Activity-Based Costing

Introduction

Most organizations experience various problems concerning the allocation of overheads. The activity-based costing method has come to be known as the perfect solution to this issue. There is a specific relationship between the concept of activity-based costing and allocation of the overhead costs. According to Stouthuysen, Schierhout, Roodhooft, and Reusen (2014), the activity-based costing method, which mostly is referred to as ABC, is an accounting approach that makes it possible to determine all accounting activities and the costs that are associated with these activities and then assign the costs that are associated with each identified activity in a direct manner to the pricing of the activity’s output. This happens in order to avoid the averaging of the costs in all the outputs. Even though it is a reliable method which used for the procedures of allocating costs and pricing the goods and services, most people believe that this concept that is quite complex to implement and that it mostly depends on data which most firms may not have in terms of access. This concept can be a rather important one for certain organizations but not as effective for the other ones at the same time.

Application of ABC

Activity-based costing is a method of allocation of the costs to a product or service based on the activities that included those. It is an approach that is different in application from the traditional method of costing which uses some arbitrary techniques in allocation of the costs to a product. Kumar and Mahto (2013) affirm that this method is not favorable to an organization that provides only one type of service or goods. It is best applied across industries due to the fact that most organizations produce one or more products as affirmed by Aldogan, Austill, and Kocakülâh (2014). The reason of its inapplicability in most small scale firms is that it is a complex method that requires certain data that may not be available to such companies. This concept is rather important in terms of reducing the impact of underpricing or overpricing aspect of some services or goods; in this case, it allows the firm to provide the prices that are sufficiently precise.

Comparison with Traditional Costing in Terms of Application

There are various approaches that are used concerning the activity-based costing method and traditional costing technique which lead to many different outcomes. This can be illustrated in a fairly simple way through the use of product manufacturing methods which are practiced by the majority of firms. Elhamma (2015) notes that the same principles can also be applied when it comes to a wide range of other business environments that are not primarily engaged in manufacturing, such as the financial industry. For example, a firm that is involved in the manufacture of automobile parts uses machine operation in sequences. In this case, the traditional costing method, which is different from the activity-based costing one, will view the costs involved in two categories: direct and indirect. The first category of direct costs refers to the money which can be allocated to a specific unit of a product and traditionally includes direct labor and direct material costs, according to Rahman and Ghafeer (2014). The second category of indirect costs refers to the producing overhead, which cannot be assigned directly to a certain specific unit of product. Instead, the costs are assigned to the specific batches, runs, or time periods. In this category one can have the following: the material purchase order cost, the costs for the set-up of a machine, the machine maintenance and clean-up costs, the costs associated with calibration and machine testing, and, lastly, the costs related to the packaging of products.

As for the activity-based costing method, the overhead and indirect costs are determined and then put together as one activity pool. An activity pool refers to a set of activities that are required by the firm in order to ensure completion of the production of the goods or service. Rof and Capusneanu (2015) suggest that those can be such processes as purchase orders or performances, for instance, the set-up of some machines. In effort to estimate the pool of activities, the activity-based costing method identifies the units which are known to be the cost drivers for each pool. According to Stouthuysen et al. (2014), the total costs of the pool of activity (purchase orders) are driven by the number of purchase orders that are processed. Following the process of determination of the product’s pool costs, an accountant will be able to continue with calculation of the cost per unit. Therefore, the product unit cost is determined through division of the activity pool costs by the number of units produced in a given period. The above activities include various stages which are all important in terms of the allocation process.

The differences between these two methods are not only based on calculation of the costs associated with a product. Aldogan et al. (2014) observe that the differences are further influenced by data analysis, overhead components, and the opposition between direct and indirect measures. In terms of data analysis, it is evident that activity-based costing needs deep knowledge of the resources and activities used in generating overheads. The traditional system is created in such way that it requires the overhead costs and a simple rule of allocation of the overhead.

The ABC method recognizes the fact that individual component of overheads can be distributed in a different way for varying products. Rahman and Ghafeer (2014) make the following observation: there are cases when one product uses more resources related to maintenance while another product may use relatively lower amount of maintenance resources. The traditional method simply aggregates the overheads components making fewer categories and uses a single rate of allocation for all products.

The activity-based costing method considers overhead costs as the direct costs due to the fact that actual costs usage for each type of product is determined through the actual cost drivers. It is from this point that the costs can be apportioned reasonably into the different individual units of the products. Kumar and Mahto (2013) explain that traditional cost accounting determines the total overhead accurately, but the distribution of the overhead is based on one indirect measure that has been previously determined. Thus, the allocation of the overhead will basically depend on such form of measure.

Importance of ABC

Most organizations decided to adopt the use of the activity-based costing method due to what is believed to be the ability to offer accuracy and improve the process of costing. These are the means through which businesses are able to receive real costs and proof of the actual profitability of their business activities. Elhamma (2015) adds that it is a great method that ensures accuracy due to the fact that it turns most of the costs, which are considered indirect by the traditional costing method, into the direct costs. In most organizations that have been able to implement ABC, the method is used in terms of supporting decisions concerning pricing, addition of a product to the portfolio or its deletion from it, evaluation of different methods of improvement, and the decision on outsourcing or creating an in-house production method.

