Activity-Based Costing
Introduction
As the financial analyst for Eddison Electronics Company (EEC) it is my responsibility to have knowledge of the various types of costing methods the business can use to plan and control costs related to the products we manufacture. Costing systems are notification systems that necessitate precise types of information to be recorded to be of importance to a business. It is from this trace of records that other information can be studied to accurately determine costs associated with the products EEC manufacture (Managers-Net, 2009). With that being said, there are several costing systems that could be employed by EEC to effectively determine costs of the products we manufacture, however; in this case the costing system to be studied is an activity based costing system. The definition of this concept will be discussed, as well as the advantages and disadvantages of this system. Also, the differences between an activity based costing system and traditional based costing systems will be discussed. In order to accurately determine costs for the business EEC should determine when and how to use this system which will also be discussed.
Activity Based Costing System
Activity based costing is a costing method that works to improve managing the operating cost of a business. It does this by determining the connection between an activity and the cost associated with manufacturing a product. The system is greatly efficient in relating costs to processors, management duties, products, and even customers. It is a two-stage method of allocating costs for a business. The first stage consists of costs being allocated to groups and the second stage consists of cost groups being allocated to products. The main objective of an activity based costing system is to center on the activities as the central cost items when it comes to processing a product. It then uses the related costs of these process activities as elements for gathering the costs of additional cost items. In this respect, an activity based costing system simulates that activities bring about costs and cost items can generate the need for activities. Thus, it is imperative to recognize that when using this type of costing system the costs will be allocated to the activities of the operations performed within the business, and this allocation will be based upon the utilization of resources used. For instance, with the business utilizing an activity based costing system the costs for every activity related to manufacturing a product will be independently collected as a cost item and these related costs will then be applied to the product as different activities are undergone. Once this is done the finishing cost of the product will be developed from the specific costs of the activities related to manufacturing the product that were undertaken. In order to accurately calculate the spending related to each activity, activity based costing will allocate the costs of every activity connected with manufacturing a product to the cost items used to produce the product which will be based on cost drivers. Fundamentally the activity based costing system will allocate and assign the rate of production to the product manufactured in order to be precise in evaluating the inventory item cost for the company. However, it must be clearly understood that an activity based costing system should not be used for accounting purposes, but rather it should be applied in processes of decision making regarding the prices of our products, marketing of our products, and production of our products (Garrison, Noreen, & Brewer, 2010).
Activity Based Costing Advantages
There are several advantages to employing an activity based costing system. First, by using this type of system to determine costs related to the products the company manufactures the individual activities within the process of producing the product will be assessed based upon their own utilization of resources which in return will permit more accuracy to be obtained regarding the expenses associated with each activity. Furthermore, by using an activity based costing system the company can recognize elevated operating costs by their individual unit and ways can be found to decrease these costs. In relation to identifying the activity responsible for the elevated costs, it can then be conveyed to the users only when the product makes use of the activity. Finally, an activity based costing system can aid in future product planning, such as if the company were to introduce a new product. In this sense, activity based costing can determine all activity costs associated with the new product, and before launching the product pricing can be determined, as well as other associated expenses (Managers-Net, 2009).
Activity Based Costing Disadvantages
Even though there are some exceptional advantages to an activity based costing system, there are some disadvantages also. The difficulty in executing the system seems to be a crucial disadvantage. This is because properly identifying the activities to be allocated has to be plotted throughout the company which takes a lot of effort and this can become troublesome. Furthermore, once the system is executed it can be expensive to keep up since the information related to various activity procedures must be gathered, verified, and recorded into the system. Finally, if this costing system is used for all activities within the company then it can become very time consuming (Managers-Net, 2009).
Activity Based Costing Systems Compared to Traditional Systems
An activity based costing system assigns costs to activities as it relates to the cause and outcome connection which link costs and activities that drive costs, while other costing systems are intended to allocate costs to products. For instance, a traditional costing system will lean toward assigning secondary costs based on easy identified information, such as the direct work hours of processing a product. This process of allocating costs can be extremely mistaken since, unlike an activity based costing system, there is no essential connection among the costs that are being allocated and the activity they are being allocated to. With that being said, activity based costing systems have an intrinsic flexibility to present unique reports which can assist management in making judgments about the cost of activities taken on which can aid them in designing, producing, selling, and delivering a company’s products. Also, as previously mentioned, the fundamental theory of an activity based costing system is that the activities within a business cause costs, while a traditional costing system theorizes that products are the cause of costs within a business. Therefore, a distinct difference in an activity based costing system and other traditional system is the theorizations related to costing are entirely different (Reference for Business, 2011).
