Identifying the True Cost of Producing Goods or Services - Example

Running header: ABC Costing Student’s name: Instructor’s name: Subject code: Date of submission: Activity based costing is far superior to the traditional approach to absorption for identifying the true cost of producing goods or services. Introduction: The increasing level of automation in the modern day manufacturing has seen overheads become the major components of cost. Traditionally, absorption costing was the method utilized in determining as well as allocating overhead. However, the method has been found to lead to incorrect overhead allocation and hence a poor basis of decision making. A better or superior method of cost allocation has therefore become necessary in today’s manufacturing environment where cost information is a major component in decision making process especially as regards make or buy decisions as well as pricing. Owing to these, activity based costing has been invented and has been found to be far much superior in tracing overheads to individual products hence providing healthier overhead allocation and therefore better product cost information. Through absorption costing, direct costs as well as overheads are assigned to cost units by use of one or different absorption rates (Pinson, 2004). In Activity based costing however, resources are traced and assigned to activities while activities are assigned to cost objects on the basis of consumption estimates. It is worth noting that a costing method ought to provide information that helps in waste minimization as opposed to being wasteful itself. In this regard, absorption costing has been found to not only be economical but also a more reasonable method of cost allocation and hence a far superior method of cost allocation as compared to the traditional costing methods. Why traditional costing methods/ absorption costing method is deemed to be a poor method of cost allocation; Absorption costing method makes use of a single volume based cost driver. For this reason, the costing system results in distorted cost of products. In most cases, the method assigns overheads to products using the basis of their individual usage of direct labor. This gives rise to an inaccurate product cost. The weaknesses of the absorption costing model arise from its assumption that costs are caused by products. In this regard, it is assumed that every time a product has been produced, cost is incurred. While this assumption is reasonable for some direct costs, it can not be assumed to hold for those activities that are deemed to be indirectly performed on the product units. The main weakness for the approach adopted by this method is that for most of the overhead activities, the proportions of the activity actually consumed by a product do not correspond to the single cost driver (Eric, 2003,). This is true for today’s manufacturing companies since products are produced using both manual labor and technology. Absorption costing uses volume based cost drivers like direct labor hours in assigning manufacturing overheads. In this case, one ends up with cost of goods sold that only includes product costs as defined in financial accounting. By assigning cost directly to products as opposed to activities then to product units, the cost report attained gives information on only what is spent but not why it is spent. When reporting on costs, separating costs that are traceable and those that are fixed is of paramount importance. This is because traceable fixed costs can then be booked to departments while common fixed costs are pooled together in the absorption costing approach. However, the base of determining the traceability of costs in the arbsorption costing model is unclear. The method has only one or few indirect cost pools for a single department or the plant as a whole. Application of costs in absorption costing model is usually based on an indirect cost driver. These indirect cost applications are usually financial based. Absorption costing method therefore, makes use of a system in which the total cost of producing a few products is divided among the various products. This implies that the method actually gives costs that may either be higher or lower than they actually are and hence they are distorted. The method is therefore deemed to be misleading and hence not suitable for use in cost allocation and decision making. Why activity based costing is superior to other traditional costing methods Of late the application of activity based costing system has greatly increased. The method has a lot of benefits over the traditional absorption costing methods which makes superior. Some of the reasons why the method is considered superior to the traditional approach to absorption for identifying the true cost of producing goods or services include; Accuracy ABC method accurately determines the costs of products more accurately. This is because the method uses cost drivers in determining its overall overheads. The operations of the firm are closely monitored to determine all the activities that take place during operation. The cost drivers are allocated to the products, and all the resources utilized are determined as they are used by the pro\duct or activity. It is therefore difficult for the firm to miss any such activity and the final cost of the product or activity will be accurately determined (John, 2005). The use of multiple cost drivers prevents a firm with high volume products to subsidize lower volumes ones. Moreover, products that do not use require certain activities in their production do not share such costs as is the case in the case of direct method of costing, for instance inspection cost may not be attributable to molasses in a sugar production firm. This accuracy will also be reflected in the pricing of goods and services. The firm is therefore able to maintain profitability without exploiting the customers the other hand they are able to charge a premium for completive products while maintaining demand in the market. Finally, low volume goods and services will not be under charged when the firm adopts activity based costing. Planning and cost control. Unlike absorption costing methods, Activity based costing facilitates pooling of costs by activities which helps the managers and decision makers to control the firms cost as well as make appropriate plan. Information obtained from absorption costing system will also be of help to companies in redesigning their products to use more common components that will reduce cost in the long run. Use of activity based costing technique is also useful in helping the management come up with activity based flexible budgets that are more accurate as compared to conservative budgets since the behavior of overhead costs is identified by their multiple cost drivers. This technique is vital in future planning. Firm’s can accurately determine the cost associated with producing a given product even prior to its launching. This is not possible with the traditional cost allocation methods such as absorption costing. Profitability This technique unlike the traditional costing techniques gives insight for properly analyzing customer profitability, channels of distribution, region and other supply chain components which directly influence the profitability of an organization (Shaper, and Volley, 2011). This is because the resources consumed by the organization and the performance of the supply chain components are well linked. In addition, the technique will also aid in coming up with measures to facilitate cost reduction on the firm’s products and thereby boosting the organization’s profitability. Cash flow management Activity based costing technique as method of cost allocation unlike the conventional methods facilitates the organization in cash flow estimation. Through separation of costs into activity pools and identification of a cost driver in individual cost pools, the analyst is able to more accurately determine the levels of various costs which will be incurred in the production process. In addition, the technique will also be useful in providing the management with accurate cost information relevant to purchasing decisions. Variance analysis The use of activity based costing technique will aid the management to accurately determine variances. This is because the actual costs are more accurate as opposed to the traditional methods of determining the same. Material usage variance, labor usage variances as well as other variances will have more elaborate meaning if the firm has adopted activity based costing (Peterson, 2006). It is easier to investigate such variances when the firm is using ABC method, as opposed to the traditional method of cost estimation. Conclusion Although activity based costing has several drawback such as its complexity and time consuming, the technique is modern and is widely applicable in organizations. This technique is able to identify waste in the firm and therefore help management in cost reduction. The firm is also able to improve its processes and exclude all the dummy activities that increase costs. This technique also facilitates performance management and the employees are able to work as expected. Budgeting is also simplified with the adoption of Activity Based Techniques. Organizations should adopt the three generations of activity based costing. The three generations include the product costing, process and performance costing as well as the value chain costing. This will enable the firm’s management to monitor its operations as opposed to the use of traditional costing methods. The ABC method will also help the firm in properly identifying the fixed and variable costs which will result to optimum decision making. However firms should not completely disregard the use of the traditional cost allocation methods but the ABC techniques is most appropriate. References: Pinson, L, 2004, The ABC performance breakthrough, Dearborn Trade, Chicago. Eric, S, 2003, Tapping the potential of ABC, John Wiley and Sons, New York. John, M 2005, Cost accounting, Rutledge, London. Shaper, M, Volley, T, Weber, P & Lewis K 2011, cost driver optimization in activity based costing, 3rd ed., John Wiley & Sons, Milton. Peterson, D, 2006, managerial accounting, Macmillan, Melbourne. Read More