Explanation of Activity-based costing method

It is a well known fact that with globalisation and rapidly changing technologies, the business environment is also evolving. This has allowed the industries and its operations to become more complicated and diversified in nature.  Activity-based costing is one of the most popular and worldwide used methods of the current times. ABC is simple, precise and practical at the same time.

It is a method where the allocation of costs is done and assigned based on their specific activity. It is based on a principle that all the potential drivers of damage can be allocated to their business as every event can be priced. Also, not to forget the variety of cost drivers present when these overheads are assigned based on their respective activity (Ehlers, 2014). It is required for every corporate to trace its indirect costs which incurred due to they’re to determine the value of the project which will in return help in arriving at the overall aggregated figure for a particular service or product.

ABC features

In contrast to the traditional method, ABC provides greater flexibility and accuracy in deriving total expense from a specific product or service. While evaluating costs by using Activity-based costing one must undertake five potential step which is detailed below-

In the very first step, for the evaluation of values, one must look for all such activities that were incorporated and driven by funds to develop a product or service. Quantification of events that were undertaken by any employee/s is also required to be done and incorporated in the cost function of the goods or services (Horngren, 2011).

Advocating of various indirect costs to their specific activities by creating cost pools for each one of them is the second step in ABC. Identification of various cost drivers and the reason attributing the same is the third step in ABC. This is due to the need for evaluating and assessing the influence of the effective cost of an item employing identifying all the drivers. Also, the cost drivers are of great help in tracing the ineffective pricing of goods or services.

The evaluation of overhead absorption rate for each cost pool is ascertained in the fourth stage in ABC.

In the final stage, assigning of a variety of costs is done to their specific items depending on the funds utilised to manufacture the same.

Activity-based costing method is the most appropriate accounting approach for such companies engaged in the process of manufacturing. ABC shall not be useful for companies that are not involved in the process of building. This is because the organisations involved in the production process are more into documenting which makes it easier for the indirect costs to be traced and allocated and identifying the overall product costs (Lanen et. al, 2008). The suitability of Activity-based costing is limited for organisations that are not engaged in the manufacturing process to record all the intangible costs incurred.

Features of Activity-based costing approach

Attributes of Activity-based costing approach

ABC allows the management in deriving all the items that form the net cost of all the details and services. The control of the company shall then identify these costs and avoid the same to reduce the cost of such items and services. Activity-based costing is popular and globally accepted for a variety of traits. The first and foremost being the ability of Activity-based costing to assist the management in a way that it can assign its indirect costs adequately.

The users get to come across information that is reliable and valuable at the same time which allows them to take appropriate decisions (Peirson et. al, 2015). ABC also helps in the segregation and classification of expenses into two categories that are direct and indirect costs. This aids the management of the organisation in determining the actual value of the price. Activity-based costing also helps the control in tracing the exaggeration of damages that might have occurred. Activity-based costing also aids the management in advocating about the tenure for which exercise is undertaken using duration drivers and counting the times a particular operation is repeated using transaction drivers (Peter & Kevin, 2006). Activity-based costing has cost drivers who are by far one of its most important segment for the users. Production orders, consumed power, etc. are some of the examples of cost drivers.

Direct costs are directly associated with a product or service and so is easily identifiable unlike in the case of indirect costs as they are neither directly associated with a product or service not easy to identify. Such unidentifiable costs are ignored to evaluate the actual value of a product or service. One fine example, in this case, can be machine expenses and labour expenses (Marsh, 2009). These expenses depend on power consumed and machine hours. ABC has also helped the management in managing the costs and its reduction. It can be said that Activity-based costing assists the management in taking required decisions that are appropriate and substantial for a company to overcome its shortcomings.

The contrast between ABC and traditional costing method

 Considering the present scenario, ABC is the most effective method mainly due to 3 reasons. First and foremost reason being the requirement of apportionment of manufacturing overheads to their respective activities. The ever-rising customer demands and variety of products and services is the second reason. The range of goods that are manufactured in huge numbers and also the presence of such items made in small units being the third reason (Phua et. al, 2011).

