Product Costing- Traditional Methods and Activity

Introduction

Activity-Based Costing is a method to measure the performance and cost of activities in a system. This costing methodology integrates the contributory relationship between activities of a system and its cost drivers. Unlike any traditional costing system, ABC allocates cost to activities depending upon the utilization of resources and allocates cost to cost objects depending upon their utilization of activities of a system. In simpler words, ABC is a costing model, which identifies and differentiates different types of activities in an organization and simultaneously assigns cost of each activity. The product cost is calculated using actual consumption of resources (Bradtke, 2007).

Product Costing-Traditional Methods and Activity

To have a firm and practical resolution to the cost calculation of a product various methods are used. One can embrace the new and efficient way of the activity-based method of costing products and cost allocation or the traditional method. The approach of activity-based quotation mainly looks at actions and incorporates the ABC technique, which is a fundamental tactic in the decision-making process of an organization. ABC method is Important accounting equipment that breaks down the details of cost of an organization (Pryor & Sahm, 1996). The point that the ABC method tries to insist on is that if the details are simplified or broken down and handed to managers, then the managers are in a position to make more sound decisions concerning the organization’s costs. In the past years, managers were inconvenienced by the situation of lack of such information.

ABC method is used as a mirror of the activities taking place in the organization. This is possible because each process in the organization is scrutinized while gathering information to be used for the ABC method. This venture will advantage the enterprise in that unnecessary activities that do not generate income and yet consume cost will be surfaced making it easy to eradicate misuse of resources. Some other advantages that the enterprise will acquire include a better understanding of overhead costs, better utilization of unit cost instead of the earlier method of total cost, and making wastage on non-value-added activities to be easily be surfaced. All these advantages will lead to the strengthening of the agricultural enterprise.

Everything that has advantages has disadvantages and the activity-based method is no exception. The first major disadvantage that is faced while implementing this method is the fact that too much time is wasted in the collection of data in that numerous data is gathered from numerous activities and this process consumes a lot of time. The enterprise must also have substantial resources in order to install the ABC system; this means that the ABC system is costly. Once this system is installed, it is still costly to maintain since numerous data has to be collected, checked, and fed into the system. Another disadvantage that could be incurred in Activity Based method is misinterpretation of data collected. Information gathered by ABC method should be carefully used especially when this information is being used for purposes of decision-making. Before taking a step towards making decision-using information that has been gathered, using ABC method manager should have an understanding of which activities are relevant to the situation in the process of decision-making.

Decisions concerning allocation of money to product processing would be greatly affected since this method is dealing with generalization of cost. Pricing of products produced by the farm will remain a main issue especially with the change of the market where products are focusing more on the consumer. Other dysfunctional decisions that could be made could be made due to the use of traditional cost allocation traditional methods of cost allocation are inconvenient when it comes to pricing of products. This method does not produce the true value of a specific product (Bnet, 2010). These methods would lead to the crumbling of the farm enterprise if it chose to use them. One would prefer the alternate solution provided in the case. The two solutions differ in that the first solution is based on the use of the traditional cost allocation method while the new ABC method is far much effective. Traditional cost allocation is a method that deals with assumptions, which is not a pleasant way to make decisions of the farm enterprise (Bnet, 2010).

One critical assumption that is made by the traditional cost allocation method is assuming that cost objects consume resources as compared to ABC, which assumes that cost objects consume activities. The initial suggestion focuses more on the organization’s charts rather than the actual processes as compared to the suggested solution that broadly deals with or focuses on the process of production (Payne, Raiborn & Askwik, 1997). The new solution proposes that more machinery be used instead of labor. This move aims at reducing the overhead cost, as is the aim of the ABC cost allocation method (McNamara, 2010).

The difference in ABC and traditional allocation methods

The conventional costing models assign costs to any system activities in two ways. The “direct costs” include the cost of materials or rather raw materials and direct labor and any other costs are subjectively allocated to the product. The other costs are usually allocated by using direct labor, direct labor hours, or machine hour’s mechanisms. The costs associated with sales, marketing and other administrative activities are not included in product costs. On the other hand, the ABC model shares some similarities with the conventional costing models in the treatment of direct costs. However, it does not allow direct labor to be treated as the proxy application method for indirect expenses (Cokins, 2001).

The central difference between ABC model and other costing models is the treatment of indirect costs. The primary action undertaken by ABC model is to analyze and then separate indirect activities and their associated costs. This is done to create meaningful cost pools, which can then be correctly assigned to the processes. This method provides a better reflection of how the costs were actually incurred. The ABC model recognizes that different processes and products consume resources in different proportions, and the conventional costing systems fail to recognize this fact.

In the ABC model, all costs are linked with resources. These resources are consumed by activities; and these activities have no costs. The costs which are later associated with these activities are the cost of resources that have been consumed per unit of activity. The cost of these resources and activities is then applied to the cost object of a product or service, which is produced by the process.

ABC may make more sense in this setting since it approaches the case of accounting for cost from a totally different angle as compared to fixed cost/variable cost type of cost allocation. ABC tries to portray a clearer picture of the amount of cost needed for this setting through spotting of activities in the setting and the resource cost. ABC provides a new mindset. It begins with the customer’s needs and finalizes with the “cost to serve” those needs. ABC method works very simply all resources and costs are put into one cost pool. After all the costs merged with an activity are summed up, they are allocated to customers, products, or processes based on an “activity unit.” An activity unit, otherwise known as “cost driver,” is mostly the output unit that the activity produces (Harvey, 2010). Each customer is assigned a cost based on how many activity units are consumed

To allocate overhead costs more precisely accounts use activity-based overhead rates. An activity-based predetermined rate is found by separating manufacturing overhead costs by activity and developing a predetermined overhead rate for each activity.

