Advantages of Activity Based Costing - Example

Executive Summary The reports which evaluates the manner in which using activity based costing will prove beneficial for the business shows that the business will be able to ascertain the cost correctly and determine the manner price correctly. This will also help them to move from the traditional method to activity based costing mechanism and will highlight the manner in which the business will be able to improve effectiveness and ensure better decision making Table of Contents Introduction 3 Activity Based Costing 3 Problem in present system and way it will overcome 4 Analysis of cost using both methods 5 Implication for Management 8 Limitations 8 Conclusion 9 Recommendations 9 References 11 Introduction The report evaluates the manner in which using activity based costing will prove beneficial for the business shows that the business will be able to ascertain the cost correctly and determine the manner price correctly. It shows the difference which exist between traditional method, the problems that will be overcome, analysis of change in price, implication for the clinic and limitations. Activity Based Costing Activity based costing in a method which helps to ascertain the actual cost for each product and services by allocating the different cost to each cost activity based on the actual consumption. The process ensures that the indirect cost are converted into direct cost by developing cost pools based on which the different cost are assigned. The process of ascertaining cost is quite different from the traditional methods as it looks at ensuring that the correct cost for each product is clearly identified. The traditional method of costing instead proportions the total cost on all the items which has been manufactured instead of developing activity pools and finding out the correct cost correctly. This can thereby lead towards incorrect identification of cost which can further lead to a situation where the pricing mechanism fails. The activity based costing method is thereby an improvement and helps to ascertain the cost of different pool correctly. The advantages of activity based costing are as It helps to ascertain the cost of the product correctly and helps the business to determine the price which will be charged for the products It helps to provide an opportunity where the profit making products and loss making products can be easily differentiated and business decisions regarding the product can be made accordingly It helps to provide an edge in comparison to the competitors as it helps to create and develop the path through which better and effective decisions are made Activity based costing thereby helps to differentiate between the traditional methods and provides an opportunity to find out the cost of the product correctly. This helps to create and develop the required framework through which business effectiveness is multiplied and the cost are better ascertained. The perceived benefits which the usage of activity based costing provides surpasses the cost associated with traditional method of carrying out activities and provides an opportunity where evaluation and identification of cost becomes better. Problem in present system and way it will overcome The present system which has been used by the clinic highlights the following problems Inaccuracy in the estimation of cost as the method uses traditional method where the entire cost is divided on the different products directly by apportioning the cost equally (Dunn, 2010) Inaccurate pricing mechanism has been used which doesn’t helps to find out the correct price of the product and will thereby have an impact on the price that has to be charged for the product (Dunn, 2010) Doesn’t help to differentiate between the profit making and not profit making products and thereby has a role on the manner in which different business decisions are taken (Dunn, 2010) The use of activity based costing will help to overcome the problem as it will help to create the required fundamentals through which correct price of each product can be ascertained. This will help to ensure that the clinic is able to apportion the cost based on actual consumption and will thereby create path through which correct cost estimation will become possible. Having different cost centres and cost pools will provide an opportunity to evaluate the different direct and indirect cost associated with the product and will provided an opportunity where steps can be developed through which cost can be controlled. This will help to bring a complete transformation in the manner decisions are taken and will thereby help to increase the overall effectiveness through which decisions will be taken. Analysis of cost using both methods The traditional method of costing which has been used in the clinic shows that the following cost and profit estimation for the different units CLINIC INCOME STATEMENT TOTAL HD PD Revenues Number of patients 164 102 62 Number of treatments 34,967 14,343 20,624 Total revenue $3,006,775 $1,860,287 $1,146,488 Supply costs Standard supplies (drugs, syringes) 664,900 512,619 152,281 Episodic supplies (for special conditions) 310,695 98,680 212,015 Total supply costs $975,595 $611,299 $364,296 Service costs General overhead (occupancy, administration) 785,825 Durable equipment (maintenance, depreciation) 137,046 Nursing services (RNs, LPNS, nursing administrators, equipment technicians) 883,280 Total service costs 1,806,151 1,117,463 688,688 Total operating expenses $2,781,746 $1,728,762 $1,052,984 Net income $225,029 $131,525 $93,504 The new method which will used the activity based costing mechanism has identified that the general overhead will be distributed based on usage where 75% is used by HD and 25% by PD. With regard to the other cost nursing overhead cost