Activity-Based Costing and Its Advantage for Companies

Introduction

Costing is one of the most essential aspects of the business. In this age, there is increasing competition because of the forces of globalization. Every business must utilize the best costing option to ensure that its products have the best prices, both for competitiveness, and to assure the business of a healthy bottom line. Activity-Based Costing provides several advantages, which ensure that businesses attain these objectives. It is important to have a clear understanding of the various aspects of Activity-Based Costing to appreciate its place in business.

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Defining Activity-Based Costing and its Components

Activity-based costing is one of the methods of determining the expenses incurred to offer a service or to make a product (Blocher et al., 2010). Various scholars stress different elements of activity-based costing. Lal, (2008) defined activity-based costing as “costing in which costs are first traced to activities and then to products” (p. 323). This definition focussed on the process of Activity Based Costing. Lal used a simple definition to avoid ambiguity. Its problem, alongside many simple definitions, is that it made the concept appear too simple and straightforward. On the other hand, Lewis (1995), provided a three-point definition for activity-based costing.

Lewis’ (1995) first element to define activity-based costing was the method used to measure the cost of processes. The second element was the assignment of activity costs and the third element was the recognition of the “causal relationship of cost drivers to activities” (p. 114). Lewis’ definition disaggregated the various components of activity-based costing, which stressed the costing dimension and the activity element and then stressing the relationship between the two. It is clear from these two definitions of activity-based costing revolves around the relationship between activities and the cost incurred by them in a business concern. Lewis’ (1995) definition missed the critical aspect of tying the results of costing the activities to the final product.

Activity-based costing assumes that during production or the provision of services, the costs associated with the final product come from the activities in the production process. It traces how the activities consume resources to facilitate the development of a consistent way of allocating resources (Arpi & Wejke, 1999). This approach differs from other costing approaches that tie costs to either department or entire production plants. Its main advantage is that it allows for a point to point determination of the actual cost of the product. It attempts to include all the processes that go into the production of a service or product that has a better chance at actually pinning down the real cost of production of a particular product (Fischer, 2000).

There are a few important concepts in the practice of activity-based costing. The first one is activity-based management (ABM). ABM was a natural outgrowth from the development of activity-based costing because there was a need to adapt management techniques to take into account activity-based costing. While activity-based costing focusses on the assignment of costs to activities, ABM focusses on ensuring that all the administrative processes required to facilitate that activity-based costing are in place.

Secondly, there is the concept of activity-based budgeting (ABB). This is the process of developing the organizational budget around activity-based costing to ensure the meeting of its overall objectives. Its main purpose is to ensure that resource cycles adhere to the rules of activity-based costing to maximize the benefits that accrue from its use. Some organizations move a step further and associate the budgets to particular individuals in their value chain to enhance compliance with the budget (Panda, 1999).

Reasons for Using Activity-Based Costing

Several issues motivate organizations to use activity-based costing. First, activity-based costing, as opposed to other costing methods such as unit-based costing, provides a better way of calculating the cost of production incurred when producing a service or product (Hansen & Mowen, 2010). The use of activity-based costing increases the accuracy of determining the cost of production because it exposes hidden costs (Northrup, 2004).

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This is because the method concentrates on the process. Therefore, it is easier to tell where resource consumption takes place. Other costing systems fail to delve into the details of the production process in the manner that activity-based costing does. It provides a different view from the traditional approaches and yields better quality information regarding the cost of production. This makes it easier to calculate profits for each product (Bragg, 2007).

The second benefit of activity-based costing is that it helps in identifying important and redundant processes. Important processes add value to the production process, and may even be critical to it. Redundant processes in the other hand are processes that do not yield much value to the production process. They consume resources in a way that is either not commensurate to the benefits derived from them or do not add any value to the final product.

These processes may include filling paper forms for later digitization when digitization can take place during the original filling of the form. Since activity-based costing brings all processes to sharp focus, it allows managers to decide on whether a certain part of the process is vital or not, based on the cost the company incurs versus the benefit if derives (Bragg, 2007).

Activity-based costing also makes it possible for businesses to increase their operational efficiency. Since activity-based costing focuses on processes, it is easy to determine alternate processes that will yield the same results faster or at a lower cost (Kimmel, Kieso, & Weygandt, 2010). This is one of the main benefits of activity-based costing. By focusing on the processes, it is not hard to figure out how to become more competitive in the marketplace by eliminating procedures that cost more when the opportunities to improve come along.

This power to quantify the cost of a process is very necessary for contemporary decision-making (Black, 2009). While there may not be much room for change in innovative organizations, activity-based costing still provides them with an upper hand because companies can quickly adapt their processes to take advantage of emerging technologies and processes. Companies will be able to decide clearly on whether the opportunity is important to the organization based on the value it will add to its processes.

