Inception of Activity Based Costing - Essay Example

ACTIVITY BASED COSTING Introduction In 1984, Kaplan and Cooper developed activity based costing for product cost measurement and operational control (Davies & Pain, 2002). This method examined the entire value chain of a firm and looked at all activities to identify the cost drivers that drive profits. Though it is well neigh impossible to accurately arrive at the cost of the product or service, activity based costing is a way ahead compared with traditional methods of costing. If a company manufactures only one product, there will not be any complexity in allocation of overheads. If there are multiple products, the amortization of costs to different products poses a challenge. Activity based costing enables reasonably accurate allocation of overheads. Need for a New Costing Method: The activities in an organization are spread across the organizational processes and value chain. The traditional methods of costing faced severe criticism due to inaccuracies. While it is easy to apportion direct costs to individual products in a company with a wide product mix, it is difficult to apportion indirect costs to the products. Therefore traditional methods sought estimates to assign overhead costs. In the earlier paradigm, Labor costs constituted a substantial part of the total cost of manufacture. Therefore direct labor costs were used to assign the overhead costs to various jobs relating to the manufacture of products. But today there has been a paradigm shift with technology pervading the value chain replacing large chunk of Labor by automated processes. The proportion of materials cost in many industries has augmented with the dwindling of labor costs. Similarly increasing automation and shrinking life span of machines have led to the increase in capital costs. There has also been a concomitant increase in overhead costs pertaining to information technology and depreciation of expensive plant and machinery, maintenance and utilities in most industries. In the new paradigm, the companies found direct labor as the basis for apportionment of overheads inaccurate to capture the costs for the products. The companies therefore used machine hours instead of direct Labor for apportioning the overhead costs. With the growing complexity of manufacturing processes, neither direct Labor nor machine hour would suffice as bases for allocation of overhead costs to processes of products. Therefore the new circumstances demanded multiple bases for allocation of overhead costs. These factors paved the way for the evolution of activity based costing, which uses multiple bases for overhead allocation. Inception of Activity Based Costing: The inception of activity based costing took place in the United States in John Deere and Company nearly 25 years ago. Since then, several companies such as IBM, Procter & Gamble, Hewlett-Packard, Caterpillar, AT and T, American Express have adopted this method of costing (Weygandt et al, 2005). The high cost of implementing this costing system is a barrier for adoption by many companies. The Japanese preferred the traditional costing methods, which use labor costs as basis for overhead allocation. Japanese industry believes that reducing labor costs results in substantial cost reduction. Therefore Japanese companies are ready to trade off accuracy in favor of more focus on labor costs. The Process of Activity Based Costing Activity based costing begins with the consideration of four different groups of activities that give rise to overheads; production demands, quality, movements and design. The volume of production does not appear in the reckoning. The identification of the use of labor and machinery is done through interview, questionnaire, observation and process activity mapping. In activity-based costing, the overhead costs are split into fixed and variable costs. The variable costs are divided into long and short-term variable costs. It is also assumed in activity based costing, that the fixed costs do not show variance with the increase or decrease in activity in a given time period. Short term variable costs are volume dependent, which are direct labor costs and material costs. The activity based costs are variable costs of long term. These bear direct relationship with the activity level. These costs may not be productive and may not show instant variation with the quantum of activity. These could be costs such as cost of machine setup or costs of goods receipt. In activity based costing, the overhead is allocated to multiple activity cost pools. These cost pools in turn are allocated to products or services on the basis of cost drivers. The activity based costing has its own terminology. The production of a product or provision of service would involve activities which could be actions, events, work sequences or transactions. Most often activities are cross functional. For instance, the function of buying encompasses Purchase, administration, finance, accounting and HR across the process of procurement. Each distinct activity is an activity cost pool. Its cost drivers have direct relationship in terms of cause and effect with the consumption of resources. Activity based costing is based on the premise that products consume activities and activities consume resources. The overheads are allocated in a two stage process. The first