Comparison between ABC and traditional costing method

Activity-based costing helps the management of an organisation to derive its costs appropriately which could be of great help for the organisation to understand their consumers and their needs and products they can offer to cater the needs and requirements of the consumers. Also, identification of costs might differ by-products, area and delivery channel. At the macro level, activities can be somewhat like direct payment of premium or amount of dividend at the office of the agent at a deeper level. In the case of the insurance sectors, it becomes difficult for them to analyse the consumption process of infrastructure resources. But with the application of activity-based costing method, this shall be overcome (Lanen et. al, 2008).

Activity-based costing helps in the measurement of cost objects, resource cost and cost of affairs. Cost objects consume cases while activities consume funds. Also, resource cost is apportioned and assigned to events depending on the funds and activity costs derived from them which is later reassigned to the cost objects by proportional usage of these activities combined. This allows the management of the organisation to have a way to allow supervision by being aware of the resources and activities that are associated to cost objects. This will also enable the management of the organisation in evaluating the operational efficiency and testing its financial details and make appropriate decisions (Horngren, 2011).

Activity-based costing primarily focuses on the affairs of the organisation to derive the cost behaviour of the organisation. The processes aids in developing quantities of resources and activities for consumers, goods and services and helps in manufacturing appropriate standards of the unit costs. It offers more significant details of cost concerned with business processes and activities along with the consumers, products and services which are taken care of by such actions (Ehlers, 2014). The cost drivers ascertained from a variety of information systems also help in evaluating activity costs from customers, products and services which further paves the way for the rise in demand for the activities of the organisation.

Activity-based costing is methods that are used to learn cost variance in the long run. In short, activity-based costing is not the method that is used to understand that how costs change in the short-run instead, it is used to analyse the behaviour of the expenses for the long-run purpose. Also, it must be understood that such activities implemented by resources are not aligned with the net volume of units produced (Shield, 2005). Instead, the demand arises as a result of the diversity of the consumer needs, complexities and product mix.

Outcomes or lesson from the articles that will be useful for Management accountants

In Australia, the banking sector has been introducing newer innovative services and products owing to the ever-rising public demands to fulfil the needs arising out of the current market scenario and that has been signified in the articles. The ABC method of costing is one of the most powerful tools in the methods of costing. Hence, it is very important for the manufacturing industries to take this method into consideration while preparing the cost function of a particular product. This system will not only improve the costing technique but will also help the firm to depict information in a way that is beneficial for the business which makes it necessary for the companies to utilize such methods of costing in the management areas

|i. To attain federal funds banking industries have been trying to implement new measures and personalising its products and services to cater to public needs . To enhance its overall efficiency, banking industries are implementing more modern and updated technologies. Performing advanced and updated techniques are one of its strategies to assist the customers in availing most of the banking services as and whenever required without having to go to the bank for the same (Balakrishnan, Labro & Soderstrom, 2014).

1. The indirect costs are allocated based on the actual reason apportioning the same after which the allocation of such expenses is done depending entirely on the activity. This means that indirect costs are not allocated to their machine hours instead the reason owing to these costs are looked out and then the same values are assigned depending on their activity. It is a very significant process that allows the allocation process to be performed only on items that demanded it (Balakrishnan, Labro & Soderstrom, 2014).

iii. With the use of activity-based costing, the management of the company can efficiently allocate its indirect costs and assign to its activity. ABC helps in the attribution of expenses to a particular item (Shield, 2015). ABC allows the management of the company to trace the reasons behind the rise in product cost. It is a straightforward and effective method of allocation of indirect costs as compared to the traditional methods (Douma & Hein, 2013). Unlike Activity-based costing method, traditional methods are not that simple, effective and precise.

