Abc Costing Essay

ABC Costing Activity-based costing (ABC) is a special costing model that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing models. Aims of model With ABC, an organization can soundly estimate the cost elements of entire products and services.

That may prepare decisions on either identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced (product and service portfolio aim) or identify and eliminate production or service processes that are ineffective and allocate processing concepts the lead to the very same product at a better yield (process re-engineering aim).

In a business organization, the ABC methodology assigns an organization’s resource costs through activities to the products and services provided to its customers. ABC is generally used as a tool for understanding product and customer cost and profitability based on the production or performing processes. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives. [edit] Prevalence

Following initial enthusiasm, ABC lost ground in the 1990s, to alternative metrics, such as Kaplan’s balanced scorecard and economic value added. An independent 2008 report concluded that manually driven ABC was an inefficient use of resources: it was expensive and difficult to implement for small gains, and a poor value, and that alternative methods should be used. [1] Other reports show the broad band covered with the ABC methodology. [2] ABC has stagnated over the last five to seven years, — Kaplan, 1998

However, application of an activity based recording may be applied without change in methodology to an extension as an incremental activity based accounting, not replacing any synoptic and retrospective modeling process with costing, but to transform concurrent process accounting into a most authentic approach. [edit] Historical development Traditionally cost accountants had arbitrarily added a broad percentage of analysis into the indirect cost. [3] In addition, activities include actions that are performed both by people and machine.

However, as the percentages of indirect or overhead costs rose, this technique became increasingly inaccurate, because indirect costs were not caused equally by all products. For example, one product might take more time in one expensive machine than another product—but since the amount of direct labor and materials might be the same, additional cost for use of the machine is not being recognized when the same broad ‘on-cost’ percentage is added to all products.

Consequently, when multiple products share common costs, there is a danger of one product subsidizing another. ABC is based on George Staubus’ Activity Costing and Input-Output Accounting. [4] The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Management-International, now known simply as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing. [5]

Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products.

Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products. Activity-based costing was first clearly defined in 1987 by Robert S.

Kaplan and W. Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. [6] They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost.

Like manufacturing industries, financial institutions have diverse products and customers, which can cause cross-product, cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be attributed more accurately to products and customers. Activity based costing, even though originally developed for manufacturing, may even be a more useful tool for doing this. [7][8] Activity-based costing was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century. 9] He states that traditional cost accounting focuses on what it costs to do something, for example, to cut a screw thread; activity-based costing also records the cost of not doing, such as the cost of waiting for a needed part. Activity-based costing records the costs that traditional cost accounting does not do. The overhead costs assigned to each activity comprise an activity cost pool. [edit] Alternatives Lean accounting methods have been developed in recent years to provide relevant and thorough accounting, control, and measurement systems without the complex and costly methods of manually driven ABC.

However lean accounting is a snapshot concept for capturing just partial derivatives or differentials of selected cost functions. Lean accounting takes an opposite direction from ABC by working to eliminate peculiar cost allocations rather than apply complex methods of resource allocation. Lean accounting is primarily used within lean manufacturing. The approach has proven useful in many service industry areas including healthcare, construction, financial services, governments, and other industries.

Application of Theory of constraints (TOC) is analysed in a study[10] showing interesting aspects of productive coexistence of TOC and ABC application. Identifying cost drivers in ABC is described as somewhat equivalent to identifying bottlenecks in TOC. However the more thorough insight into cost composition for the inspected processes justifies the study result: ABC may deliver a better structured analysis in respect to complex processes, and this is no surprise regarding the necessarily spent effort for detailed ABC reporting. [edit] Methodology