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Activity Based Costing

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Executive Summary
The success of any business that offers a product or service is greatly dependent on the ability of the products it offers to compete in a market. If a firm can determine its costs and the demand at each possible price offering it is likely to find the market price that maximizes profit. (Bakken, 2012). Hence, it is important that companies employ strategies that will ensure that cost allocation is accurate and gives management an accurate view of production cost. Having a full picture of every production step and their respective cost can help management make better pricing and sells decisions.
This paper is aimed at exploring the process of cost allocation, specifically, the Activity Based Costing System (ABC). It examines how the ABC system diverges from the previous traditional accounting system. It highlights the advantages and disadvantages of the ABC model, and presents an alternate approach that tries to fix the loop holes that exist in the ABC system. This paper shows that the analysis of costs and resources used in the production of goods and services is the most important tool needed in determining business performance (Veres, 2011).

Cost Allocation: Purpose and Process
When a firm produces more than one product or provides more than one type of service, a resource may be shared. This shared resource places a financial burden on the firm. Cost allocation is the process of assigning the financial burden to the associated production process. It is an internal accounting tool that assigns cost for resources that support production. According to Jaimbalvo, Cost allocation is important because it supplies information necessary for making appropriate decision, it curbs frivolous use of common resources, encourages managers to evaluate the efficiency of internally provided services and helps in the determination of the “full cost” of products for financial reporting purposes and for determining cost-based prices. The following sequence of events at a dress making factor further highlights the above points. The couture making department at K&Z dress making factory may decide to have an embellishment as part of the design in its latest piece. The chief designer may decide to have the embellishment handmade as opposed to attaching a ready-made appliqué. If the embellishment is handmade, it will require four workman hours from support staff that are usually on standby to help with any process as needed. However, the readymade alternative will only require thirty minutes from support staff. If cost is allocated in such a way that an hour of use of support staff cost $120, it means that it would cost the couture department $480 to attach an embellishment to one dress. It is important that the use of the support staff is allocated a cost, so as to access the true cost of making the dress. If the dress would sell for only $600, it would make sense for the appliqué to be used. This decision frees the support staff whose time is more efficiently spent performing other less time consuming processes like packaging of finished product which takes a minute a dress. In this example, the allocation of cost to indirect resource (i.e support staff) helps stop the unnecessary and uneconomical use of resource. It helps established a true cost of production, hence, making the manager decide to use a cheaper alternative. This helps saves cost and maximizes profit.
Cost allocation is a three step process that involves identification of cost objectives, formation of cost pools, and selection of an allocation base to relate the cost pools to the cost objectives (Jaimbalvo, 2011).

The ABC system
The ABC system is a cost allocation method that was initiated around the mid-1980s because traditional methods of allocating cost to indirect resources were viewed as inaccurate (Stout & Propri, 2011). The old traditional method of allocating cost for the use of indirect resources was based on production volume. For example, if a company had two production lines, A and B, that shared a common resource, the allocation of cost will be based on the final units produced. This means that if production line A has 500 end products, while production line B has 250, it is assumed that production line A will bear a third of the financial burden of using the resource. However, the reality may be that production line B requires more complex procedures and as such, used more of the resource than production line A. To better accurately allocate cost to resources, the ABC costing approach was developed.
The ABC system works by identifying activities in an organization and assigning cost to each activity in such a way that the cost information obtained is a reflection of resource demands and their consumption. The cost allocation system used in ABC varies from the traditional method and provides a clearer and accurate view of product cost. ABC identifies and analysis every activity associated with producing an item. Through the process of data gathering, the cost of the resources consumed performing the activities are grouped into cost pools (Jaimbalvo, 2011). The cost assigned to the activity is then assigned to products that require the activity for production (Jaimbalvo, 2011). This is done using the allocation base in the ABC system known as the cost driver.

Advantages of ABC System
The major advantage of ABC costing is its ability to produce more accurate costing estimates. In the model, companies are allowed to assign cost only to products that require a particular activity for production (Cardos, 2010). Hence the method eliminates the allocation of unnecessary cost to any activity, and therefore prevent higher than normal price estimates. Another advantage of ABC is that costs are broken down by the number of activities, instead of being hidden in one overhead cost pools (Cardos, 2010). This makes it easy for management to have a clearer view and better understanding of overhead cost. Having a clearer view of a company’s account helps management make the following decisions; they can remove unsuccessful items from the product lines, they can allocate resources to more profitable items, they can also do away with the cost of maintaining or running non-profitable activities in the production process, they can allocate resources to profitable items that use less resources and finally, they can stop waste and inefficiency which consequently contributes to boosting productivity ("Activity based costing " ).

Disadvantages of the ABC System
Despites its marked success and many market applications, the ABC approach has some disadvantages. One major disadvantage of the traditional ABC system is that it generally depends on information gathered from employee surveys of time spent on specified activities. To gather this information, most companies typically have their employees submit monthly surveys on production activities. Compilations of such information become a burden when the company is a large multinational with 2000 employees and over 50 locations. Because of the large volume of staff at multiple locations, it becomes difficult and expensive to ensure that data collection is accurate and timely. For example, the company would need to have a department dedicated to setup and implementation of the system. This department will constitute another financial burden the company has to bear. Since the data is gathered through surveys, some employees may not find the time to complete the surveys. Also, those that do complete the surveys may have some errors. These factors will make the final analysis inaccurate.
Another challenge that arises during the implementation of the ABC system is the need to accurately handle the granularity of activities for certain operations. Traditional ABC uses a single cost driver for each activity sales (Stout & Propri, 2011). This approach becomes a problem when slight variations are made to met specific needs. For example, normal procedure may involve delivery of final product by company delivery truck which takes five to seven business days. The use of a single cost driver for each activity (delivery) would mean that it would be impossible to accurately allocate cost in a special circumstance where the delivery truck is made to do a next day delivery to met a costumer’s need. In other words, most traditional ABC implementations cannot easily track slight differences in resource demands.
Generally speaking, the ABC system is expensive to build, time-consuming to process, difficult to maintain, and inflexible when needing modification. These problems are particularly apparent in small start ups and medium-sized companies that are not likely to have a sophisticated information processing system or funds to implement the system.

