Activity-Based Costing - Essay Example

MANAGEMENT FINANCE No) (Lecturer) Introduction Activity based costing is the product and service costing system, where cost is traced to a product or service based on the activity which was performed to come up with a certain product or service. This costing method takes an assumption that each product produced demands an activity. Therefore, each product cost will be directly proportional to the activities done in production (Baker 1998). Unlike the traditional method where cost share accumulated within departments, then allocated arbitrarily to products and services or customers. Activity based costing state the goal of the costing system and prevailing level of competition. Company should consider a system that will give accurate results and should be certain depending on the data inputted into the system. The system also should be simple to understand and be friendlier to the end users. In addition, the system should also be flexible for it to respond easily to the changes in the organization and for simple decision-making by the junior staff. Activity based costing method is more flexible hence it produces reports which can be used by the management in decision making, this is because it has got a certain methodology of costing products and services. Compared to the traditional method, activity based costing system cannot distort costs of the products that might occur if the products cost would have been done arbitrarily. There are four steps the company should follow to implement Activity based costing system. The first step is identification of activities in within the organization. The company will be required to analyse all the activities under every department. Under this step, the company should consider the processes, which are operational in the departments, this is because in some cost centres there are activities, which were operating; but they have ceased operating. Berry limited has three activities: machine setup, ordering and machine running. Berry limited cost pool comprises of material ordering cost, machine running cost and general facility cost of $280000, $316000, $42000 and $361400 respectively. Second step is the allocation of resource costs to the company activities. The cost is traced to find why it occurs; the cost can be director in direct cost. Direct cost is directly related to the output, the direct cost of product X, y and Z are $980,000, $1024000 and $1012000. Indirect cost is the cost that cannot be associated with a particular output; the cost is for the general company. Berry limited incurs a total of $1,377,400 indirect production cost. Third step is the identification of the outputs. Berry limited output includes; product X, Y, and Z are 20,000 units, 16,000 units and 22,000 units respectively. The products out rely directly on the cost drivers and the activities, which was done during the production process. Each product should be properly traced right from the raw materials, labour cost, and other general costs which were incurred to produce a finished product. Under this step, all products are sorted properly to make the costing process more efficient and certain. Fourth step is the allocation of activity cost outputs. Cost drivers affect assigning of costs. Cost drivers are those factors that regulate the total cost of an activity, In Berry limited cost drivers are; number of purchase, number of batches and number of machine hours. It assumes that cost drivers influence the indirect cost while cost drivers cannot affect direct costs like cost of materials and direct labour cost because they are cost drivers on their own. Direct material cost direct labour cost total cost X 500,000 600,000 1,100,000 Y 448,000 576,000 1,024,000 Z 484,000 528,000 1,012,000 Total 1432000 1704000 3136000 Overheads apportionment X 1100000/3136000*1377400= 483144 Y 1024000/3136000*1377400= 449763 Z 1012000/3136000*1377400= 444493 Overheads rate per unit X 483144/20000= 24 Y 449763/16000= 28 Z 444493/22000= 20 In summary, Berry limited total quantity per item is multiplied with the direct materials cost and direct labour cost (number of units * direct labour material cost) to find total cost per product. Then allocate indirect labour to each product based on the direct cost per product. For example total direct cost of product Y over total direct cost for the period then multiply with total indirect cost (direct cost of Y/total direct cost * total indirect cost= Y indirect cost). Then total cost per unit of a product should be calculated by adding direct cost and indirect cost then divide by number of product units for the period. Then multiply activity rate with activity usage, for example machine hours per unit multiplied with total hours spent by labour divided by the number of units produced in the period Activity based costing focuses mostly on activities of the company, therefore, in this case Berry limited activities are supposed to be classified. The first class of activity is unitactivity; this is anactivity, which must be done to produce any product, for example direct labour and cost of raw materials. Second is batch activity level, this is inactivity performed any time a batch is produced, for instance, machine setup (Kaplan &Anderson 2007). Third is a product level of activity, this is an activity that supports the production of any product and finally is the general level of activity for example security and maintenance in the company. This costing method is advantageous to Berry limited because it gives accurate method of costing products or services, hence providing precise option of pricing of products or services in the company. It is a more comprehensive way of defining overheads and the cost drivers. It also shows the cost and non-value adding events, enabling managers to focus on cutting down unnecessary costs, which the company has been incurring (Bradtke 2007). It allows customer and product productivity breakdown. Activity based costing support techniques of management such as the balance scorecard and performance management. Balance scorecard is a