On the whole, the use of the activity-based costing method varies in numbers from one industry to another. The conducted surveys indicate that most organizations that have been able to make use of the method are found in the manufacturing industry at 20% and up to 50% (Kumar & Mahto, 2013). This is then followed by the companies that provide its clients with financial services which are rated from 15% to 25%. The next one is the public sector rated at around 12%-18%. The industry that uses this method the least is the sphere of communications that is rated at 6% to 12% (Kumar & Mahto, 2013).

Activity-Based Management

The ABC method was initially introduced into the accounting scene in the 80s. The use of the method has increased over time even though there are a huge number of firms that are yet to start utilizing this sort of techniques. Rahman and Ghafeer (2014) share the following opinion: the slow adoption of the activity-based costing method can be attributed to two major trends, which have been advancing in a continuous but slow manner. The first trend is associated with an increasing capability and availability of the resources for implementation of costing. The second is connected to the increasing extension of the approach that is being implemented into areas that are new to its application in order to address a wider range of issues in the sphere of management.

As far as implementation of the activity-based costing method is concerned, there is an explicit need for some complete and detailed information relating to certain specific activities which relate to the particular products, tasks, and services. There is also a call for complete information that is related to the resources that have been directed at the same activities as reiterated by Elhamma (2015). In most large organizations, the implementation of the activity-based costing method is a complex process that involves using much data and labor. According to Rof and Capusneanu (2015), since the 80s, the activity-based costing method has become more easily accessible and applicable in the sense that there have been improvements in costing software in addition to the increased availability of data from complex and comprehensive computer systems and software. Examples of such systems include the Enterprise Resources Planning software and the Manufacturing Resources Planning Systems.

Activity-based management is basically defined as the whole set of actions that can be used on a basis that is better informed using the information derived from activity-based costing. Stouthuysen et al. (2014) assert that the main aim is to ensure that the same level of output is achieved with the lower amount of costs. Therefore, activity-based management, just like activity-based costing, makes use of the very important stages. The first stage is associated with identification of the activities that the organization performs while the second stage entails calculation of the costs related to each activity. Finally, the last stage involves identification of the cost driver for each of the activities.

Identification of the Activities

In general, most organizations perform several different activities, and in most cases, it is not feasible to conduct a process of identification of all activities that an organization plans and performs. It is important for the accountants of the firm to exercise good judgment concerning determination of the activities in the organization that are significant as emphasized by Aldogan et al. (2014). Example of such basis for identification includes use of time spent on one activity in the organization. However, there are some organizations which in most cases only make definition of the high level activities in order to ensure that the activities remain at the lower level.

The indirect costs have to be apportioned appropriately to the different activities through the use of suitable basis. One of the best ways of undertaking this task for the organization is to consider the amount of time that is taken to complete every activity in order for each to allocate the amount of money, which is absolutely vital according to Rahman and Ghafeer (2014). Activity-based management asserts that only having information concerning the costs for each activity is not enough. It is as well important to go ahead and allocate the costs of the activities in question.

Identification of the Cost Drivers

It is not possible with the use of activity-based costing method to apportion the costs to the activities without determining the cost drivers. Kumar and Mahto (2013) postulate that the cost driver is the factor that causes the variation in the costs of a certain activity. As for the traditional costing method, there was an assumption that the cost driver is the volume of production which was measured with the help of the number of units as well as the proxy that included the number of hours known as the machine hours.

As for the activity-based management method, it is recognized that the cost of the activity depends on the other factors that may not necessarily be the volume of production but some other ones. For instance, such case as the sales order processing, which is actually an activity that accumulates the costs, is based on the number of orders that have been processed. This means that even when the number of sales orders occupies five lines or even ten lines, the amount of time that is required to process will remain the same, according to Elhamma (2015). Moreover, some typical examples of the activities and their cost drivers include: the process of introduction of new products, the number of these newly introduced products, the machines and the numbers of hours, received materials and all receipts for those, set up machines and the number of set-ups.

Following the determination of the cost drivers, the most important thing is to apportion the cost of the activities among the different products that made use of the activities. There are two types of the activity-based management method. The first is associated with operation activity-based management which presupposes doing things correctly and properly as identified by Aldogan et al. (2014). It also relates to making the organization more efficient through reduction of the costs of the activities and then elimination of the activities that do not actually add any value to the organization. The second type is connected with strategic activity-based management that concerns doing the appropriate things. Therefore, it involves making decisions in terms of which products one should make and which customers’ one should be able to sell those products to. This is actually based on the highly accurate analysis of data.

Conclusion

It is vital to note that the activity-based costing method is a derivation of the traditional costing approach. Basically, one may come to conclusion that the traditional costing method is not accurate in terms of allocation of the costs to different products: therefore, it affects pricing and profits. The activity-based costing method is seen as a more accurate way of allocation of the costs based on the cost driver factor; thus, allocating to each product that made use of the costs when the matter concerns the production process.