Activity-Based Costing and Its Application in Industry - Essay Example

Activity Based Costing Before going into the discussion regarding activity based costing and its applications in the industry, let us get a better understanding of what activity based costing actually is. As the name suggests, activity based costing (ABC) is a costing mechanism that is used to assign different activities to all products and services provided by the companies to their customers. Bradford (2008) asserts, “Activity-based costing is a process where costs are assigned due to the cause and effect relationship between costs and the activities that drive costs”. In activity based costing, data about the costs of all activities related to the processes of planning, designing, manufacturing, and distributing is gathered and analyzed. After a complete analysis of the data, activities are associated with all products and services of a company in order to know which products contribute to the increase in profits of the company and which products or services result in loss for the company. Need of professionals One of the major steps that the top management must take while planning to implement activity based costing system in a company is to set up a team of skilled professionals related to the filed of accounting. The basic purpose of the team should be identify those activities which turn out to be expensive for the business processes instead of resulting in increase in the profits of the company. The team of professionals should be skilled enough to identify the details of the hidden costs related to the business activities. Some costs are not entirely obvious and need to be identified through proper examination of the business processes. The team should outsource or cut back all unnecessary activities in order to make the business processes cost effective. Use of Computers Activity based costing makes use of computers for the proper identification and analysis of the gathered data. Computers gather the data, which help the managers, assign costs to different activities based on their use. Computers first gather data and details of hidden costs from different sources and then assist the managers in making most suitable and appropriate decisions regarding the activities related to different business processes. Companies can get rid of those activities related to the services that tend to be expensive instead of being cost effective. Essentials for Top Management The top management needs to have a complete understanding of the ongoing financial issues of the company in order to implement activity based costing system. The top management of a company sometimes needs to perform a test run on those departments of the company, which do not meet the financial expectations of the company. Activity based costing help the top management identify those areas or activities which result in increasing the expenses for the company. Therefore, we can say that activity based costing is very useful for the top management as it helps the management identify and sort out the financial issues related to any specific department of the company. Activity based costing is basically a traditional accounting system which makes use of gathered data about the costs of different activities in order to know which products or services are profitable for any specific company. Lightcap (2008) states, “Activity based costing, or more commonly ABC, is a method for determining accurate costs”. Activity based costing helps the companies make critical decisions regarding their products and services. Companies can increase the development of those products, which result in increasing their profitability, and can stop manufacturing those products, which result in decreasing the profitability. Activity based costing also helps the managers create a better budget for their companies. Managers get to know the real expenses related to different business activities, and based on the analysis of all costs and expenses, they design a perfect budget that not only proves to be cost effective but also makes the companies achieve financial stability. Applications in the Industry Activity based costing is useful for the companies in many ways. Some of the significant benefits of activity based costing include identification of the profitable and unprofitable customers, products, and services, identification of contributors to the profits, assistance in the accurate analysis of costs related to different business activities, identification of reasons of financial instability, assistance to the managers in improving business processes, and helping managers achieve better positioning of products. Let us discuss some of the benefits that make activity based costing a very useful accounting mechanism for the industries. 1. Identification of Profitable and Unprofitable Customers, Products, and Services One of the most significant advantages of activity based costing for the industries is that it helps the management know about the most and least profitable customers. Activity based costing gathers complete data about the potential customers of the companies and assists the management perform a complete analysis of the gathered data. The management staff identifies the customer’s profitability after deducting the product cost and the cost of serving each customer from the actual price of the product. The profitability of each potential customer of the company can be identified through dealing with the product cost and the customer cost separately. The management staff, after performing complete analysis of the customers’ profitability, decides whether to maintain business relationship with a customer or not. Activity based costing is very helpful for the industries as it makes them understand the value of each customer through the level of profits which they receive through dealing with them. Another benefit of activity based costing is that it helps the management know whether the products and services are proving to be cost effective or not. ABC examines the cost of each activity related to the products’ planning and manufacturing processes and assigns the activities to the products and services based on their usefulness. The management staff stops manufacturing those products, which turn out to be expensive for the company. 2. Assistance in Accurate Analysis of the Costs Another benefit, which industries can get from implementation of activity based costing system, is assistance in the accurate analysis of costs of activities. Dunn (2003) states, “Activity Based Costing or ABC offers a workable and more effective insight into overhead accounting”. There are different activities associated with the manufacturing and marketing phases of a product development. For example, in the manufacturing phase, there are different activities associated with the manufacturing of a product such as arranging raw material, converting raw material into useable parts, and assembling the parts to shape a complete product. These activities play an essential role in determining success and failure of a product. Properly planned and cost effective activities result in success of a product whereas inappropriate planning of activities result in failure of a product in the market. Activity Based Costing helps the companies analyze which activities are most suitable for the products and services and which activities decrease the profits of the company. 3. Identification of Reasons of Financial Instability Another advantage of activity based costing for the industries is assistance in identification of financial instability. Some companies related to any specific industry are not able to achieve financial stability. The main reason behind financial instability of companies is that they lack the implementation of a proper analysis system. ABC system helps the companies analyze different issues related to their finance, manufacturing, and marketing departments. ABC system not only analyzes the activities but also helps the management staff take proper decisions for the problems related to different departments. Improper management of departments results in misuse of resources, which is one of the main reasons for the financial instability of the companies. 4. Assistance to the Managers Activity based costing assists the managers in carrying out different business processes such as cost estimation, decision-making, and application of costs to the products and services provided by the company. Activity based costing is very helpful in accurate cost estimation of products and services. Managers can make important decisions related to the product development by examining the actual cost of the product and the profit gained by the product. Managers can eliminate the manufacturing of unprofitable products based on the analysis. They can also lower the prices of highly priced products by examining the market trend and customer demand for those products. If a product does not make good profit, managers of the company can eliminate its manufacturing in order to save money for the company. Similarly, if a product is obtaining high profits for a company, managers will opt to increase manufacturing of that specific product in order to obtain maximum profit before the trend of the customers towards that product declines. 5. Better positioning of Products Another significant benefit of using activity based costing system is assistance to managers in better positioning of the products. Activity based costing helps the managers achieve better positioning of products using cost effective modes of advertising. ABC system points out those areas related to product positioning which need some improvements and the managers work on those areas in order to sort out the problems and achieve better product positioning. Summing it up, we can say that activity based costing system is one of the most important systems for any company or organization because it provides many significant benefits to the companies. Activity based costing helps the managers assign actual costs of activities to the products and services, which enable the companies, get success in achieving competitive advantage in the market. References Bradford, T 2008, Activity-Based Costing (ABC), viewed 24 November 2010, . Dunn, P 2003, Activity-Based Costing, viewed 24 November 2010, . Lightcap, V 2008, Development of Activity Base Costing, viewed 24 November 2010, . Read More