stage of allocation of overhead costs to individual activity cost pools is followed by the second stage of allocation of overhead costs to products and services based on cost drivers. The activity cost pools could be such as placement of purchase order, setting up the machines. The number of individual activity required for a product or service is the cost driver. For instance, the number of times a machine is set up for product A is one of the cost drivers of product A. The relationship between overhead costs, activity cost pools, cost drivers and the products and services in a complex activity based costing system with seven activity cost pools is shown in figure 1. This is for a lift jack company which manufactures to automotive jacks; an automobile scissors Jack and a truck hydraulic jack. While this example is purely illustrative, there could be large number of activity pools in many more complex processes. Source: Weygandt et al, 2005 Figure 1: Complex Activity Based Costing System An Illustration of Differences between Traditional and Activity Based Costing The contrast between traditional costing and activity based costing is illustrated by an example of a company XYZ Ltd., which produces product A and product B. Product A is produced in high volume of 25000 units per annum, while product B is produced in low volume of 5000 units per annum. Each of products A and B require one hour of direct labor for production. Therefore product A and B would require 30000 labor hours. The envisaged overhead costs for manufacturing are $900000. Therefore predetermined overhead rate is $30 per labor hour. For product A, the direct materials cost per unit is $40, while for B it is $30. Each product has a direct labor cost of $12 per unit. a) Unit Costs under Traditional Costing Here the process is fairly simple. The overhead is allocated based on labor hours. MANUFACTURING COSTS PRODUCT A PRODUCT B Direct Materials 40 30 Direct Labor 12 12 Overhead 30 30  Total 82 72 b) Unit Costs under Activity Based Costing According to the process, first the activity cost pools are identified. XYZ Company identified; setting up machines, machining and inspection as three cost pools. The overheads such as supplies, depreciation and salaries were then assigned to each cost pool as follows: ACTIVITY COST POOLS ESTIMATED OVERHEADS Setting up Machines 300000 Machining 500000 Inspection 100000 Total 900000 The cost drivers for each activity cost pool were then identified: ACTIVITY COST POOLS COST DRIVERS EXPECTED USE OF COST DRIVERS Setting up of machines Setup: Nos. 1500 Machining Machine Hours 50000 Inspection Inspection: Nos. 2000 An activity based overhead rate was arrived at for each cost driver as follows: ACTIVITY COST POOLS ESTIMATED OVERHEADS EXPECTED USE OF COST DRIVERS ACTIVITY BASED OVERHEAD RATES Setting up of machines 300000 1500 200 Machining 500000 50000 10 Inspection 100000 2000 50 Then expected use of cost drivers for each activity was computed as follows: ACTIVITY COST POOLS COST DRIVERS EXPECTED USE OF COST DRIVERS PRODUCT A PRODUCT B Setting up of machines Setup: Nos. 500 1000 Machining Machine Hours 30000 20000 Inspection Inspection: Nos. 500 1500 The overhead costs for each cost pools were allocated to each product based on the expected use of cost driver for the product and activity based overhead rates as follows: ACTIVITY COST POOLS COST DRIVERS ACTIVITY BASED OVERHEAD RATES OVERHEAD ASSIGNED PRODUCT A PRODUCT B Setting up of machines Setup: Nos 200 100000 200000 Machining Machine Hours 10 300000 200000 Inspection Inspections: Nos. 50 25000 75000   425000 475000 No. of products manufactured 25000 5000 Overhead Cost Assigned 17 95 The cost comparison between traditional costing and activity based costing for product A and product B are as follows: MANUFACTURING COSTS PRODUCT A PRODUCT B Traditional Costing Activity Based Costing Traditional Costing Activity Based Costing Direct Materials 40 40 30 30 Direct Labor 12 12 12 12 Overhead 30 17 30 95 Total Cost per unit 82 69 72 137 It is seen in the above illustration; the traditional costing has understated the cost of the low volume product B and overstated the cost of the high volume product A. By and large, under activity based costing, the low-volume product tends to absorb more overhead costs as compared with traditional methods of costing. This is because the low-volume products normally require greater focus such as greater number of setups and inspections. Therefore under activity based costing low-volume products cost more which stands to reason. The concept of economies of scale gets reflected at high volume. Advantages and Disadvantages of Activity Based Costing: Activity based costing has several advantages. The process results in the creation of more cost pools. Greater number of cost pools and cost drivers lead to substantial improvement in accuracy. The relevance of the apportioned overhead costs to the product or service would increase. Since activity based costing enables tracing overhead costs sometimes directly to the activities, many indirect costs would then become direct costs to the activities leading to greater managerial control on costs. Activity based costing leads to better pricing policies with more accurate cost estimates and realistic profitability. This helps in better make or buy decision with more accurate cost data to back up. It