Time Driven Activity Based Costing (TDABC)
The time driven activity based costing is a modified form of the traditional ABC model. It addresses the problem of high costs of interview and survey of people that was associated with the earlier model. A major problem with the traditional ABC model was that the setup process was capital and labor intensive. Also, when there is a modification in activity processes involved in production, more cost is incurred in upgrading the system. TDABC make it easier to update and maintain the costing system when there is a change in resource spending or when a new activity is added sales (Stout & Propri, 2011). This advantage is derived from the fact that TDABC involves only the unit cost of supplying capacity and the time required to perform a transaction or an activity.
The major advantages of TDABC include the following: * It only relies on simple time estimate that can be obtained by simple observation, eliminating the need for time consuming interview and survey processes to define resource pools (Stout & Propri, 2011). * It can be easily updated to reflect changes in processes, order variety, and resource costs (Stout & Propri, 2011). * It significantly reduces the time required to process compiled data because the collated information can easily be fed from transactional ERP and CRM systems (Stout & Propri, 2011). * Data gathered is easily corroborated by direct observation. * The use of time equations for time estimation makes it easier for managers to navigate. Consequently update are easily done * It can be easily scaled to handle millions of transactions while still delivering fast processing times and real-time reporting (Stout & Propri, 2011). * It explicitly incorporates resource capacity and highlights unused resource capacity for management action (Stout & Propri, 2011).

Implementation of ABC in real-world business enterprises
ABC costing has been applied in various industries in the real world market enterprise. The manufacturing industry is one sector that has taken particular interest in this approach. The major reason for this is profit maximization. The economic theory suggests that the general demanded of a product or service is a direct function of the price that is charged. As such, a higher price would result in lower demand and a lower price would result in higher demand. It is therefore important that products are not overpriced, so as to maintain a healthy demand. It is also important that products are not underpriced, so as to maintain profitability. Striking a balance between profitability and maintaining a healthy demand is the key to sustaining a business.
XYZ Company is a consumer electronics manufacture that recently redesigned its internal accounting system using the ABC approach. Prior to adopting the system, the company experienced a wide range of problems that include; increased foreign competition, growing indirect manufacturing costs (associated with an expanded product line), increased inventory holdings and diminishing cash flow sales (Stout & Propri, 2011). Using the ABC system, the company was able to partition manufacturing overhead costs into multiple cost pools and assigns an appropriate cost driver to each cost pool. Manufacturing support was then allocated, based on the cost from cost pools. Implementation of the system helped the company better manage resources. They were able to manufacture electronics at a lower price and compete with other manufacturers sales (Stout & Propri, 2011).
After a few years, XYZ management noticed that the cost driver for ordering related support costs did not accommodate the various prices associated with various delivery methods (Stout & Propri, 2011). . The method did not account for potential cost difference that can occur from order to order. For example, an order may require special handling and overnight delivery, while another may require costumer pick up. The inability of the cost driver to take into account such differences would mean that a consumer is undercharged or overcharged. They also noticed that it was expensive to make modifications to the system. Technology manufacturing is a fast pace industry that constantly undergoes multiple modifications and upgrades within a short time frame. As such, it was important that they are able to easily modify activities and cost pools as the need arises.
To solve the problem, the company upgraded from the basic ABC system to TDABC system. The process involved two major steps. The first step was a calculation of the capacity cost rate for the center (cost of capacity supplied in dollars divided by the practical capacity of resources supplied, expressed in minutes) sales (Stout & Propri, 2011). The next step was to estimate the unit time associated with each engineering design change. The consensus was that since the traditional ABC approach relied on employee surveys, it cannot be a hundred percent accurate. It was common for employees to overestimate the time spent on activities so as to show that they have worked hard. The TDABC eliminates the use of employee surveys in determination of time estimates. It relies on visual observation and technological tools for time calculations. This method is proven to be more accurate. After months of implementation, the company noticed overall improvement in indirect resource usage and sales (Stout & Propri, 2011). This shows that TDABC systems provide more accurate estimates of resource-capacity usage.
The use of indirect resource puts a financial burden on a company. The ability to accurately allocate cost to these resources, especially when shared by multiple production lines, is very important. It can mean the difference between proper price and improper pricing. It can also mean the difference between a company’s product being able to compete in a market or not. As a result it can make the difference between a company staying operational or shorting down.
References:
Activity based costing. (n.d.). Retrieved from http://www.brighthub.com/office/finance/articles/78752.aspx
Activity based management. (n.d.). Retrieved from http://www.investopedia.com/terms/a/abm.asp
Bakken, D. G. (2012). are you sure the PRICE is right?. Marketing Research, 24(2), 8-14.
Cardos, I. (2010). An analysis of activity based costing (ABC) journal literature. International Journal Of Business Strategy, 10(2), 36-43. Stout, D. E., & Propri, J. M. (2011). Implementing Time-Driven Activity-Based Costing at a Medium-Sized Electronics Company. Management Accounting Quarterly, 12(3), 1-11.
Veres, T. (2011). ACTIVITY-BASED COST ALLOCATION AND FUNCTION ANALYZES IN TRADE. Annals Of The University Of Petrosani Economics, 11(2), 281-288.…...

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