Activity Based Costing and Cost Management - Report Example

Title: Activity Based Costing Students name: Institutional Affiliation: Introduction Firms are facing a large decrease in resources since the economic crisis. This has led to large lay offs so as to free up more resources. The decline in resources has also led firms to improve the organization and management of costs. This has led to the identification and implementation of Activity-Based Costing and Activity-Based Management to develop better cost management (Cooper et al, 1992, pp 55-57). Activity-based Costing (ABC) is a technique used in costing which classifies activities in a business and allocates the cost of every activity with funds to all products as well as services according to the real utilization by each. Activity based costing assigns additional indirect costs into direct costs as contrasted to conservative costing. Activity based costing is complimented by Activity based management as it uses Activity based costing analyses of the different processes in an organization to discover inadequacies in addition to non value added actions and as a consequence allowing one to determine prospects for the reduction of costs or profit improvement (Compton, 1994, pp 32-40). Cost assigning methodology follows that, it is easier for the management to trace direct materials and labour to products. However, it is difficult to allocate directly, the indirect costs to products. In as much the products may use the common resources differently; there is need for some weighting in the process of cost allocation. The cost driver as a unit of activity causes change in an activity cost. Activity Based Costing therefore relates indirect cost with the activities which drive them. Background East Coast Marine Ltd (ECM), before the introduction of Eloise Smith as the new cost accounting manager, would have used a flawed material handling rate of 10% which they calculated as follows: Payroll $180 000 Employee on-costs 36 000 Telephone 38 000 Other utilities 22 000 Materials and supplies 6000 Depreciation 6000   Total material handling department costs $288 000 Material handling rate = total material handling department costs total direct material costs = = 10% Activity based costing enables managers and accountants to split tracking costs necessary to produce single units to process a batch of a product and maintain a manufacturing facility up and running (Cooper & Kaplan, 1992, pp 1-13). Since cost drivers are primary structural determinants of an activity cost, the linkage and interrelationship which affect it, determine the cost behaviour of activities and links with other activities which affect them. As a methodology followed by managers in organizational operations, ABC is vital in resource allocation and help segregate the fixed, variable and overhead costs. When these costs are split, then it is easier to identify the cost drivers. There is greater interrelationship between ABC and cost drivers, as in order to carry it out, the cost drivers have to be established for the different cost pools. For East Coast Marine Ltd, profitability and cost reduction are very important drivers for resource allocation. The firm requires growing as well as increase profits. This led them to revise their material handling costs are allocated. This turned into a per purchase order basis of $1.00 whose computation was done as below: Total Material Handling Department costs $288 000 Deduct Direct costs: Direct government payroll $36 000 Employee on-costs (20% ´ $36 000) 7200 Direct phone line   2800   46 000 Material handling costs applicable to purchase orders $242 000 ¸ Total number of purchase orders ¸ 242 000 Material handling cost per purchase order $    1.00 Purchase orders in the case of East Coast Marine Ltd prove to be a more dependable cost driver than the more traditional dollar amounts. Seeing that resources are used during the processing of a purchase order, the number of purchase orders play a big role in this firm as the size of the order has a negligible impact on resource consumption. The new technique of apportioning material handling costs between the commercial contracts and government contracts adopted by East Coast Marine Ltd has led to a reduction of $74 600. This is computed as follows; Previous method: Government material $2 006 000 ´ Material handling rate ´     10% Total (previous method) $ 200 600 New method: Directly traceable material handling costs [$36 000 + (20% ´ $36 000) + $2800]   $ 46 000 Purchase orders (80 000 ´ $1.00)   80 000 Total (new method) $126 000 Net reduction $ 74 600 Analysis of Activity Based Costing Activity based costing’s first stage is the activity centres (Tsai & Kuo, 2004, pp 271-277). This is basically the aggregation of actions into activities. The activity centre costs are then reported after the allocation is