will be allocated based on pool centres i.e. nurses, registered nurses, area used, and electricity consumed so that correct estimation of cost becomes possible. This makes the cost and profit analysis based on activity based costing to look as CLINIC INCOME STATEMENT TOTAL HD PD Revenues Number of patients 164 102 62 Number of treatments 34,967 14,343 20,624 Total revenue $3,006,775 $1,860,287 $1,146,488 Supply costs Standard supplies (drugs, syringes) 664,900 512,619 152,281 Episodic supplies (for special conditions) 310,695 98,680 212,015 Total supply costs $975,595 $611,299 $364,296 Service costs General overhead (occupancy, administration) 785,825 589368.75 196456.25 Durable equipment (maintenance, depreciation) 137,046 102784.5 34261.5 Nursing services (RNs, LPNS, nursing administrators, equipment technicians) 883,280 662460 220820 Total service costs 1,806,151 1354613.25 451537.75 Total operating expenses $2,781,746 $1965912.25 $815833.75 Net income $225,029 -$105625.25 $330654.25 Using the activity based costing mechanism shows that HD is loss making whereas PD is a profitable product. The difference arises due to the manner in which cost estimation has taken place as activity based costing ascertains the cost based on the pool centres and actual usage of different resources. This thereby helps to ascertain the different cost correctly and provides the framework based on which different decisions are taken. In addition to it using the mechanism also provides an opportunity to find out the cost correctly and helps to identify the profit making units (Horngren, 2011) The traditional method showed that both the units were profit making units as the cost were divided equally which made both the units look profitable. Calculating the actual cost based on the pool centres and actual usage highlighted that HD was a loss making unit where as the actual profits of PD was underestimated. This will help to improve the overall relevance of decision making as it will provide and create the required opportunity through which better business decisions will be made and the overall relevance of the manner in which the research is being carried out will improve. Implication for Management The usage of activity based costing will help Mary White Dialysis Clinic to take important decisions regarding the different products. The process helps to provide complete information regarding the manner in which different products are performing. The management based on it can look to improve their focus towards PD as it is a profitable unit. Further the management will have to look at developing ways and process which looks at reducing the cost and will thereby improve the overall efficiency so that the business will be able to reduce cost on loss making units (Cokins, 2009). Mary White Dialysis Clinic through the process will be able to make changes in the manner different business activities are carried out and will be in a position through which major transformation takes place and the business is able to develop the required fundamentals which will help to improve the overall effectiveness and ensure that the decisions which are taken is better. Limitations The limitation of the activity based system which will have an impact on business decisions which have been taken by Mary White Dialysis Clinic are as The identification of cost pool and cost centers becomes a problem as incorrect estimation of the cost pool and centers will result in incorrect price estimation and will thereby have an impact on the estimation of cost and price which has to be charged (Jan, 2000) The mechanism looks at estimating the prices based on pool centers and cost centers which will thereby make it difficult to consider the external factors and the role in has on pricing mechanism which will thereby impact the estimation of cost (Jan, 2000) It doesn’t consider the manner in which competitors have looked at estimating the price and influence of other factor on the price. This is an aspect which needs to be considered and will thereby have a relevance and impact on the manner prices for the product is determined (Jan, 2000) The same will have an impact on the working of Mary White Dialysis Clinic as determining the correct way of carrying out activities and the manner it will have an impact on the performance is an area which needs to be analyzed and looked at so that correct and proper information can be collected regarding the manner in which business decisions need to be taken. Conclusion The report evaluates the manner in which using activity based costing will prove beneficial for the business shows that the business will be able to ascertain the cost correctly and determine the manner price correctly. It shows the difference which exist between traditional method, the problems that will be overcome, analysis of change in price, implication for the clinic and limitations. Recommendations The reports which evaluates the manner in which using activity based costing will prove beneficial for the business shows that the business will be able to ascertain the cost correctly and determine the manner price correctly. This will also help them to move from the traditional method to activity based costing mechanism and will highlight the manner in which the business will be able to improve effectiveness and ensure better decision making References Cokins, G. 2009. Advantages of activity Based Costing. Global Product Marketing Manager, SAS Institute Inc Dunn, A. 2010. Activity Based Costing. Industrial Relation Centre, California Institute of Technology. Retrieved May 8, 2012 from www.irc.caltech.edu Jan, E. 2000. Activity Based Costing. Retrieved on May 1, 2014 from jan@emblemsvag.com Horngren, C.T. 2011. Cost Accounting: A Managerial Emphasis (1st Australian Edition). Pearson Publications Read More