ABC Costing - Assignment Example

Running header: ABC Costing Student’s name: Instructor’s name: Subject code: Date of submission: Management accounting 1. Overview of activity based costing ABC or Activity based costing is a type of costing system that differs from tradional absorption costing and hence replaces labor based costing in that it matches costs with activities that cause the costs. The activities that cause the costs are called cost drivers. In other words, ABC system identifies the activities that the organization performs before assigning indirect costs to products hence assigning indirect costs less subjectively than other costing methods. Thus, ABC system makes a number of assumptions including; i) That products consume activities ii) That it is the activities as opposed to products that consume resources iii) That these activities are the cost drivers iv) That these activities are not always based on production volumes Thus, as opposed to traditional costing methods that allocate cost to cost centers such as finance, manufacturing etc, ABC system allocates costs to such activities as attending to customers, setting up a machine etc. When an ABC is approach most advantageous/appropriate? As indicated above, a major assumption of ABC system is that activities consume resources and hence are the cost drivers rather than volume. As such, ABC system would be most appropriately applied in companies that have significant amounts of overheads that relate to diverse activities in their provision of goods or services to customers of varying levels of demand. In other words, the system would not be appropriate for firms with little overhead costs that relate to almost identical products that call for similar attention. Based on this therefore, ABC system will be appropriately applied in Mary White Dialysis clinic. The perceived benefits and costs of ABC system The proposed ABC system has a number of benefits including; i) It leads to improved business process. As costs are allocated to activities, there emerges a clear picture of the business processes or activities that perform well and the ones that need improvement. As such, ABC would be useful in identifying non value added activities hence helping to better allocate resources to more efficient and hence profitable activities. In essence, employing ABC will add value to the business’ continuous improvement. ii) Identification of wasteful products – application of ABC enables one to understand better where overhead costs are going. As such, it is possible to identify wasteful products as well as unnecessary costs leading to more productive application of resources. iii) The process would also help the organization in fixing product or service prices that are excessive and hence incorrect. All in all, ABC leads to improvement in overall product or service quality since it reveals cost and production issues in need of adjustments. However, the system may have some undesired costs which may include; i) The system may be expensive to implement and also time consuming. The entire process of breaking down business activities uses valuable resources in collecting, measuring and entering data into the new system. This is also time consuming ii) The system does not conform to accounting standards and hence not useful for external reporting. As such, interpretation of ABC data together with regular accounting information may be misleading leading to bad decision making. As such, ABC is only useful for managerial purposes. 2. The problems associated with the costing system currently used by the clinic and how an ABC system overcomes these problems: The system currently being used by the clinic has a number of problems which including the arbitrary allocation of costs to the two services being offered by the clinic. This has resulted in some services being allocated costs that they do not consume while others are allocated more costs than they should be allocated. For instance, the current system in determining the cost of PD services still allocates machine operators costs to it despite the fact that patients being given this service do not use dialysis machine and hence no such cost should be allocated to this service. The problem with this is that one activity may be overcosted and hence overpriced while the other may be undercosted and hence underpriced. This affects resource allocation as well as decision making which may lead to the quality of service being compromised. To overcome this, the proposed ABC system will allocate costs on the basis of activities that consume resources. This will ensure that each of the two services is allocated a fair share of its related costs hence ensuring the services are properly costed and hence priced. This will ensure the correct reimbursements are sought and that service quality is improved. 