strategic planning used to strengthen the internal and external channel of communication of an organization. Performance management is the process of regulating productivity of departments and individuals in the within the company. Activity based costing system enables the managers to trace performance of product, service and customers. Implementing activity based costing system is costly in terms of time and resource. It consumes a lot of time in collecting relevant data, classification of available data and entering them into the system. Time also will be wasted because migration will be onphases, hence there will be interruption in the company costing processes (Cokins 2006). Expert knowledge is required to implement and train the staff of the company on how to use the system. The software is also expensive to implement and maintain but assist in automation of processes. Berry limited should implement activity based costing to replace the traditional method in place for cost effectiveness. The system of activity based is a dynamic system that has kept on changing over the decade. The company should regularly revise the system to meet the current requirement. The system will facilitate proper decision making by the company management at all levels (Goektuerk2007). Activity based costing will enable the company to achieve its objective of maximizing profit with minimal production cost. If the activity based costing system will reduce the production cost hence reduces the selling price of the products and definitely customers will buy more products of Berry limited which will increase the profitability level of the company. Budgeting is a process of coming up with a budget. Budget is a financial document used for planning for expected income in the future. An individualor a group of persons, usually a budgeting committee, can come up with a budgetin an organization. Budgeting committee comprises the top management of the organization that come up with the organization budget and approves its validity. Budgeting plan, control, evaluate performance of various department and act as motivation to an employee in terms of productivity. Budgeting planning function is the preparation of short and long-term plans for the different department in an organization. Every department are required to prepare short and long-term plan of all the activities. The department short-term plan should merge with the long- term plan of the general organization. The budget committee in preparation for the whole company will derive the data from the various departments to come up with a more detailed budget (Nelson 2005). The budgeting where the company uses the department budget to come up with an overall budget uses bottom up approach. Budgeting is a controlling mechanism to the organization activities. Budget control the employee to work in line with the ones in the planned budget. The budget, enable the company to compare the plan and the actual results and if there is a negative deviance from the original the employee are called for to explain the reason for deviation. When a deviation is reported on time, the organization can take the necessary action to correct the deviance. Every department in an organization should have a budgeting executive to monitor the process of budgeting to control implementation of the budget in an appropriate way. The executive measure their performance, department performance and individual employee performance in an organization using budgeting. The performance is measured in terms of variance between the actual and the plan results. If the variance is favourable the management reward individuals who contributed to the outcome. On the other hand, if the variance is adverse the management will know that their performance is poor and find the necessary action to improve the results. Budgeting is a decisionmakingtool. The strategic management sets the total expected income and the expected source of income and the expected expenses or cost for a particular period. Budgeting for income and cost will make the management give priorities to relevant department sin an organization to avoid shortage or excess surplus. If there will be surplus the planning committee will consider making investing in other alternative projects and a scenario where the management are expecting a deficit they may decide to cut some expenses to reduce costs in the company. Budgeting is important because the management use to regulate expected income and cost hence it is a decision-making mechanism due to the reason that it gives clear estimation. Budget that is challenging but realistic can motivate individuals to work hard towards the set target. Department managers should be allowed to set their own budget that can be achieved given the resources and time. The set budget will act as a reminder to the employee to work an extra mile to achieve the set standard. A well-set budget serves as a communication mechanism within the organization. If there is good, communication within the company, the entire employee will cooperate to the achievement of the budget. Organization that performs well in the economy rewards their employee when they achieve a favourable variance. Budgeting will have an effect on Berry limited performance and revenue. The budget will act as a yardstick to measure individual performance and the total yield of the three products. Managers of thecompany can adopt a realistic budget that can be achieved within a short time to increase the total revenue. The implementation of activity based costing and activity based budgeting will increase Berry limited financial performance. Financial performance will be achieved by an increase in the company revenue and product diversification. Budgeting will enable Berry limited to perform efficiently and effectively. The management will be able to compare the forecast and actual revenue to gauge their performance within theperiod. Since the company is focusing on maximum profit via sales revenue, the sales managers will pressure the sales person to achieve the target revenue. Berry limited will maximize the