Advantages of Activity Base Cost

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Introduction

As time elapses and new days come the world encounters new ideas of improving the past events. Therefore, the business world is not an exception and the past methods of evaluating business finances become inefficient. This is the reason of coming up with new techniques that can be fixed in the present. Activity base cost is a new method that simplifies the assessment of business organization monetary condition.

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Background of the study

Activity base cost began n the 1980s. The reason that led to the introduction of this was inefficiencies of traditional account methods. (“Management accounting”, par 4)

The developments of traditional methods were used long time ago when the manufacturing industries relied on manual labor. As the companies experienced changes, the past methods failed to provide the detailed results. This paved way for the new method of cost analysis, which is activity base cost in order to provide in depth results (Tyler, par 2)

Activity Base cost is an important activity in an organization. It plays a big role towards attaining the goals and objectives of the organization. This is the means of identifying activities in an organization and assigning them cost. Activity Base Cost is the means by which calculation of the cost of a business organization is done through focusing on the activities actual cost, then coming up with the estimate of products or services costs (“Activity based costing”, par 3).

Objectives of the study

Activity base cost is very significant to all business organization, manufacturing industries and other relevant institutions. This is so because both institution and organizations incur in one or more different types of costs. Activity base cost therefore helps in allocation and identification of these costs, thus making the institutions or organizations to come up with better business plans or budgets.

It is important to study activity base cost as a method of cost analysis because it helps an individual understand how organization benefits from it. It also provides the knowledge of cost analysis and its importance or benefits to an organization.

Literature review

This literature review provides the purpose of this study, which is to provide the background information about activity base costing and its importance to an organization. It will also highlight its importance relative to improvement of cost analysis.

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Activity base costing and its importance in the organization

After noting from the previous definition that activity base costing is the way in which calculation of the cost of the business organization is done through focusing the activities actual cost, then coming up with the estimate of products or services costs. We are now going to look at a different definition for better understanding (“Activity Base Cost” par 1). Activity base cost is the method that identifies events in an organization, and then assigns the costs resource to all services and products according to the actual consumption.

After knowing the meaning of activity base cost we now want to learn more about its importance in an organization. Activity base costing is an important tool towards attaining excellence in organizational strategic plans. It also helps in the cost analysis of the business in general. Analyzing costs in an organization is very important because it helps the management to make plans for organizations future. In the past direct labor has been the method used to allocate factory overheads. This is method irrelevant and therefore, activity base cost is its substitute.

This method has become one of the most improved and it allows the organization to use many different forms of allocation basis depending on how production overhead affects costs. The cost of raw materials determines the allocation of costs, working hours of the machine, the set up time, waiting time, the number of requisition or purchased orders and number of produced units. With this, a single company can use more than 35 ways in overhead allocation. These cost allocation bases are the cost drivers because they drive cost (Flesher, par 2).

Activity base cost is an important tool in the companies and other business organizations because it shows the customer profitability information. Actually, this information is very important because it brings up the customer perspective. This information is also very significant because it helps in the identification of the most suitable customer strategy. It also helps in the strategy execution and therefore organizations have to know how to make their customers glad and they will remain profitable. The provided service must add value to the clients whilst concurrently maintaining a cost-efficient way.

We have been looking at the importance of base costing. On the contrary, base costing has disadvantages. These disadvantages are direct and indirect cost. Lewis defines- direct cost as the means of identifying and tracing cost objective, cost objectives are in different forms; they can be a department, a procedure, a function or a product. Each of them is the cost center. Direct cost is actually a separable cost as opposed to an ordinary or joint cost (Lewis Pp7).

Let us discuss product as a cost objective. Direct labor and materials are the only costs that are usually direct. They are directly related or traceable to the product itself. The other factory costs are usually indirectly associated to the products. Indirect product cost on other hand may be a direct cost as observed with other cost objective inside or outside the factory.

In this paragraph, we are going to discuss joint cost. Joint cost is also the common costs incurred for the basic raw materials, which can undergo further processing. They can also include factory overhead and direct labor.

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Costs are further subdivided into product cost and period cost for them to be identified as expenses or product cost. Here, the ending inventories or direct resources include costs incurred for the reason of manufacturing products. Product cost is work in process or the finished goods, product costs are some time the non-manufacturing cost that is incurred during a fiscal period. Period costs are usually the expenses, its examples are marketing and administrative expenses which we incur during the fiscal period. Sections of the unique cost of the equipment charged against the revenue of each accounting period are expenses that depreciate. Salary, wages suppliers, utilities and office personnel are examples of expenses relating to the accounting period.

