This literature looks into the different concepts of accounting and it emphasizes the activity-based cost accounting model that has been put into effect in the management of organizations. The study begins by defining the three terms that are closely related to each other, that is, accounting, cost accounting, and activity-based cost accounting. From the definition, it is clear that accounting is the broader concept and it is from this that cost accounting comes about. This means that cost accounting is a sub-division of accounting, besides other sub-divisions.
From cost accounting, activity-based accounting was developed. The traditional cost accounting methods were found to be insufficient and to solve the traditional cost accounting drawbacks, the ABC model was created. The historical development of the model explains the key contributors and it explains how it has been improved to date.
The study also looks at the aspects relating to the implementation of the model, that is, how it is used by organizations to enhance their cost management strategies. The positive and negative implications are also identified and this goes on to explain how the implications have affected the current managerial conditions in organizations. The study concludes by arguing on the need to adopt and implement the model to improve the performance of organizations.
Definition of terms
According to Hermanson (2008), accounting is the process of analyzing, recording, and making a report of data in the books of accounts. Entries are made in accounting books referred to as ledgers as contra entries and in chronological order and the transactions made are also said to have both a debit entry and a credit entry. Records keepers or accountants must ensure that proper records have been made so that there are no possibilities of fraud in the organization.
Hence, accounting plays an important role in an organization and it is necessary that proper accounting standards are followed in implementing an accounting system in the organization. The accounting concept has a historical basis, which has continued changing with changes in the management of organizations. The various procedures in accounting have led to new ideas and this has consequently resulted to different categories of accounting. These include financial accounting, management accounting, cost accounting, tax accounting, internal and external accounting (Hermanson, 2008).
This is a system of accounting that involves analyzing the costs and benefits of an organization. It is the process by which the company’s costs and benefits are recorded in the books of accounts and decisions made from these records. Cost accounting enables an organization to know its gains or losses in its operations, in that when the benefits are greater than the costs the company knows it is working towards achieving its objectives, and when the costs are higher than the benefits, the company knows that it may be incurring more losses than gains and corrective measures are hence implemented (Scott, 2006).
According to Scott (2006) cost accounting is used together with other accounting procedures like financial accounting to be able to know the financial position of an organization at the end of the accounting period. The existence and origin of cost accounting is also based on the origin of the early accounting methods and therefore, while looking at the history of accounting, the cost accounting concept will also come into effect. Since cost accounting takes into consideration the costs and benefits of an organization, the social, economical, political and environmental factors that cause these benefits and/or costs must be identified while making the appropriate decisions.
Cost accounting therefore, unlike other accounting concepts, involves a wider perspective of the financial outlays and advantages. It does not look at the cash inflows and outflows alone but also considers other non-cash benefits and expenses. It entails looking at the factors that bring about the costs and benefits of an organization and it is from these factors that management decisions are made (2006).
Hicks (2007) defines activity-based costing as an accounting procedure that identifies the costs of various activities and assigns resources in relation to these costs. It involves identifying the costs used up by each activity in the organization in the process of producing particular goods and services. Activity-based costing helps the management to identify those activities that are causing losses to an organization and those which are helpful to the company. By identifying the costs of each activity, resources are distributed in the proper proportions and analysis of is easily made from each of the activities.
Activity-based costing is generally referred to as the ABC methodology and it is used as a tool for clearly analyzing and understanding each of the different products of an organization. It allocates activities to the different goods and services provided by a firm. It therefore assists in making management decisions in terms of marketing, resource allocation, customer satisfaction and profit maximization (Hicks, 2007).
Historical Background of the ABC methodology
The concept of the ABC methodology began in the late 1970s and early 1980s in the United States of America, mainly in the manufacturing industries which were involved in producing different products. Initially, traditional cost accounting methods were used to account for the direct and indirect costs that were incurred in the process of producing goods and services. With time, however, it was found out that it was not possible to account for the costs of each of the products and inaccuracies were arising because some products did not incur the indirect costs. There was a problem in trying to establish those costs that were being incurred by the different products and it was therefore found necessary to come up with a more advanced accounting model that would be used to distinguish the direct and indirect costs of each of the products (Kaplan, 2007).
The major contributors of the ABC approach to cost accounting were Robin Cooper and Robert Kaplan whose ideas appeared in an article titled Harvard Business Review. The two scholars aimed at bringing an end to the challenges being encountered in implementing the traditional cost accounting procedures. They aimed at establishing an accounting system that would accurately determine the actual direct and indirect costs of producing individual goods and services. This way, managers would also be able to make decisions based on accurate and clear information.
According to Cooper and Kaplan (2007), the activity-based cost accounting approach would be used to assign actual costs to a particular activity based on the cost and effect relationship. It would bring an end to the method of assigning arbitrarily costs to an activity and in turn causing discrepancies in the actual cost valuation. The ABC methodology was first implemented in the US manufacturing sector and it enabled managers and accountants to be able to separate direct costs from the indirect costs. During the 1980s, the manufacturing industries were able to reduce their direct costs through technological advancement. However, indirect costs continued rising and the management found it necessary to assign costs in using the ABC concept.