The fourth advantage of activity-based costing is that it improves the overall-decision making capacity of the enterprise. It makes the entire organization cost-conscious because of its insistence on the cost of activities. Since it is easy to link activities to specific individuals, it is also easy to attach either a cost to the work they do, in terms of the materials that the process they supervise consumes, or the labor cost.

When people on the shop floor know the impact of their work, they tend to behave in ways that improve the efficiency of the work they do. Activity-based costing provides such advantages. It also empowers managers to know what issues to prioritize and what outcomes to encourage in their day-to-day work, because of the clarity of the cost of each activity under their watch.

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Implementation of Activity-Based Costing

Lal (2008) identified four steps in the implementation process of activity-based costing. The four steps are; identification of the main activities of the company, identification of the factors influencing the cost of activities, collection of the costs of each activity, and finally the charging of support overheads to products based on how the company uses them (Lal, 2008).

The main activities of a company usually reside in the departments. These activities vary depending on the nature of the company; however, business processes tend to be similar. They include purchasing, processing of receipts, finance, and marketing (Northrup, 2004). Their significance varies from organization to organization.

Identification of cost drivers is the second step in the process of instituting activity-based costing (Lal, 2008). Cost drivers emanate from the activities of the company; they normally take on measures such as time, quantity, and quality (Fischer, 2000). For instance, the longer a certain process takes the more expensive it is.

Hence, it will call for careful planning to ensure that a particular activity does not exceed certain time limits to keep its production cost down. Similarly, a particular activity such as printing may have a volume advantage. This means that printing more copies of a document reduces set up time and maximizes resources such as ink and energy. Such measures make it possible for the company to design a profitable production regime.

The third step in the implementation of activity-based costing is the collection of costs of each activity (Lal, 2008). The main aspect of this step is the identification of the actual cost of each activity. The cost items tend to appear under conventional cost centers in the company. This step aims at putting a cost tag on each activity in the company to describe the cumulative effect of the processes.

The fourth step in the process is linking these costs to products (Lal, 2008). The process of linking products to overheads takes on the measures identified as cost drivers. The idea is to link the cost of all the activities to the products that utilize those processes. It gives a clear picture of the impact of each activity in the value chain from the perspective of the cost drivers.

For a company to transit from other models of costing to activity-based costing, there is a need for patience. Many managers fall for the trap of seeking to change everything at once, or too rapidly. Switching to activity-based costing too rapidly may yield unusable results, and in the process will expose the company to more problems because of abandoning their historical pricing model. Just like manufacturing efficiency requires time and training, so implements activity-based costing.

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Organizations that Use Activity-Based Costing

Organizations that use activity-based costing cut right across different industries. Manufacturing companies, as well as the service sector, find activity-based costing a useful model for pricing. Kimmel, Kieso, and Weygandt (2010) noted that “Allied signal and Coca-Cola have both enjoyed improved results from Activity-Based Costing” (p. 776).

The method is versatile enough to fit in any context; however, it is easier to implement activity-based costing in situations with distinct process flow such as in the manufacturing industry. Nonetheless, it is difficult to use activity-based costing in the creative arts sector because each product goes through a unique process; activity-based costing can only apply in general terms under such conditions. The application of this model of pricing is dependent on the nature of an organization that needs it. It is, however, a very useful way of fixing the overall costs of business, regardless of the type.

References

Arpi, B., & Wejke, P. (1999). International Turnaround Management: From Crisis to Revival and Long-Term Profitability. London: Palgrave Macmillan.

Black, K. (2009). Business Statistics: Contemporary Decision Making. John Wiley and Sons: New York, NY.

Blocher, E.J., Stout, D., Cokins, G., & Chen, K. H. (2010). Cost management: A strategic emphasis (custom; 5th ed.). Boston, MA: McGraw-Hill.

Bragg, S. M. (2007). Management Accounting Best Practices: A Guide for the Professional Accountant. New York, NY: John Wiley & Sons.

Fischer, L. (2000). Workflow Handbook 2001. Lighthouse Point, FL: Future Strategies Inc.

Hansen, D. R., & Mowen, M. M. (2010). Cornerstones of Cost Accounting. New York, NY: Cengage Learning.

Kimmel, P. D., Kieso, D. E., & Weygandt, J. J. (2010). Accounting: Tools for Business Decision Makers. New York, NY: John Wiley and Sons.

Lal, J. (2008). Cost Accounting. New Delhi: Tata McGraw-Hill Education.

Lewis, R. J. (1995). Activity-Based Models for Cost Management Systems. Westport CT: Greenwood Publishing.

Northrup, C. L. (2004). Dynamics of Profit-Focussed Accounting: Attaining Sustained Value and Bottom-Line Improvement. Boca Raton, FL: J Ross Publishing.

Panda, N. M. (1999). Activity-Based Costing for Indian industries. New Delhi: Mittal Publications.

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