Activity Based Costing Techniques - Report Example

Topic: ACTIVITY BASED COSTING Name: Lecturer: Course name: Course code: Date: Introduction In this essay a critical analysis establishes a comparison of the present costing system (absorption costing system) used by Creations Ltd against activity-based costing (ABC) method which is critically preferred to be implemented in the company (Drury, 2006). The condition of Creations Ltd is decisively accentuated by unrealizable budgeted returns. It is ideally found that the historic Absorption costing approach fails to reflect management goals of ascertaining direct cost and overheads per the product produced by the company. Activity Base Costing is opt to accurately allocate company cost objects to cost and later charge them on their cost drivers. On implementation of ABC costing system, Creations Ltd management believes to realize exact margins as the budgeted. Even though the Creations Ltd Company is gaining prominence due to its popular products, its financial performance shows a dilapidated trend (Botten, 2009). Due to this management ascertains a necessity to analyze the company performance basing on both financial and non financial explanatory components for understanding the case.  The analysis will aid identification of accuracy of costing system implemented in the organization. Following the case of Creations Ltd, the company uses Absorption costing systems, which thereby causes inefficiencies in realizing cost per each product produce in the company therefore failing to comply with budgeted overheads. This describes the scope of the firm basing analysis of distinctive features of the historical Absorption costing approach and the Activity Based costing technique (Smith, 2008). The analysis is will also overlook the merit and demerits of Absorption costing over Activity Based costing technique.      Decisive analysis of Activity Based Costing technique. Activity Based costing includes analysis of cost driver, activity analysis, and measures the performance[Rob92].ABC costing is preferably used to as a respond of the values of production process. Basing on ABC costing data, ABC aids assisting the management to improves decision making by determining the products, services and customers to utilize the overheads [Mic99], it also identifies the opportunities that add no value (NVA) activities thus improving the activities of the business. Activity Based Costing Framework Product cost Cost assignment (ABC) Resources Resource Driver Assignment Cost Drivers Activities Managing and Measuring Processes Activity Driver Cost Objects (Outputs) Better decision Reason for Making Cost of things Figure 1 Figure 1, gives an demonstration on how ABC traces costs from an company’s ledger chart to the activity they perform, and then to the cost objects they are engage in (i.e products, services, and customers). Resource drivers establish the level trough which a resource is consumed by every activity in the organization, while the activity driver determines how cost objects (products, services, and customers) consumes the same activity costs [Mic99]. Resource drivers are the time percentage taken by each employee to accomplish a certain activities, while the activity drivers refers to the number of services rendered, products produced and the number of customers served. The cost assignments view transforms the expenses of resources (salaries or supplies) in to the cost of work activities and ultimately in to the final cost objects The process view timely gives a series of work activities and accumulates the assemble activity costs throughout the business process. Cost Drivers are often determined by a surveying manager’s, workers or the subject matter expertise in the organization[Jud98]. A lively and open contribution from the company employee’s managers and experts in such surveys is decisively produces ABC information that accurately reflects organizational consumption of its resources at both cost object and the activity levels. ABC costing is categorically not a financial accounting system, but it’s a technique that provides a more reliable way in viewing and interpreting information’s by critically measuring the performances and cost of business processes and also their outputs. ABC basically is used to provide information to procedurally assist the organizations in achieving their budgeted goals in more efficient and effective way. Research on ABC Costing The extensive research shows that Absorption costing method uses a similar technique with ABC costing to allocate and ascertain cost to their cost drivers and furthermore to the cost pools[Rob92], Absorption cost accounting, however differs from ABC costing as ABC operates on the basis that activity cost are incurred through the utilization of resources[Moh00], for example incase a consumer demand for products and services they trigger performance of activities in serving their needs. Absorption cost accounting systems were primarily designed to satisfy the requirements of external reporting. They rarely provide timely and significant information to business managers and staff.  As such they fall short to give necessary information for the managers realize the dynamic cost uniqueness of their business. Activity Based costing is developed and implemented to overwhelm the limitations of historic absorption based costing. ABC costing identifies major understanding and controls of the costs while improving their performances[Jud98]. Unlike Absorption costing technique many business organizations has always found uneasiness in provision of a clear picture of the information systems needed to support strategic managerial decisions [Mic99], operational improvements. Although Creations Ltd market competiveness in their historic costing method, ABC costing can also reengineer efforts business information for the need needs to stay productive and competitive in the market. Activity-Based Costing can coordinates with various departmental initiatives to aid in resolving business financial and operational information goals which might not be reflected in traditional Absorption costing method. Hence with ABC system, operational and the chief managers no longer call for accounting experts to effectively understand and manage costs as ABC costing provides better imminent into exact operational costs and illuminates alternatives to improve ways of managing business, rather than non illuminated statement costs with no justification on their use and contributions to the business[And07]. ABC further assigns resource type to the work activities so as it will be easy to trace throughout the production process. Problems in the current Absorption costing system Normal Absorption costing system uses budgeted overhead rates which can disfigure actual results from operations.  