How to Use an Activity Based Costing System
Activity based costing starts by first categorizing key activities in the process of manufacturing a product. Then cost pools are formed for collections of activities that can be assigned together in the process, and then the cost drivers are acknowledged. Depending on the stability among accurateness and difficulty the number of costs drivers used will vary from product to product. Charges are then calculated once a determination is made on the needed cost drivers for the activity. The charges are then related to the individual cost drivers for every product that is being measured. The individual unit operational costs are then obtained by dividing the overall cost of the product by the overall product units (Rockford Consulting Group, 1999). The formula for calculating activity based costing is: activity based cost per-unit = total activity cost/total number of units for activity (Cliff Notes, 2011).
Company’s Use of an Activity Based Costing System
In using an activity based costing system managers within the company will try to allocate costs to major activities of manufacturing the company’s products in which costs are incurred. As a result, managers will be given sufficient information regarding the resources each activity uses. The use of this type of costing system can also assist the company in developing a way to analyze and rationalize performance measure improvements of a product. Performance measures include measurements of efficiency, time taken, and output quality of a product. There are a few steps involved with the process of implementing an activity based costing system. First, the major activities involved with manufacturing the company’s product will need to be identified. The major resource pools that can be applied to the product should then be established. Next, the costs, outcomes, and benchmarks related to processing the product should be analyzed. And finally, any additional improvement opportunities related to the product should be identified. In addition to this and as previously discussed, performance measures should be identified at the product process level. These performance measures should be used to monitor and evaluate the processes related to manufacturing the product to ensure that the activity costs associated with the costs objects are maintaining accuracy (Bradford, 2009). In relation to process improvement activity, the most expensive parts of processing a product can be presented so that a comparison can be done on what the costs would be for redesigning the product. This would enable costs to be lowered for the company in manufacturing the product and, in addition, the profitability of the product can be established beforehand (Managers-Net, 2009).
Conclusion
An activity based costing system must not be observed as a solution to all cost issues within the company, but, rather it should be seen as a progress system to improve the overall efficiency of the products we manufacture. When properly applied, this system will reduce the any related problems with cost misrepresentation by developing a pool of cost for all activities associated with the products we manufacture that can be segregated as a cost driver. This type of system can be applied when aiming to facilitate cost management with the products we manufacture. Although it should only be applied at internals that are stated by the need to make accurate decisions related to the activities of the processes of our products. By using an activity based costing system managers will also be permitted to calculate the costs of defects and more effort can be given to take corrective actions to obtain the highest returns possible. In my opinion, activity based costing foresees that workers carry out activities and activities consume resources. A wise analyst will know that by controlling activities it is ensured that the company is controlling costs at their source. However, even though this system can be a power tool for controlling costs associated with the products we manufacture, it should be made known that if the company is considering this type of system it should be implemented along with a separate system to track cost in a manner that conforms with the Generally Accepted Accounting Principles (GAAP) of filing financial statements, since this system does not (Managers-Net, 2009).
References
Bradford, T. (2008). Activity-based costing system (ABC). Types of accounting costing systems. Retrieved from http://www.suite101.com/content/activitybased-costing-abc-a52148
Cliff Notes. (2011). Activity-based costing activities. Retrieved from http://www.cliffsnotes.com/study_guide/Activity-Based-Costing-Activities.topicArticleId-21248,articleId-21225.html
Garrison, R., Noreen, E., & Brewer, P. (2010). Managerial accounting, (13th ed.). New York, NY: McGraw-Hill Irwin.
Managers-Net. (2009). Activity based costing. Retrieved from http://www.managers-net.com/activityBC.html
Reference for Business (2011). Encyclopedia of Business, (2nd ed.). Activity-based costing. Retrieved from http://www.referenceforbusiness.com/management/A-Bud/Activity-Based-Costing.html
Rockford Consulting Group. (1999). RCG University. Activity-based costing. Retrieved from http://rockfordconsulting.com/activity-based-costing%20(ABC).htm