finalized. This is then followed by allocation of activity costs to cost objects (Tsai & Kuo, 2004, pp 271-277). This is where Activity based costing points out the ambiguity of analyzing and apportioning overheads to the products and as a result the necessity to analyze total overheads into more defined and detailed total overheads for the purposes of absorption. The estimates of cost elements help in elimination of unprofitable products and services, and at the same time, lower the overpriced products and services. The ineffective processes are also eliminated. Giving more consent to concept which yield better through the same means. Activity based costing also exposes the limitations of using a sole blanket total overhead recovery rate and consequently the call for absorption of each category of overheads that are founded on their particular cost drivers. This shows that Activity based costing is actually an extension of the traditional costing system (Steve R. & Ken, 1994, pp 1-7 ). Activity based costing played a big role in current costing methods as it helped demonstrate the call for the addition of overhead costs from support departments into the final product costs. Conclusion and Recomendations Activity based costing’s most triumphant benefit is its ability to target cost reduction (Evans & Ashworth, 1995, pp 26– 30). It provided a detailed scrutiny of costs vis a vis activities that are requisite for costing providing a supplementary visibility as well as a new viewpoint on overhead cost allocations. This spans through products, to activities and departments and allocate the resources to the most rofitable among them. According to the recomendations of Eloise Smith, a cummulative dollar impact of $234 346 as forecasted over three years. These forecasts are calculated as follows: In summary, the cumulative dollar impact of the recommended change in allocating Material Handling Department costs is $234 346, calculated as follows: Studies have established that Activity based costing has a great deal to offer to total quality management of organizations (R & Ken, 1994, pp 1-7). Particularly, it serves for budgeting, performance measurement, and ensure both product and customer profitability. Furthermore, process design ensure better product and thus, improve the product quality. This gives satisfactorily reasons for its implememtation and application. Eloise Smith has very good recomendations for East Coast Marine Ltd. The new methods that she proposed for the firm will play a big role if they adopt them since it would play a great deal to reduce the distortions in the costs of products (Nayab, 2011, p 1). Other than that, East Coast Marine Ltd would be in a position to improve profitability as activity based costing provides precise and enlightening product costs as well as customer profitability capacities. Since unnecessary costs are also eliminated and the sevice and product prices are fixed, the outcome will be desirable. This consequently enables the management to make superior strategic decisions in regards to pricing and the apportioning of purchase orders. Eloise has an ethical responsibility to put forward her propositions and concerns for action by upper management if the immediate supervisor is not giving her the assistance she requires. The structure set in an organization can be reviewed to adjust accordingly. This is majorly by dynamism involved with the management. Ethical conflicts are very sensitive and it may even prove necessary for Eloise to resign so as to follow up with the top brass of the organisation in the event that internal channels are not sufficiently adressing the issues. References: Compton, T. R. (1994). Using Activity-Based Costing in Your Organization - Part 1. Journal of Systems Management 45, no. 3 , pp 32-40. Cooper, R. (1992). From ABC to ABM: Does Activity-Based Management Automatically Follow From an Activity-Based Costing Project. Management Accounting 74, no. 5 , pp 55-57. Cooper, R., & Kaplan, R. (1992). Activity-based systems: measuring the costs of resource usage. Accounting Horizons , 6(3) , pp 1-13. Evans, H., & Ashworth, G. (1995). Activity-Based Management: Moving Beyond Adolescence. Management Accounting-London , pp 26– 30. Nayab, N. (2011, May 18). Pros and Cons of Activity-Based Costing. Retrieved 28 1, 2013, from Bright Hub: http://www.brighthub.com/office/finance/articles/78752.aspx p 1 R, S., & Ken, G. (1994). Should Activity-based Costing Be Considered as the Costing Method of Choice for Total Quality Organizations? The TQM Magazine , pp 1-7. Steve R., L., & Ken, G. (1994). Should Activity-based Costing Be Considered as the Costing Method of Choice for Total Quality Organizations? The TQM Magazine , pp 1-7. Tsai, W., & Kuo, L. (2004). Operating costs and capacity in the airline industry. Journal of Airport Transport Management , pp 271-277. Read More