Being different from the tradition costing techniques, ABC costing requires a rigorous fact finding mission regarding the operations of the company. The below are the main steps in ensuring a fully operational and effective ABC.
1. Identification and classification of activities that are related to the company’s products.
The area under scrutiny will be every bit of the value chain, for example production, product design. Marketing, and distribution.
A summary of all activities that sum up the production as well as selling of the produce is prepared. To ensure accuracy in the information gathered, processes like interviewing employees who are in charge of the activities, analyzing the company’s operations are adopted. Analysis of costs to different units is done at the production level to avoid any cases of duplication of wrong classification of different elements of cost (Benet, 2012).
2. Estimation of the cost of the activities identified and classified previously.
The specific activities that generate revenues for the company are estimated .This will be for all different resources that aid the firm in generation of income, for example: Human resources like labor provided by employees in machine maintenance, production, as well as other activities related to the machinery and equipment held by the company for production purposes (Wagener, 2008).
Physical resources owned by the company for the sole purpose of production. This may be machinery, or buildings occupied by the company.
Information gathered and used in the analysis must incorporate employee data obtained from the personnel interviews as well as the financial data obtained from the accounting and finance department. With the aforementioned resources, then cost estimation will be not only a simple process, but also a source of reliable and accurate information (Wagener, 2008).
3. Calculation of a cost driver.
4. Assigning the costs to the products.
The cost driver rates that have been calculated in step three above will be used to assign the activity costs to the goods or services. As a way of example, if a certain product will use 3 machine hours in production and the cost driver rate calculated in step three is $60 per hour, the product will be assigned $180 based on its machine usage (Judith, 1998).
Cost of overheads assigned to goods and services can be computed using the above procedure since each item will be assigned a specific amount of the indirect cost based on usage. In this way, the profitability of each product or service will be understood better since every element of cost used to produce it will be exactly known (Judith, 1998).
Question 1 b.
Activity based costing is most appropriate in manufacturing industries where most of the costs are easy to identify a specific cost incurred with a product. All costs in this case will be associated with the products, hence there will be no complexities with assigning costs prevalent in service industries like management cost or staff costs related to overtime or trainings. Hence in an industrial setting where there are more than one cost centres,using activity based costing will be an important tool to calculating transfer pricing from a cost centre to the next. This is because each common cost will be calculated effectively for each cost centre (Judith, 1998).
Activity based costing will also work best in companies dealing with system orders. Production based on the request of the customer will require keen tracking of each order so as to ensure profitability is maintained for each order. This will be enabled by ensuring the costs for each order are profiled separately (Judith, 1998).
When activity based costing is used say for service industry, the key area will be to outline the ways on how to allocate the general costs among the different cost centres.
Benefits of an activity based costing system.
- There will be a better understanding of indirect costs with regard to the different cost centres.
- Activity based costing reduced redundancy and unnecessary wastages in the product line. This is achieved by ensuring all ineffective cost centres are identified making the costs more visible than ever.
- Activity based costing offers a perfect background for managing performance as well as balanced scorecard (Gary, 2001).
Disadvantages of the costing technique adopted by the clinic.
The clinic had adopted ratio of cost to charges method which works best for government cost based programs. This is the traditional costing system adopted by most firms and has the following disadvantages:
The traditional technique adopted above does not have well developed cost centres to facilitate allocation of overheads. It is clear that the cost allocation has been based on the revenue generating cost centres. This will result to inaccurate costing of services offered by the clinic since overheads have not been accurately allocated to the cost centres. This means that some of the services rendered by the clinic said to be profitable will turn out to be otherwise if proper costing technique of overheads is adopted (Gary, 2001).
The traditional technique adopted by the clinic there has been a misconception that all indirect costs should be aggregated to one cost pool. Further, the subdivision to different cost centres has been based on profitability of each cost centre. It has been said that HD department that registered 61% of the clinic revenues had an allocation of 61% of the service costs. In this way, the costing method does not bring in to focus areas which absorb more service costs compared to others, but merely allocates the costs since they have been incurred. This method is thus detrimental when adopted by any firm for control purposes. Under ABC costing, there will be consideration of the service activity before the service cost allocation (Gary, 2001).
New cost apportionment based on activity based costing has been calculated in the excel document. There is a difference between the profit margins given under traditional costing method and the under ABC costing. This is as result of assigning costs arbitrarily to products without establishing strong foundation of their basis (Panda, 2004).
Under the RCC method the profit margins department wise are as below:
$ 131,525 $ 93,504
Based on the new ABC costing method, the profit margins are as below:
$ 89,604.19 $ 135,424.81
This present a decisional head ache for management since all along, HD department has been perceived as the profitable of the two. In contrast, after proper allocation of service costs, PD department turns out to be the better option. This might tempt the manager to commit more resources were the return is higher (Panda, 2004).
Limitations of activity based costing.
Activity based costing techniques offers a strenuous challenge to put in place. This is because of the numerous resources required .Extra screening and research to ensure that all costs are directed to the right cost centres. It will also pose a great challenge to maintain. Data relating to various activity measures have to be collected, checked and inputted in the enterprise resource system (Panda, 2004)
When it comes to making decisions, data that has been captured in the activity based systems must be handled with caution. It has been highlighted that costs that are assigned to products are the ones that are potentially material. Hence, identification of the costs that are relevant to a certain activity must be identified first to avoid issues of misinterpretation (Gary, 2001).
There are numerous challenges in adopting ABC method since most of the managers prefer traditional costing methods which seems to be easy in terms of implementation and understanding. Hence, activity based costing method may serve to complicate the costing procedures for the organization, subsequently yielding negative results (Gary, 2001).
For reporting purposes, ABC does not generate reports that conform to generally accepted accounting principles (GAAP).In this matter, a company that has successfully implemented ABC system will be forced have another cost system that will be purposely used for external reporting only. This relegates the ABC system to only internal reporting only, limiting its overall use in the organization (Gary, 2001).
Gary C. (2001).Activity based cost management. New York: John Wiley & sons.
Judith B.J (1998). Activity-Based Management for health care .London: Oxford printing press.
Panda N.M (2004).Management accounting .New Delhi: Mittal productions.
Wagener B. (2008) .Activity based costing .New York: Mc GrawHill.
Benet M.G. (2012) .Activity based costing .New York: Pearson publishers.