There are also some costs that are unexpected, consideration of this these costs are important. Actually, these are the cost that an organization finds itself spending without planning for it. They are classified as expired and unexpected costs. Usually assets are the unexpired costs; they are the cost of products that are still contained in the producer’s inventories or assets. The sale of stocks causes the assets to become expired expenses or costs. Then they are matched to the revenues of period as cost of sold goods. Assets purchased in prior periods or in the present are the expired periodic orders. Examples of these are the prepaid insurance in assets. These are the unexpired costs. As time elapses, a proportionate share of the insurance cost is expensed. There is also a need to have a look at cost concept and terminology. Under cost concept and terminologies, we have the prime cost, conversion costs and non-manufacturing costs. In this paragraph, we are talking about prime costs. Prime costs consider both direct material and labor, but leave out factory overhead. The importance of isolating the total direct product cost is that they are the major inputs to products.

Conversion costs take into consideration the direct labor and factory overhead. Direct materials are included in conversion costs. The importance of word conversion is its representation at cost of converting direct material into units of the complete products. With the prime costs, the conversion costs are important portion of the whole production cost. In the industries where the manufacture of raw materials are relatively cheap, and where factory overhead is wide to contain the requirements of the labor force, the conversion cost may go beyond the prime costs.

Non-manufacturing costs, considers all the non-manufacturing activities in a manufacturing firm (“Activity Based Costing” par 1). These include market activities, its physical distribution and promotional activities, the administrative activities in an organization such as executive offices, accounting, legal and financial, engineering and research, maintenance, security and housekeeping, personnel and human resources. The descriptive names of these activities vary between companies. The expenditures of these activities are period costs, charged to the current periods as expenses. Promotional activities like selling and advertising give the rise to marked expenses

Under activity base costing we also have to learn about allocation of indirect costs. The most important function that managerial accountants should consider is the capability or ability of tracing the costs and the expenses to production department, product line, job orders and other cost objectives of the company. For one to analyze and inspect accounting data one should make an effective effort to trace costs and expenses, so that we can know the appropriate cost objectives. Direct materials as costs are easy to trace to product lines. Therefore clerical expenses of revealing this production type is low (Lim pp 4).

Supposing time and expense were unlimited, it will bring possibility to identify many costs and expenses with a cost objective, the same way a product line, a function or departments do. Theoretically, almost all expenses and costs can be traced once the cost objective is defined but practically this can be too expensive to establish elaborate system of tracing production cost to product lines. A typical manufacturing industry may have several hundred different products.

The outcome of inappropriate allocation of the directly unnoticeable cost to the product lines causes the shifting of product lines, therefore profitable product lines discontinuation might arise. Marketing executive officers that are insufficiently informed have an obligation to make product decisions based on intuition rather than profitability. It is very important to use the most specific method of allocation within the practical limits of cost-effective procedures. The drastic effects of global struggle on a few Americas industries have caused a long overdue questioning into the sharing measures used in traditional cost accounting systems.

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Given that activity, base costing is an important tool or activity in organization and industries we have to understand that it has some factors influencing or limiting it. We still find that in activity base costing, some overhead costs are not easy to assign to products and customers, as the chief executive salary. For the reason that there isn’t a noteworthy way of sustaining these costs, they are not assigned to customers and products. If there is a chunk of overhead cost that has not been considered, contribution must be made from each of the company’s product to meet their deficit. Before making use of activity base cost, the unconsidered overhead cost is usually very large (Thomson par 5).

Under this topic, it recommended that one know what cost are all about. Cokins says; given the two cost views, cost process and assignment seem to be logical, people who design or use activity base cost system often have difficulties to develop the power of the two views. This is because practically, these two views are confused. The problem usually is in defining and designing of costing models in understanding what exactly costs are. Any way let us ask ourselves what costs are. Costs are actually abstract and intangible; we cannot see or hold a couple of costs in our hands. However, we all know they exist; they are like an echo in which we know they exist even if they are measured or not. (Cokins Pp 5)

Workload always determines the costs in a way that when there is a change, the workload costs can either decrease or increase. This affect the activity costs through their cost drivers. Prompting of work activities is through the events and the costs. Given that costs are not tangible, activity base cost operates as an imagining system similar to an electrocardiogram or like a digital camera. Activity base cost records an image. This makes someone to clearly understand or have the image of the process carried out.

Costs measure affects more than illuminating root causes. However, activity base cost systems system provides an enterprise wide image of all collective effects with the casual relationships that causes organization costs. Therefore, costs provide insight into the origin of causes, but mainly through their inferences. We should note that an organization cannot manage its costs but it manages the things that cause costs. Activity base costing as a system help to make costs tangible, in order to bring meaning given that many people believe they are intangible. With this explanation, I believe costs are now well known.

Here, we are looking on the cost drivers and activity drives. Activity base cost recognizes the term activity very well, contrary to the term drivers that has many variations. The problem is that the word cost drivers is used in many ways with different meanings. For clarity, cost driver is something described in words but not necessarily numerical. For example, can be a cost driver that results in many clean-up work and the resulting costs. In contrast, the activity drivers in activity base cost models assignments must be quantitative, the use of measurements that allocates costs. In the activity base cost models, vertical cost assignment view there are three types of drivers that are all quantitative.

