Strengths and Weaknesses of Costing Systems - Essay Example

Strengths and Weaknesses of Costing systems Strengths of Activity-Based Costing System Activity-based costing identifies organizational activities, and assigns the cost of each activity to all products and services (Drury, 2012). Activity-based costing uses information from Enterprise Resource Planning System to apportion costs to products and services. ABC system guarantees accuracy in its reports since it uses automatic information from the ERP (Gilbert, 2007). The ERP system enables the system to be accurate because it gathers exact information such as number of orders, raw materials used and production capacity on a daily basis in an organization. The system is also accurate because it identifies products and then assigns to them direct and indirect costs. This means that ABC identifies the cost of producing various products. This then enables companies to determine the products that are highly profitable and those that produce low returns (Kaplan, & Anderson, 2005). Organizations then decide to produce the profitable products in large quantities and the less profitable ones in low or no quantities. ABC system helps managers in forecasting demand for their products and predicting sales using the company’s capacity. The capacity of an organization refers to the ability of employees and machines to produce goods of a certain quantity. Organizations compare the products that employees and machines produce in a day and those that consumers purchase on the same period. If the company sells all the products that it produces, it discovers that its demand is higher than its capacity (Drury, 2012). If consumption is less than production, companies, are able to tell that the level of demand is below its capacity. Organizations then determine the amount of output to produce using the comparisons. ABC system is vital in identifying wasteful products and ensuring resources are used productively. According to Kaplan and Anderson (2005), activity-based costing system allows managers to eliminate costs spent on non-value adding activities. This provides greater visibility into business processes and operational cost drivers. Improving information visibility also enables cost managers to deploy quality-related initiatives by identifying and eliminating poor quality activities together and their cost drivers (Gilbert, 2007). This is beneficial to the company as it increases efficiency and profitability because firms concentrate on profitable activities and products. Weaknesses of Activity-Based Costing System Setting an activity-based system is costly and time-consuming. Extra costs are caused by the need to hire the services of a consultant with specialised knowledge and experience in the set up of ABC system. Additionally, the software for ABC costing system implementation may increase operation expenses, leading to poor financial performance. Acquiring an Enterprise Resource Planning system is also expensive and it may be unaffordable for some firms (Gilbert, 2007). Such organizations then have to use the traditional method that ignores time and capacity. Another weakness of ABC system is possible misinterpretation of data (Turney, 2004). ABC costing system reports contain several pieces of complex information such as mark-ups and margins that may make the reports confusing. Poor interpretation may lead to making wrong decisions, which can risk business performance. An ABC system is also weak in that it does not inform companies about the customers who are highly profitable. This forces companies to use Balanced Score Cards that causes additional costs to organizations (Turney, 2004). Strengths of Volume-based Costing System Applying volume-based costing system involves allocating factory overhead costs to individual products and services. Organisations use volume-based costs drivers that are contingent upon the number of units manufactured (Drury, 2012). Volume-based system accumulates costs from both production and nonproduction activities, and allocates costs from nonproduction departments to production departments. This ensures that the organisation cater for costs incurred by all other auxiliary services to production. Volume-based Costing has an advantage because it enables managers to determine the activities that consumer numerous resources and produce low costs (Drury, 2012). Business leaders then develop techniques of reducing the high cost of some activities to make them profitable. This means that organizations concentrate on the activities that produce high profits. This increases the overall profitability of organizations. Volume-based costing system is affordable to small firms that do not have the capacity to install other complex costing systems. Turney (2004) argues that volume-based costing system tends to be simpler than activity-based costing system because it does not have complicated features and it is inexpensive to operate. Therefore, companies that cannot afford expensive systems like ERP can still determine the costs that they spend on completing various activities. The use of Volume-based costing also enables organizations to save the cost that they would use on acquiring expensive systems such as ERP that require skilled workers to operate. This means that organizations that use this system also save the cost that they would use to employ skilled workers. Weaknesses of Volume-based Costing System Volume-based costing does not account for the unique manufacturing systems in different operations yet businesses have various production departments. Separating costs from various production characteristics is critical for quality cost management (Drury, 2012); however, volume-based costing fails to reveal diverse features of different production operations. For example, the system calculates the costs that companies incur on labour without defining whether the cost accounts for manufacturing or services. Companies, therefore, may fail to recognize the actual cost that they spend on labour relating to the individual departments. Volume-based system uses a common plant or departmental cost drivers to allocate costs. The system ignores differences prevalent in activities for various production operations within the firms. Organizations, therefore, do not determine the most essential activities in their businesses using this approach. Volume-based costing is characterised by low levels of accuracy and high costs of errors. Cases of inaccuracy are caused by emphasis on total costs, which sometimes negates other cost drivers that may affect the cost of a product or service (Gilbert, 2007). This is because volume-based costing system considers only total costs that comprises of fixed and variable costs. Lack of accuracy leads to repeat preparation of financial statements that increases the expenses of management. Additionally, using volume-based costing may lead to poor management decisions since it excludes critical costs of manufacturing when calculating the costs of production. The system excludes the costs that are not identifiable as direct or indirect because it assumes that they are unclassifiable. Therefore, when managers make decisions that are based on costs that leave out the unclassifiable expenses, it means that such decisions are wrong and may lead to unfavourable results such as low sales and profits. Volume-based costing ignores time and it does not notify companies about profitable consumers. This means that organizations have to supplement the system with other techniques such as BSC (Drury, 2012). This causes additional costs, which consequently reduce the profits of companies. References Drury, C. (2012). Management and cost accounting. Andover, Hampshire, UK: Cengage Learning. Gilbert, S. J. 2007. Adding time to activity based costing. Harvard Business School Working Knowledge. Retrieved from http://hbswk.hbs.edu/item/5657.html Kaplan, R. S., & Anderson, R. S. 2005. Rethinking Activity Based Costing. Harvard Business School Working Knowledge. Retrieved from http://hbswk.hbs.edu/item/4587.html Turney, P. B. 2004. Common Cents: How to succeed with Activity Based Costing and Activity Based Management. New York: McGraw-Hill. Read More