As a result, the increasing machine-related overhead rate pressed the costs in need of additional cash to be stimulated (Paul M. M Collier, 2006).  In this aspect, the responsible system churns out poor three-year financial performance regardless of product market availability.  The use of machine hours does not only understate indirect manufacturing costs but it will also lead to also the substantial product contribution.     The shortcomings of traditional cost accounting method evaluated by ABC costing: Arbitrary historic Absorption costing technique leads to inaccurate make/buy decisions. The faulty forecast that cost injected will be limited when changing from make to buy. This prediction can be inaccurate as total product cost actually to increases while the prediction from cost system decreases[Rob92]. Inaccuracy in historic cost system is as result of omission of overhead to acquire materials and assemblies which disfigures expected cost diminution analysis. Absorption cost accounting system presents minor controls to the organizational managers on the effect of marketing, sales, and distribution and other product related cost or cost in product line profitability. Absorption costing systems can evidence a number of customers having the same profit margin when the facts are support costs incurred are dissimilar. The overhead resources used by different product and product lines is at a considerably different charge, hence a adjustments in product mix drastically changes the overhead cost incurred thus this is not reflected in the historic cost method.  Improvement Contribution and other merits of ABC system Apart from Creations Company having a market its production techniques is considerably the key effect of the declining returns of the firm. Activity based costing (ABC) will extensively aid in determination of accurate cost of the product.  ABC costing technique recommend on the cost improvement and even strategic plans to increase the firms productivity.  This strategy reserves the right for firm products to be continuously manufactured.  Manufacturing costs have minimal approach (Chadwick, 2005) on pricing of products and ABC technique will broaden the pricing skills obtain full benefits.  ABC also focuses on indirect costs (overheads) that are very relevant to the predicament of the Creations Ltd Company since it intends to trace the cost rather than allocating them.  Recommendations for the Creations Ltd Costing System Creations Limited needs to alter its existing system with the ABC technique, so as to gain positive returns when the company decides to expand its up-market two product which would greatly reflect the manufacturing complexity and labor-intensiveness of products.  If expansion of product line is conceded in the future years, much more the implication of ABC is distinguished because the manufacturing processes of expensive market product is considered more risky than the low return of the Creations product.  As a result, proper costing technique is necessary for the company to exploit its expansion benefits.  Since ABC also allocate indirect costs to the overhead (i.e. the cost of transportation), the prominence of extensive market products in distant places. In its current manufacturing scheme, its poor automated process does not make the “machine hours" a material basis for settling an overhead absorption rate.  Emphasizing the error on a company’s schema only worsen the problem,  the current departments are manually done thus this shows that "machine hours" does not represent the cost driver for general operating cost of each department.  Furthermore, the firm is a low-cost of manufacturing where it currently made a great sensation through market position (Botten, 2009).  However, its profit continued to bend for repeatedly for years signifying that business inadequacy of the demand-side approach.  As a result, the supply-side should attain value similar to the demand-side.  Owing to considerable under cast in the present costing, the product lines proves that adversity is reflected in the cost measurement and related efficiencies.  ABC can provide extensive data for the firm to advance its value chain in producing low-volume up-market product line.         Limitations of the newly proposed ABC system             Initially, there is an underestimation in the cost incurred in production of Creations Ltd products as they were based on machine units.  At the premeditated side, the change in adopting ABC will leads to an increased market price (Hoque, 2009) particularly of the its two products and hence can reduce market competitiveness of the firm.  This will be experimental especially when there are similar products from competitors in the market are of lower cost.  Thus, ABC has the limitation of infusing its findings instantaneously and directly in the market. The above recommendations are considered to have a simultaneous execution strategy.  As the firm is operating in low returns scale, adoption of ABC system requires incurable (Drury, 2008) elements that Creations Ltd Company may experience financial blog jam.             ABC system is considered incompatible with mass production processes and machine-intensive products this is because of its minimal activities.  This is why Creations two products are inconspicuous under ABC because limited human intervention.  Secondly, the act of collecting levels and activity data is claimed tedious and costly. In the behavioral side, ABC can create managerial resistance as it can reflects inefficiencies of the processes where their departmental link.  Without support from departmental managers, ABC adoption would be considered futile.  Conclusion            Creations Ltd should adopt ABC costing technique with similar operations in lowering focus on low-cost product line.  It transfers geographical design of market (Kader, 2011) and successes in up-market indicating changes in operating settings that requires modification in internal capabilities.  By the act of adopting ABC system, it’s fully response to both internal adjustments and external changes that is measurable and can evaluate on a intervallic basis (Chadwick, 2005).  With this, it critically analyzes whether the strategy adopted has high returns or incase of low returns they should focus on innovative progress. In order to succeed in adoption ABC costing system, the Creations Ltd should combine commitment of managers.  Installing incentives and create a board of committees to oversee the progress of ABC system adoption with a clear material plan focus in mind of starting point to augment enthusiasm on implementing and support to a newly established management accounting system.  Reference list Al Bhimani, M.B., 2009. 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