1. The usage of a single rate of allocation of overhead is very unreliable and can thus lead to misallocation of expenses to the products. This can be portrayed as the ideology of misallocation of the overhead costs based on the affairs that are taking place within a particular department but on a wide note (Shield, 2015).

Article comparison and discussion

Activity-based costing method is one of the most useful and effective methods that can be used to assign costs to different goods and services so that their net production cost can be effectively analyzed. In the traditional methods of cost allocation, a simple approach is used for allocation of costs, whereas in the ABC method of allocating the costs are distributed in various pools and drivers for the calculation of the usage of the overheads. It should be duly noted that the best costing technique is to use cost drivers (Drury, 2011).

The drivers that are being used to calculate the overheads will also help to find out the consumption of affairs made by a specific item. For example, assessment of the cost can be made on the basis of size, complexity, machine hours, etc. These methods are generally carried out by firms which are governed with the help of managerial accounting. In order to assess the quality of the ABC method, all the factors like implementation cost, originality, practicality and the procurement of data should be considered (Douma & Hein, 2013).

There may be situations arising where a more experienced and sophisticated traditional costing method is used by the organization and is yielding greater revenue for the firm in a practical and informative manner. In such cases, the use of the ABC method will not be acknowledgeable because of the practicality of the situation. However, it is still very necessary for an organization to measure the effectiveness of different costing methods before assigning it to managerial plans (Davies & Crawford, 2012).

It has been observed that the misplaced information and incomplete data may cause the goodwill of the firm to degrade thus affecting their business on a long-term basis. Hence, it is observed that the organizations which use the ABC method for costing, ascertain the fact that the cost is based on both future and past references. Therefore, the ABC method can be a very useful tool for cost because it will provide data on the basis of collective information gathered, thus protecting the firm from any type of degradation in the profits (Vanderbeck, 2013).

It should be made clear that the activity-based costing method is a much elaborated method which is used to allocate overhead expenses to the cost of the products and services without the grouping of cost into separate activities. The analysts have also discussed that the use of traditional methods of costing is very intuitive and may cause inaccurate allocation of costs as overheads which will further result in inefficient management decisions for the pricing strategies and the continuation of the goods in the market (Brown, 2013).

It should be clearly noted that it is very important for an organization to ascertain the actual cost of the product where there exist cost-plus pricing or competitive bid pricing methods in the system. The decisions that are made on the basis of the inappropriate cost data are said to influence the business directly, which may lead the firm to incur losses in the future and thus decrease the scope of profitability for the company (Choi & Meek, 2011).

In the traditional methods of cost allocation, a single rate is analyzed and multiplied by ascertainment of the sole factor in order to find the cost using the overheads for a particular project, service or product. These methods are generally not appropriate and hence may allocate unethical costs as overheads to different products as there is no proportion observed in relation to the connected factors.

There may also be a case in which an employee is operating a machine and at the same time, he is also performing other tasks, which may result in the direct utilization of labours and hence may cause problems in the cost allocation process. Also, it has been observed that generally the working hours of the machines are disregarded at the time of cost allocation, and other activities like assembling, transportation, etc. are charged with more value, thus making the allocation of cost uneven in nature because of the involvement of indirect labour (Balakrishnan et. al, 2014).

Conclusion

The ABC method or the Activity Based Costing Method is one of the most relevant methods that can be used by an organization for the purpose of cost allocation. This can also be because of the fact that the ABC method helps to keep a track of each and every cost relating to the production of a particular commodity. This method is also said to provide a clear view of any other direct or indirect costs that have been incurred while producing a particular commodity and have not been assigned to the cost function. The information about the fixed and variable costs can also be conveyed to the organization’s managerial framework with the help of Activity Based Costing.

Variable expenses are those expenses which change with the change in the quantity of production whereas the fixed costs are stagnant and they do not change with the quantity. Hence, it can be summarised that the Activity-Based Costing method will be very useful for the manufacturing industries, as it will help it to analyze all types of cost by quantifying them and then assigning them to particular cost pools.

References

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