production of one of the products that is preferred by the consumers. The company will allocate more resource to the product to produce an extra unit for an extra unit. The budget will be used by Berry limited to make strategic decisions. Production director of the company used the results of the previous budget to come up with the decision that the company should use a bottom up approach type of budgeting. The results from budgeting will show the production cost of the company, and the reason why they should implement the suggestion by the production director to implement an activity based costing. In his opinion, the system will enable the company to minimize production cost and maximization of revenue. The budget will guide the management to make a decision to adopt new strategies. The stakeholders of Berry limited to make various decisions also use budgets. The share holders of Berry Company will measure performance of the company directors by comparing the current and the projected results. If the variance is positive, they will retain the directors but if the variance is negative, the share holders will call for an explanation from the directors. The government will use the budget to project the total tax from the company at end of the financial year. The financial institution will use the budget to find financial position and find if the company can repay back their loans. The company’s suppliers will use the budget to find the new credit limit to the company. The management of Berry limited will use the budget results to evaluate the performance of the production department. The projected sales within the period will measure the efficiency of company production managers and the department staff. The budget results should have a positive variance between the periods of projection (Wildavsky 1986). If the company does have positive actual revenue, the company production and department will be evaluated as the best department. The production manager suggestion will be implemented in the company processes. Organization using the same budget for planning, controlling and performance evaluation can lead to conflicting ideas. Budget used as a tool for planning is a forecast for the future period and should be realistic. The budget should be realistic to be achieved in a short time possible using the available resources. Budget as a motivating factor to employee should set a target that is challenging. The two functions are conflicting in terms of asset standard. Planning requires a simple realistic budget but a budget for motivation require a challenging budget that call for an extra effort by employees. Planning budget uses is prepared prior the period while a budget to measure performance of the company needs the most recent data (Baker & English 2011). The two function conflict in terms of data used in the preparation of the budget. The planning budget focuses overall organization but a budget to measure performance focus on a particular department organization performance. The company may have conflicting needs with the department needs because of the levels of production. The organization should not have one budget serving all the function of the company. Different budgets in an organization should be incorporated depending on the organization needs. A budget for planning should be precise and realistic, for motivation to be complex and a budget used to measure performance should be prepared using the most recent data. The various budget scan be assigned to the different department for better and desirable results. Despite the various advantages of budgeting, it has drawback as well (Dugdale& Lyne 2010). Budget is rigid and does not allow adjustment for the change whenever it arises. The prevailing conditions in the economy keep on changing, and the company need to give an allowance for change. The budget is fixed and no allowance for adjustment is given. Hence, the budget is not a good measure of the present company performance because change is inevitable in the organization. A budget focus on the plan targets of the company hence, exerts pressure on the employee. The pressure will lower the relationship among the employees of the company. Poor relationship will lower the overall performance of the company. If the employees do not achieve the set target it demoralise them and feel they are losers. The target might have been set on unrealistic level that cannot be achieved at the current conditions. In conclusion, for budgeting to effective, Berry limited should prepare a flexible budget that allows adjustment in incorporate changes (Butz 2011). The flexible budget should adopt a bottom up approach; and the short-term plan should be reflected in the long-term plan. The budgeting system should involve both the top management and the junior employees and reflect the responsibility of every person in an organization. The budget committee should be accountable to all the resources used to come up with thecompany’s budget. Reference Baker, J. J.1998.Activity-based costing and activity-based management for health care. Gaithersburg, Md: Aspen. Baker, H. K., & English, P.2011.Capital budgeting valuation: Financial analysis for todays investment projects.Hoboken, N.J: Wiley. Bradtke, D. 2007. Activity-Based-Costing.München: GRIN Verlag GmbH. Butz, C. 2011. Role and Effects of Budgeting in Managerial Practice.München: GRIN Verlag GmbH. Cokins, G. 2006.Activity-based cost management in government. Vienna, Va: Management Concepts. Dugdale, D., & Lyne, S. 2010. Budgeting practice and organisational structure.Oxford: CIMA Pub. Goektuerk, H. 2007. Activity-Based Costing (ABC) - advantages and disadvantages: How ABC can be applied to institutions of higher education. München: GRIN Verlag GmbH. Kaplan, R. S., & Anderson, S. R. 2007.Time-driven activity-based costing: A simpler and more powerful path to higher profits. Boston: Harvard Business School Press. Nelson, R. 2005. Windy. Minneapolis: Lerner Publications Co. Wildavsky, A. B. 1986. Budgeting: A comparative theory of budgetary processes. New Brunswick, N.J: Transaction Publishers. Read More