Advantages of activity-based rate

• Only products using an activity are charged for its use.
• Each activity uses the cost driver that best relates its costs to its production activity.

Costs traceable to an activity can be measured rather than allocated. Measurement is more precise than allocation. Activity-based allocation of overhead costs may be compared with plant-wide allocation as shown below.

1. All factory overhead costs in a single pool. 1
2. Overhead costs are allocated to products by using a single predetermined overhead rate.

Activity-based overhead allocation

1. Overhead costs traced to particular service and production activities.
2. Services activities costs assigned to production activities
3. Overhead costs are allowed to products by using a separate predetermined rate for each activity.

Characteristics of ABC

When an organization adopts the ABC model then it can estimate its cost elements for the entire product line much more effectively and efficiently. The ABC model enables the firm to:

• Identify those products or services which are unprofitable; after which the management can decide whether to eliminate such products or services or introduce some radical changes to correct the entire process.
• Identify those production or service processes that are ineffective; after which the management can decide whether to eliminate such processes or re-engineer them.

Any business entity, which uses the ABC model, as a costing system possesses a deep understanding of the product and customer, cost. Furthermore, the profitability is based on the manufacturing or performing processes. Due to these inherent characteristics of ABC model, it is generally used in strategic decisions; pricing, outsourcing and process re-engineering initiatives.

Types of companies that tend to benefit from ABC

The ABC model was developed in the United States in 1970s and 1980s. The pioneers responsible for developing this model belonged to the manufacturing sector. Hence, the ABC model is designed to suit the needs of manufacturing firms. Moreover, the financial institutions have diverse product portfolios and customer profiles. In this regard, financial institutions are quite similar to the manufacturing industry because due to large product lines and clientele cross-product and cross-customer subsidies can occur. ABC in this regard is a useful tool for financial institutions as well, in spite of the fact that it was tailor-made for the needs of the manufacturing industry (Wagner, 2008).

Comment on a company(GSK) that has implemented activity-based

During the research on the internet one would come across a study titled, “ABC, Process-Oriented Systems: a comparative study”, by Pierre Mévellec and Matti Sievänen (Mévellec & Sievänen). The study presents a comparison of two process-based costing systems in European countries (Mévellec & Sievänen). One of these two processes is the ABC model, which is adopted by a French pharmaceutical firm, which itself, is a part of GlaxoSmithKline. GSK is a research-based pharmaceutical company with a share of around 5% of the world’s pharmaceutical market (GSK at a glance). The company’s primary objective is to tackle three “priority” diseases, which have been identified by the World Health Organization (GSK at a glance). These three priority diseases include HIV/AIDS, tuberculosis, and malaria.

According to the study conducted by Mévellec and Sievänen, the French branch of GSK adopted the ABC model in 1992 (Mévellec & Sievänen). After two decades, the firm is still using the same costing system. Taking the financial statement of 2009 there is research and development expense of $ 6, 631million, and an assumed advertising expense of $ 4000 million in the Selling General and Administrative of $ 13,657million(Finance.yahoo, 2011) to allocated using the two methods.

Using the traditional method of cost allocation between the department’s one in charge of HIV/AIDS, tuberculosis, and malaria. The rates of allocation are shown below;

The cost is distributed to departments as shown above.

Using the ABC method the new costs will be allocated as follow;

Conclusion

From the discussion and analysis above, the former method seems to be more potent and protective of the organization’s financial and human resource interests than the latter, therefore, the organizations are urged to implement the ABC method and get rid of fixed cost/variable cost from the organization system.

Reference List

Bnet, J., 2010. ‘Throw Out Fixed and Variable Cost Thinking—Bring In Activity-Based Costing for Distribution Decisions’. Jobfunctions. Web.

Bradtke, D., 2007. Activity-Based-Costing. New York: GRIN Verlag.

Cokins, G., 2001. Activity-Based Cost Management: An Executive’s Guide. New York: John Wiley and Sons.

Finance.yahoo, 2011. ‘GlaxoSmithKline plc (GSK)- Income Statement’. Finance. Web.

GSK at a glance. (n.d.). GlaxoSmithKline. 2011. Web.

Harvey, R. 2010. ‘Throw Out Fixed and Variable Cost Thinking— Bring In Activity-Based Costing for Distribution Decisions’. Value associates. Web.

McNamara, C., 2010. ‘Complete Guide to Ethics Management: An Ethics Toolkit for Managers’. Management help. Web.

Mévellec, P., & Sievänen, M. (n.d.). ‘Allocation of Fixed Cost.’ Media cabinet. 2011. Web.

Payne, D., Raiborn, C., & Askwik, J., 1997. ‘A Global Code of Business Ethics’. Journal of Business Ethics, 16 (16), 1727-1735. Web.

Pryor, T., & Sahm, J. 1996. Using Activity Based Management for Continuous Improvement. London: London Press.

Wagner, D., 2008. Activity-Based Costing and Its Later Development into Activity Based budgeting and management. GRIN Verlag. Auflage.