short-term plans for various departments, functions and activities of the company. By making the short-term plans in as far as production of the three products are concerned, it is important that these plans and objectives should have a relation and a connection to the long-term plans and objectives of the company (Drury & Tayles, 2000). For instance, Berry Limited may have a short-term plans and objectives for producing products X, Y Z. These short-term plans will go a long way to impact the long-term plans and objectives of the entire company. Therefore, if the company is preparing a small budget for an individual product, they must know that this plan is affecting the major and overall budget of the company. Sometimes, the company might use the top-down approach in preparing and planning a budget. In this way, the main budget can be prepared whose focus is on the whole company activities. Then this budget can be broken down into various departments, functions, and activities. On the other hand, it can take a bottom-up approach where various small budgets for particular activities, functions, and departments can be prepared separately. After that, they can then be brought and joined together to make one big budget. Plans can, therefore, be used by the Berry Limited to modify its operations in order to convince the management that the companys objectives will be achieved by the end of the forecast period. Co-ordination Another purpose of budgeting is co-ordination. Here, we say that it is of no use making plans at each manufacturing department that have no relations (Emmanuel, et al., 1990). The preparations of various plans and budgets for cost allocations and production of the products X, Y and Z, must be ensured to be related in a way to bring oneness and togetherness in this company. If these products are produced by different departments or for different departments, there must be some relation or co-ordination of these departments to ensure that they all are working towards achieving the main objectives of the company. If each department achieves its goals and objectives, it is more likely that they will achieve the goals and objectives of the company. It is only possible that all the departments achieve this by working in close co-ordination with each other. This is one thing that is brought about by budgeting for each product. For co-ordination purpose to succeed, it is very important for the management of Berry Limited to identify the limiting factors. Control There is a tendency of an activity taking its actual course during its production process. It is very important to ensure that the actual activity is kept in line with the original plan. Control as a budgetary purpose is, therefore, necessary in adjusting the actual activity process to keep in line with the original plan (Hussey, 1999). In this way, the company already has in mind the particular objectives that they want to achieve by producing particular amounts of products X, Y, and Z. If they do not go according to this plan and adhere to it into strict production, it is feared that the objectives will not be achieved. In as much as there might be some factors that will be trying to make the actual production process run in a way that it wants to take a different route from the planned root, it is the duty of the management team to ensure that they control the actual production process to go in line with the budgeted process. The management team will, therefore, be able to adjust the plan to remain in line with the prevailing circumstances. Berry can be able to exercise control through frequently receiving feedback from the production processes of the three products. This will ensure that they are up to date with any upcoming circumstances that then will enable them to make timely adjustments to the actual plan to stay in line with the budgeted plan. The management will, therefore, be able to realize the variations through measuring the actual performance and comparing it to the planned performance. These variations are then reported to the manager, who then plans for appropriate corrective actions. Motivation During budget planning processes, the managers are required to set challenging but realistic targets. Such targets motivate the managers as they work hard aiming at achieving the set targets. It becomes very important in this company when various product production unit managers become motivated by the set targets and also use various ways to motivate their employees in those units (Merchant, 1998). Such targets are mostly achievable and motivating when the particular managers take part in formulating them. It is important to do so as the managers will be able to set clear and achievable targets that they know will work for them. When the top management get involved in setting clear and achievable targets, they work with zeal knowing that they have something to achieve. It is a factor that also motivates the junior staffs when they see the managers of the various units motivated, also to work towards achieving the goals and objectives of the company. Berry can also achieve this motivation through timely preparation and approving of the budgets. When the budget is passed early enough at the correct time, it becomes very easy to receive funds on time for the various cost allocations and for the various activities that require funds in the company. It, therefore, makes it clear to the management that the set goals and objectives will be achieved as adequate funds have been availed in time to carry out the various activities as required by the various production units. Performance Evaluation Budgets specify the various activities that are required of various teams in the company. For instance, at Berry Limited, the team that is responsible for the production of X products are charged with certain responsibilities and certain goals that they need to attain. It is, therefore, easy for the managers or the team leaders to measure the performance of their teams while using the budgets as their benchmarks (Proctor, 2002). Teams that will not have achieved the goals that were set by the budget by the beginning of the production process will be identified and appropriate measures will be taken towards such teams. Those teams that will be within the requirement of the budgets will also be evaluated and used as examples to other teams in the company. Such evaluations and achievements can be used by the management to apply various motivational and corrective measures to the various teams depending on their performance. If Berry is able to evaluate its performance and that of its various teams, it will be an achievement to the whole company as it will be in a position to know the strengths and weaknesses of various teams. It will, therefore, be able to put more effort on the areas of weakness and maintain its position on its areas of strength. The company will, therefore, be in a position to provide an all-round monitoring and control to its performance in all various units. However, the management of Berry must know that it is not only through adherence to the budget that can manage the companys performance. There are other factors of concern that are involved, and the company management require to be aware of such practices to be sure of total performance evaluation in the company. Conclusion In a nutshell, activity based costing is a modern system of costing that has come to replace the traditional product absorption costing system. The ABC costing system is regarded as very efficient as it uses cost drivers to allocate costs to various activities. This is as opposed to the product absorption costing method that applies raw material and labor cost, and the other costs involved together while leaving out some costs of various small activities that are involved. Budgets are also varied purposeful in our organizations, and some of the purposes of budgets include control, motivation, performance evaluation, planning, co-ordination and resource allocation. 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