Managerial Accounting: Activity Based Costing - Research Paper Example

Managerial Accounting: Activity Based Costing Introduction Managerial accounting is an approach to cost management that relies on accounting information for ‘decision-making’. The management is therefore equipped with accounting information for guidance. This paper seeks to discuss activity based costing as an element of managerial accounting. The paper will explore the approach to activity based costing, the relationship between activity based costing and traditional methods and activity based management as well as the advantages and disadvantages of activity based costing. Approach to activity based costing Activity based costing is a costing method in which an organization assigns costs to its products based on involved processes. The process of activity based costing, therefore "identifies activities that generate costs and assigns costs to those activities" (Hermanson, Edwards and Ivancevich, 2006, p. 110). Jiabalvo explains activity based costing as an approach that organizations apply in allocating overhead costs to activities and is undertaken in a series of steps. The fists step in activity based costing is the identification of the processes that generate the overhead costs. Since some of the activities are immaterial and insignificantly affects representations, only material overhead activities are identified. The identification of the significant overhead costs should include both costs that relate to production activities and other costs that do not contribute to the organization’s production process. Once the significant costs have been identified, they are grouped according to the activities that generate them. Such categories may vary from one industry to another and among the organization. Using cost drivers, the costing approach measures the activities in order to determine the rate of allocation to each single activity. Once the activities have been quantified, “costs are assigned to products” based on the activity quantification (Jiambalvo, 2009, p. 210, p. 210). Some of the major classification of activities includes operations of materials, installation, and maintenance of machines, production processes, and supervision. Cost drivers could, on the other hand, include "number of purchase orders, number of material requisitions, number of set ups, number of machine hours and number of inspections" among other cost drivers (Jiambalvo, 2009, p. 210, p. 2011). Activity based costing and activity based management While activity based costing quantifies activities with the aim of allocating costs to each category of activities, activity based management applies the results of activity based costing in ‘decision-making’. Activity based management evaluates the assigned costs to identify the activities with high rates of resource consumption. This process is then followed by initiatives to reduce the identified high costs. The scopes of activity based costing and activity based management, therefore, identifies a relationship in which activity based management depends on activity based costing. Activity based management is, therefore, a product of activity based costing (Hermanson, Edwards and Ivancevich, 2006). Giambalvo further associates activity based management with the aim of "improving efficiency and effectiveness" of the process. Through the availed costing information from activity based costing, activity based management undertakes the evaluation, control and ‘decision-making’ role towards eliminating wastes (Jiambavlo, 2009). Activity based costing and traditional methods Traditional based costing approach equally allocates costs to activities regardless of the level of consumption of resources that different activities report. This is contrary to the activity based costing that identifies a number of resources that are consumed by each activity and then dividing costs based on cost drivers. While the traditional costing approach is simple to apply, it fails to identify activities that could be uneconomical to an organization. It also does not provide information towards activity based management. As a result, reliance on traditional costing approach undermines cost management of operational processes. Application of activity based costing can, therefore, be understood as a development that facilitates cost efficiencies towards reduced costs. This is because the management approach allows for identification of uneconomical activities for appropriate decisions towards minimizing involved costs. Activity based costing is, therefore, a tool towards operational efficiency with respect to costs. This establishes the managerial accounting tool as an element towards competitive advantage. With activity based management as a link between costing and management of an organization, activity based costing becomes important to the management of an organization's operations, productivity and profitability (Maher, Roman, and Weil, 2011). Advantages of activity based costing The activity based costing approach has induced a number of benefits to organizations. One of such benefits is the accurate allocation of costs to activities. Unlike the traditional costing approach, activity based costing evaluates each category of activities and projects an exact cost allocation to eliminate under cast or overcast of costs. As a result, activity based costing offers the management a clearer perspective of involved costs of each activity. Another advantage of activity based costing is its role in influencing an organization’s management of operations. By providing accurate costs of activities, activity based costing established a ground for managerial decision. It, for example, forms the basis upon which management can identify costly activities for corrective measures. Besides facilitating identification and elimination of wastes, activity based costing facilitates generations of alternative activities for cost efficiency in operations. Activity based costing is, therefore, more beneficial than the traditional approach to costing (Jiambavlo, 2006). Disadvantages of activity based costing The costing approach is also associated with a number of disadvantages. The major disadvantage of the approach is the involved cost. While the traditional costing approach is simple with few activities, activity based accounting involves complex processes. It, therefore, for example, requires specialized personnel for quantification of activities and allocation of costs. Similarly, the numerous number of steps in activity based costing approach leads to increased cost. Activity based costing may also be tedious and confusing especially if a high number of activities are involved. This is because each activity has to be independently considered. Activity based costing is also associated with a level of inaccuracy based on its consideration of fixed costs such as depreciation while these costs cannot be directly associated with activities (Jiambalvo, 2006). Conclusion Activity based costing is a costing approach that allocates costs to activities based on the rate of resource consumption of each activity. Having been developed as an alternative to traditional costing method, activity based costing is relatively accurate in allocating costs and form the basis of activity based management toward cost efficiency and effectiveness. The approach is however costly and still has a low level of inaccuracy in cost allocation. Reference Hermanson, R., Edwards, J. and Ivancevich, S. (2006). Managerial Accounting. Minneapolis, MN: Freeload Press, Inc Jiambavlo, J. (2009). Managerial Accounting. New Jersey, NJ: John Wiley & Sons Maher, M., Roman C. and Weil, R. (2011). Managerial Accounting: An Introduction to Concepts, Methods and Uses. Mason, OH: Cengage Learning Read More