Activity base cost can bring constructive changes in financial control systems, actually as seen earlier in this document activity base costing is a method of coming up with cost estimates in which the project is subdivided into different, measurable activities or a work unit. It was the solution of improving the irrelevance of traditional cost accounting methods in the past. Activity base costing is not financial accounting system but an approach of measuring the costs and performance of business process. The outputs provide a more effective way of viewing and interpreting information. Activity base costing like the traditional cost accounting is a cost allocation methodology. However, there is a great difference. Unlike traditional cost accounting, activity base costing works on some principals that we will discuss later on.

Activity base cost brings the issue of cost analysis. Whereby all costs within an organization undergoes analysis, after the costs analysis they the allocation of their causes is arrived at. This will simplify the managerial job in the organization.

Activities incur costs through resources consumption, while customer demand for services and products makes the performance of activities. Under this, we can as well determine several benefits of activity base costing. As seen earlier on in this study, activity base cost is a tool of business process improvement; this is by linking elements like process flow analysis, and performance management. It creates support to the ongoing evaluation of effectiveness of improvement initiatives, activity base costing management endeavors included (“Advantages of Activity Base Costing” par 1).

Through identifying cost pool or activity centers, activity based control assigns cost to product services based on the amount of transaction performed in the process of product or service provision. This provides aid to managers in coming up with and making the shareholder value high and also in improving performance of the company.

Activity base cost assists in pointing out profitable customers and also the unprofitable customers. Besides that, it also helps one to identify worthy channels and goods. It is easy to identify true contributors and detractors in business if activity base cost is used. Furthermore, activity base cost management prepares managers with course intelligence to drive improvement. The other benefits of base costing activity are the accurate prediction of cost, profits and resource requirements related with changes in the organization. The change may include the changes in production volumes, organizational structure and the resource cost.

Let me briefly highlight a major limitation of activity base cost. Even though activity base cost is a very important tool in clarity of methodology, one major limitation of this method is in using it for estimating budgets. It is nearly impossible to have an accurate estimation of the costs for some critical activities. When proper estimation of the costs of a single activity is not included, it results to break down of the whole chain of activities.

.Even with the limitation above, we still consider activity base costing as the most accurate tool in cost estimation. Reason is that from the above limitation we find out that the irregularity is not with activity base cost as a method but it is with the person involved in the activity of working out the budget or coming up with organizational plan. Therefore, the person coming up with the plan should be careful not to make simple mistakes like omission so that activity base cost method of estimation remains accurate.

Findings and analysis

At the introduction, we saw that activity base costing began in 1980s (”Development of activity based costing.” par 3). The reason of its beginning was to improve on the tradition accounting methods, which failed to provide accurate results. This method therefore improved the past methods and produced accurate result required in the field. Therefore, the findings of this part has been developed and known that the introduction of this method has improved the cost analysis in an organization.

In the background of the study, we looked at the importance of studying activity base cost. This actually helps an individual to understand how organization benefits from it. It also provides the knowledge of cost analysis and its importance or benefits to an organization. The Findings here are the importance that activity base cost provides to the organizations. Most organizations that have used this method in budgeting or coming up with its plan have found success. They have also improved their working techniques and made the organizational management procedures successful.

Conclusion

Activity base cost contains fewer disadvantages to advantages, in other way it has advantages overweighing disadvantages or limitations. Well implementation of this method, can bring a constructive change in the final control system. When carrying out planning or budgeting with activity base cost there is always accurate estimation done. One can always work out where the estimations went wrong because you know what each activity contributed in your planning. The fact is that activity base cost provides the structure for the establishment of a true management-oriented system and the true benefit lies in it.

Works Cited

“Activity Based Costing.” Accounting Couch.com. AccountingCoach, LLC.n.d Web.

“Advantages of Activity Based Costing System.” Accounting for Management. Google. n.d. Web.

“Activity based costing.” BNET Business Dictionary. CBS Interactive Inc. n.d. Web.

Cokins, Gary. Activity-based cost management: an executive’s guide. New York: John Wiley and Sons, 2001. Google books. Key Business Metrics. n.d.Web.

Dale, Flesher L. “Activity base costing for manufacturers.” AllBusiness. AllBusiness.com, 1992. Web.

“Development of Activity Based Costing.” Articlesbase. ArticlesBase.com, 2008. Web.

Lewis, Ronald J. Activity-based models for cost management systems. Westport: Quorum Books, 1995. Googlebooks. Greenwood Publishing Group. n.d. Web.

Lim, Andrew. “The Importance of Activity-Based Costing/Management to the Balanced Scorecard.” Apmss.com. n.p. n.d. Web.

“Management accounting.” Wikipedia. Wikipedia Foundation. 2009. Web.

Thomson, Shane. “The Concept and Limitations of Activity-Based Costings.” Web blog post. Google Powered Search. Google. 2009. Web.

Tyler, Will. “The Benefits and Basic Information About Activity Based Costing.” Ezinearticles. 2009. Web.

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