Why Activity-Based Costing May Be Preferred to Traditional Absorption Costing in the Modern Manufacturing Environment - Essay Example

ACTIVITY-BASED COSTING By Location Activity-based costing Costing systems are very important for business organizations since they are used in the determination of the cost of products and services depending on the amount of revenue that the business organizations generate. The two costing systems that are commonly used by business organizations all over the world are traditional absorption costing and activity-based costing. For the traditional absorption costing the manufacturing overhead is usually assigned based on the cost driver’s cost. A good example of a cost driver is the quantity of direct labour that is needed in the production of a certain unit of products. Therefore, a cost driver can be defined as anything that requires the producer to incur direct costs. The other examples of cost drivers include direct material hours and machine hours. On the other hand, activity-based costing determines the cost of manufacturing a product by using the activities needed for the production of a product (Heisinger 2008, p. 24). In the recent past, it has been observed that most managers prefer using activity-based costing over traditional absorption costing. This paper aims at discussing reasons why activity-based costing may be preferred to traditional absorption costing in the modern manufacturing environment. When it comes to product costing the most important aspect that a business organization should consider when choosing a costing system is accurate. This can be said to be the main reason as to why most managers on the modern manufacturing environment would prefer activity-based costing to traditional absorption costing. The accuracy of this system comes from the fact that it focuses on the cause and effect link between activities and costs in the production context. Under this system, a business organization does not need to accord every product that is produced during the production a cost. However, the system only gives costs of products an amount if the production really needed those activities. Due to the fact that traditional absorption costing uses a single, volume-based cost driver, is known to assign overhead costs to product depending on their relative direct labour usage. The result of such assumption is always an inaccurate cost of products. Apart from being accurate, activity-based costing is also believed to have the ability of improving business processes. An activity-based costing system allocates indirect cost on the basis of a particular product’s cost driver (Cokins 2006, p. 89). The allocation of costs can also be based on the factors that create the cost. In the process of allocating costs to every product, there is always an emergence of a picture about the business processes that are performing well and those that are not. This means that business managers using an activity-based costing can be able to easily identify the processes that they need to improve in. An activity-based costing can also help in identifying processes that have no value added that can be important in improving the profitability of a manufacturer. With such capabilities a business organization will be in a position to constantly improve their production, market capital, and overall profitability. It is never a guarantee that all the products that are produced by a company will always be profitable. An activity-based costing works in a way that it accounts for costs in the same way production works are always performed. This can put a business organization to have a better understanding of where overhead costs usually go (Lewis 1995, p. 189). Using the data collected through this system, a manager can be able to identify wasteful products. It will also be possible to notice those costs that are not necessary. In such cases, mangers are always able to channel the resources that have been going to waste to other processes that will improve the overall productivity of the company (Weil & Maher 2005, p. 91). With such misappropriations resolved, it can be said that activity-based costing can be a convenient way of making sure that the productivity of a company is enhanced by identifying any excessive or incorrect pricing of a product. Activity-based costing systems can also be said to have overhead application flexibility. Under this system, calculation of overhead rates in always carried out depending on an individual activity pool. This is unlike the traditional absorption costing system where overhead rates are done with reference to all the production activities under a given company (Goektuerk 2007, p. 167). This is an advantage because it enables the overhead rates to be determined with more consideration of specific activities within the factory. Using a small business as an example, the traditional absorption costing system will determine that the general overhead rates would be calculated using direct labour hours. However, using an activity-based costing system, specifications would be made in terms of pools such as service cost pool (Daly 2002, p. 201). If cost is incurred every time a customer makes a call to the call then the overhead cost will depend on the number of calls made to the call centre. This enables the use of precise measures as the overhead driver. By using activity-based costing systems business organizations are able to make sure that their pricings for multiple products are fair and correct. This specifically applies for business organizations that are involved in the production of more than one product. This is made possible because of the fact that overheads are always allocated depending on the relevant cost drivers for specific products. The relevant cost driver for a specific product might not be the same ones for other products produced by the same company (Weil & Maher 2005, p. 101). Generalization might lead to unfair pricing of a product which will in turn affect the marketability of a product. With every product being priced with accordance to their cost drivers, a business organization will be in a position to make sure none of their products are overpriced. Overpricing will mean that such products will not be able to compete with alternative products that ate fairly priced. Activity-based costing systems can enable a business organization to make decisions on whether to outsource or produce. As discussed herein, activity-based costing systems can help a business organization in determining those products that are wasteful (Mitra 2009, p. 123). In that light it can also be said that, an activity-based costing system can help a manufacturer in knowing the production processes that they can outsource rather than doing it by themselves. Outsourcing is a way through which many business organizations avoid involving themselves in processes that are not profitable. If there are other organizations out there who can deliver the same products at a lower cost then there is no need of involving a company in such processes. The good thing about outsourcing is that apart from reducing the cost of production, it also reduces the liabilities that associate with the process in question. For instance, the company that the process is outsourced will have to carry the risks involved with the whole process. By using an activity-based costing system, a business organization can be able to focus on their strengths and the activities that use fewer resources. Just like an activity-based costing system might be useful in identifying processes and activities that are a burden to an organization, this system also identifies the processes and products that are of most importance to a company’s profitability. Identification of the processes and products that do not use much of their resources also help in knowing the processes and products that they can add without having to significantly change their production cost per unit. This is an implication that a business organization might be able to improve on their productivity and profitability by focusing on the processes that they do well and those that do not cause them much resources. This will only mean that in the long run, a producer will be able to be in a position where they do not have to spend extra resources. This will be of high benefit to their competitiveness because they will be able to offer their products at relatively lower process due to lower cost of production. It is clearly evident that activity-based costing is always preferred over traditional absorption costing. As shown herein, its advantage comes from the fact that it has higher accuracy. The other fact is that it can be used in important decision making processes such as when to outsource. Its main strength lies on the fact that it does not generalize and vies every activity individually. This system only pays attention to the activities that are required for production. For any production manager, activity-based costing will be more beneficial because it enables effectiveness, accuracy, and fairness in cost determination. The result of using activity-based costing is an organization that has a cost-effective production system. At the same time an organization will be able to make some important decisions regarding their production process. As seen herein, the use of activity-based costing can help a business organization in deciding when they should go for outsourcing and when they should just do the production by themselves. Bibliography Cokins, G 2006,Activity-based cost management in government,Management Concepts, Vienna, Va. Daly, JL 2002,Pricing for Profitability Activity-Based Pricing for Competitive Advantage,John Wiley & Sons, New York.http://public.eblib.com/choice/publicfullrecord.aspx?p=130998userid=^u. Goektuerk, H 2007,Activity-Based Costing (ABC) - advantages and disadvantages How ABC can be applied to institutions of higher education,GRIN Verlag GmbH, München.http://nbn-resolving.de/urn:nbn:de:101:1-201008158968. Heisinger, K 2008,Introduction to managerial accounting, Houghton Mifflin, Boston, Mass. Lewis, RJ 1995, Activity-based models for cost management systems, Quorum Books, Westport, Conn. Mitra, JK 2009,Advanced cost accounting, New Age International (P) Ltd., Publishers, New Delhi. Weil, RL & Maher, M 2005,Handbook of cost management,Wiley, Hoboken, N.J.http://www.123library.org/book_details/?id=5781. Read More