3. Total HD PD Revenues Number of patients Number of treatments Total revenue 164 34,967 $3,006,775 102 14,343 $1,860,287 62 20,624 $1,146,488 Supply costs Standard supplies (Drugs, Syringes) Episodic supplies (for special conditions) Total supply costs 664,900 310,695 $795,595 512,619 98,690 $611,299 152,281 212,015 $364,296 Service costs General Overhead (Occupancy, administration) Durable equipment (maintenance, depreciation) Nursing services (RNs, LPNs, nursing administrators equipment technicians) $785,825 $137,046 $883,280 $490,709.75 $102,784.50 $686,354.78 $295,115.25 $34,261.50 $196,925.22 Total service costs $1,806,151 $ 1,279,849.03 $ 526,301.97 Total operating expenses $2,781,746 1891148.03 $ 890,597.97 Net income/Loss $225,029 ($30,861.03) $ 255,890.03 Average charge/Treatment $85.99 $129.70 $55.59 Average cost/Treatment $79.55 $131.85 $43.18 Profit/Treatment $6.44 $(2.15) $12.41 Comparison with existing system 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 Average charge/treatment $85.99 $129.70 $55.59 Average cost/treatment $79.55 $120.53 $51.06 Profit/treatment $6.44 $9.17 $4.53 Explanation: The average cost and profit per treatment greatly differs between the two costing systems. Under the original system, the HD segment incurs $120.53 per treatment while under the ABC system; each treatment costs $131.85 on average. Similarly, the profit per treatment differs with the original system’s profit for HD being $9.17 per treatment while that of ABC is a loss of $2.15 per treatment on average. Similarly, the average cost for the PD service segment for the original system is $51.06 which differs from that of ABC which is $43.18 on average. The profits also differ in that the original system’s profit is $4.53 per treatment while that of ABC is $12.41 per treatment on average. The differences arise as a result of the differences in the costing system in that the new system uses activities to allocate cost which ensures that no service segment is under or over costed/overpriced. On the other hand, the old system used to allocate costs arbitrarily implying that some services were underpriced/undercosted or overpriced/overcosted. Table 1: Overhead allocation: General overhead (occupancy, administration) General overhead resource cost pool Size of pool Cost driver Allocation HD Allocation PD Facility costs $233,226 Area $171,032.40 $ 62,193.60 Administration and support staff $354,682 Patients $220,594.90 $134,087.10 Communications systems and medical records $157,219 Treatments $ 64,489.15 $ 92,729.85 utilities $40,698 Usage $34,593.30 $ 6,104.70 Total $785,825 $490,709.75 $295,115.25 Table 2: Overhead allocation: Durable equipment (maintenance, depreciation) General overhead resource cost pool Size of pool Allocation HD Allocation PD Durable equipment (maintenance, depreciation) $137,046 $102,784.50 $34,261.50 Table 3: Overhead allocation: Nursing services (RNs, LPNs, nursing administrators equipment technicians) General overhead resource cost pool Size of pool Cost driver Allocation HD Allocation PD Registered nurses $239,120 No of RN $170,800.00 $68,320 Licensed practical nurses $404,064 No of LPN $318,997.9 $85,066.10 Nursing administration and support staff $115,168 No of patients $71,628.88 $43,539.12 Dialysis machine operators $124,928 Dialysis treatments $124,928.00 Total $883,280 $686,354.78 $196,925.22 4. Implication of the newly produced information to the management; From the newly produced information arising from the new costing system, it is clear that the company has been undercosting the HD services and hence charging lower prices than they should. In fact, it has been established that the services segment has been operating at a loss which serves to decrease the company’s profitability. This has resulted from the HD services being undercosted and hence the company has been charging lower prices for the service. On the other hand, the company has been overcosting the PD services and hence charging more prices on the service provision. However, although the service segment has been profitable as indicated above, this profitability has been compensating for the loss realized in the HD department/segment. The management should therefore make a decision on the appropriate prices for the services offered by the company. The company may continue charging the current price it charges for the PD services but adjust its price for the HD services upwards. This way, the company will be more profitable since the right reimbursements will be claimed. Another decision that management can make is to lower the charges for its PD services while adjusting those of HD services upwards. This will make the PD services more affordable which is in line with the clinics mission being a non profit organization. The proposed ABC costing system despite its obvious benefits to the clinic will have some limitations which are worth considering before its implementation. These include; i) Implementing the new system will require substantial resources to establish and maintain. These costs will relate to data collection, checking and keying into the new system. The clinic may find it hard to implement the new system incase funds are limited. ii) The new costing system will have its outputs different from the traditional costing systems implying that a separate costing system that complies with accounting standards has to be maintained which is an additional cost to the clinic. iii) There is a possibility of misinterpreting the ABC output data and hence care has to be taken when making decisions so that only costs that are relevant to the decisions at hand are used. References: Johansen, M2012, Management accounting and managerial decision making, London, Rutledge. Read More