is important to bear in mind that activity based costing does not change the overhead costs but changes only its allocation amongst the products and services in the company’s product or service mix. The activity based costing also has several disadvantages. This method is more expensive to implement than the traditional methods. Therefore companies have to weigh the costs and benefits before undertaking its implementation. Many companies may find that their traditional costing system is sufficiently accurate not to warrant implementation of activity based costing. In spite of implementation of activity based costing systems, sometimes the companies may resort to allocation of overhead costs based on labor hours for their specific reasons. Such companies are only using a hybrid of traditional costing and activity based costing systems. The Need to Deploy Activity Based Costing: One or more of the following reasons could justify the deployment of activity based costing systems: varying volumes and manufacturing complexities among the product lines of the company The product lines require varying levels of support from support services of the company. The cost structure contains large quantum of indirect costs there has been a substantial change in the process of manufacture with the inclusion of technology for automation there has been a substantial change in the number of products manufactured with changing technology the managers are ignoring the cost data provided by the prevailing system but are using questionable data for decision-making Activity based costing is effort intensive and requires the whole hearted support of the management and companywide orchestration of the system. Activity Based Management Many companies who have harnessed the benefits of Activity Based Costing have extended its application from costing for products and services to cost reduction, process improvement and enhancement in decision-making capability of the firm. In this refinement, the activities identified in the activity based costing system or classified into value added activities and non-Value added activities. Value added activities are those that result in increase in the tangible worth of the product or service to the customer. For instance, engineering design, machining, painting etc add value to the product or service. But activity such as inspection, testing, repair and maintenance and inventory carrying do not add tangible value to the product or service. But this does not mean that these activities are not essential. Though these activities do not add value they are essential in an organization. We cannot possibly imagine a company without quality control a testing department where inspection and testing are carried out. This modified system of activity based management involves drawing up a flowchart which identifies value-added activities and non-Value added activities. This flowchart will enable the management to focus on reducing the non-value-added activities and thus exercise cost control. It is important for the management to understand that some of the activity costs are variable depending on the unit, batch, product line or the entire process. The unit level activities are machine related activities such as drilling, Boring and welding and labor related activities are activities such as painting, assembling and shot blasting. The batch level activities are activities such as setting up machines, placing purchase order and inspection. The product level activities are activities such as engineering design and prototype manufacture. The facility level activities are related to plant management, utilities and accounting for depreciation and taxes. This understanding of different levels of activity costs leads the managers to structure their thinking about the resources required for each activity. It is crucial for the managers to understand that the resources used for batch level, product level, facility level supporting activities do not have a direct relationship with the changes in the number of units. The number of activities at the batch level changes according to the increase in number of Batches. Similarly the number of activities at the product level changes according to the number of products in the product mix. Likewise the costs at the facility level could be controlled by changing batch product and facility level activities. Conclusion The evolution of activity based costing marks a major step ahead in imparting greater sophistication to the costing methods. In today’s intensely competitive environment, proper pricing strategy determines the success of product launches. The accurate assessment of costs is the key to decisions regarding make or buy, pricing, which impinge on the viability of producing the product or providing service. But this method is costly to implement and would suit the companies with a wide product mix. If a facility or factory produces only one type of the product, this method is not required. This method by far is most relevant, since the leaps in information technology have made its implementation less formidable. References Davies, Tony & Pain Brian. (2002). Business Accounting and Finance. The McGraw−Hill Companies Weygandt, Jerry,J. Kieso, Donald, E.Kimmel,Paul,D (2005). Managerial Accounting; Tools for Business Decision Making. John Wiley & Sons, Inc. Read More