Today, the activity-based costing accounting method is used in all sectors of the economy to assign costs to the various activities so that proper managerial decisions in respect to costs and benefits may be made. The methodology worked effectively among the US manufacturing sectors and other sectors all over the world have since implemented it in their operations.
The aspect of ABC methodology
According to Kaplan (2007) the concept of activity-based accounting follows the aspect of allocating direct and indirect costs to individual products. Direct costs like direct raw materials and labor can be easily allocated to a product. However, the indirect expenses like rent, managerial salaries and electricity and/water bills may not be easily accounted for in individual products. The ABC model comes into effect in allocating these costs effectively and accurately. The model traces the indirect costs that are incurred in producing an individual product and this way, it is possible to identify the relationship between the costs and each of the products produced.
The ABC model is considered an accurate method of assigning costs to the various activities and its aspect therefore entails identifying an activity in an organization which is related to its costs and through this management decisions are easily made (Anderson, 2007).
The ABC methodology-its importance and limitations
The methodology has been helpful to most organizations as it has provided an effective means of allocating costs to defined activities and therefore enabling an organization determine which activities and products enhance profit-making and which bring substantial losses to the organization. According to Hicks (2007), the importance of the ABC model may be summarized as follows:
- It enables an organization identify those products that are not giving profits to the organization. That is, helps the management identify those products that use up a lot of costs in terms of expenditure and in return, only make losses out of their sales.
- An organization is also able to identify the departments that are incurring high expenses and are not producing quality products. Activities that are not giving their best are also easily identified and the management is therefore able to avoid those activities that only incur expenses and are not making profits. The departments that are not performing accordingly are also re-examined and necessary action taken.
- The model also helps to allocate resources to the various activities or departments depending on their performance. An organization is able to identify the most profitable activity or department and with the cost accounting procedure, allocate resources accordingly.
- It helps to control costs being incurred at the core level. This means that as costs are allocated to specific departments and products, cost control is made at these departments and for the specific levels and not as a broad concept. This way, proper decisions on cost management are enhanced.
- It assists managers to easily identify the unnecessary costs in the different departments. Since costs are allocated to the departments and to products depending on their output, it is possible to identify costs that may be avoided and focus on those that must be incurred for the organization to perform to its best.
What are the Limitations of implementing the ABC methodology?
Despite the great advantages that come with the ABC approach to cost accounting concepts, there are also negative implications that are as a result of this concept. It is clear that not all organizations are able to make effective use of the model and problems have been arising in trying to come up with an effective model that will suit the activities of the organization. These limitations include (Hicks, 2007):
- Some indirect costs in activity-based approach are still difficult to assign to the individual departments or products. There is no defined method of assigning costs like the chief executive officer’s salary because they are directed to the entire organization and not to particular products, activities or departments. This leaves such costs un-assigned and assumptions must be made to give proportions to the means by which they will be catered for by the different departments or activities.
- The methodology is a relatively expensive model to implement and it requires qualified personnel and a more advanced managerial system. Therefore, not all organizations can implement it and those that implement it must ensure that it runs effectively and must therefore employ qualified management to run it.
- It also consumes a lot of time during the implementation process. This is because all costs must be identified and they must then be accurately assigned to the various activities or departments. If proper decisions and policies are not made, the organization is likely to incur greater losses while implementing the model.
Today’s activity-based costing approach; is it too much too soon?
The ABC concept has gained a significant response to many companies of the world and it is clear that it is making great contribution towards growth and profitability in the different sectors of the economy. However, the consistency of the cost accounting system has not been sufficiently maintained and it is important that organizations need to create consistence in the model in order to ensure an efficient means of managing costs (Scott 2006).
Scott (2006) also argues that it is important that the management properly educates its staff on the effective implementation of the ABC strategy. This is because it is a complex model and it requires experts to be able to critically analyze the costs and allocate them to the respective departments. With the change technological trends, there are even greater challenges that are likely to occur while taking in the model into the management of the organization and unless the company is well prepared mainly in terms of its expertise, the model may not work.
However, it can be argued that the ABC model has shown significant progress from the early days while traditional cost accounting policies were still in force to the current management. The world is constantly advancing and organizations need to embrace the changes in order to survive and grow.
In conclusion, it is clear that despite the challenges that organizations are facing while coping with the changes in the cost accounting policies, the activity-based cost accounting model has been of significant importance in cost management strategies of any organization. The model has been tested by numerous researchers and the findings obtained have shown tremendous results and it may be sufficient to conclude that the model should form a basis of other new cost accounting and management models that would benefit different organizations.
The activity-based model would in future necessitate extra input and work in order to be useful in planning and decision-making for all organizations. The model forms a good start to enhance cost management and productivity in an organization.
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