Activity Based Costing Concept and Management

What is Activity Based Costing?

What is Cost Accounting?

Cost accounting is involved with the following:

  • Determining the costs of products, processes, projects, etc. in order to report the correct amounts on a company's financial statements, and
  • Assisting management in the planning and control of the organization
  • Preparing special analyses that assists in making the best decisions

Example:

A significant part of cost accounting involves the unit cost of a manufacturer's products in order to report the cost of inventory on its balance sheet and the cost of goods sold on its income statement. This is achieved with techniques such as the allocation of manufacturing overhead costs and through the use of process costing, operations costing, and job-order costing systems.

Cost accounting assists management to plan and control the business through budgeting for operations, capital budgeting for expanding operations, standard costing and the reporting of variances, transfer pricing, etc.

Special analyses includes cost behavior, cost-volume-profit relationships, make or buy decisions, selling prices for products, activity-based costing, and more.

Cost accounting had its roots in manufacturing businesses. However, today it extends to service businesses. For example, a bank will use cost accounting to determine the cost of processing a customer's check and/or a deposit, maintaining a checking account, processing international wire transfers, servicing a mortgage loan, etc. This in turn may provide management with guidance in the pricing of various services.


What is cost allocation?

Cost allocation is the assigning of a cost to several cost objects such as products or departments. The cost allocation is needed because the cost is not directly traceable to a specific object. Since the cost is not directly traceable, the resulting allocation is somewhat arbitrary. Because of the arbitrariness, some people describe cost allocation as the spreading of a cost.

Accountants have made efforts to improve the cost allocation techniques. Over time, manufacturers' overhead allocations have moved from a plant-wide rates to departmental rates. Some allocations that were allocated on the basis of direct labor hours are now based on machine hours. In order to improve those bases of allocations, some accountants are implementing activity based costing. The goal is to reduce the arbitrariness by identifying the various root causes of the overhead costs.

Example:

The following are only a few of the many cost allocations that occur in some companies or organizations:

  • The cost of a manufacturing building is allocated to each of the years that the building is expected to be used. Each year's depreciation is allocated to the departments that use the building. Each department's allocated cost is then allocated/assigned to the products that are processed in the department.
  • The electricity that is used in the production facility as measured by a single meter is allocated to the departments using the electricity. Each department's electricity is then allocated/assigned to the products processed in the department.
  • The cost of raw land that was purchased for Rs.10,00,00 is going to be developed into 80 residential lots of various sizes and 10 business lots of different sizes. The Rs.10,00,00 cost must be allocated to the resulting 90 lots in a meaningful way so that the developer can report the profit of selling two residential lots and the largest of the business lots. The basis for the allocation is likely to be the net realizable values of the lots.
  • The annual salary and benefits of an employee that spends time in three main functions of a nonprofit organization.

How can a manufacturer determine the precise cost of its products?

A manufacturer may never be able to determine the precise cost of its individual products. The reason is that most of the manufacturing costs (other than materials and some labor) are indirect costs. This means that most of the manufacturing costs are not directly traceable to individual products and will need to be allocated to them. Examples of indirect manufacturing costs include the rent, property taxes, depreciation, heat, lighting, indirect production workers pay and benefits, repairs, maintenance, and others that occur in the factory.

In addition to the manufacturing costs, there are selling, general and administrative (SG&A) expenses and perhaps interest expense. Generally, accountants do not consider these expenses to be product costs. As a result these expenses are reported on the income statement when they occur and without any allocation to the products. However, these expenses are associated with some or all of the products.

The manufacturer can attempt to calculate the costs and expenses of each of its products, but I don't think the result will be the true, precise cost. In addition to the allocations (which are viewed as arbitrary), consider that changes in volume will affect a product's cost. For example, if a company's total fixed costs remain constant but its volume of products decreases by 20%, the cost of each product will increase. If volume increases, the cost of each product will decrease.


What are indirect manufacturing costs?

Indirect manufacturing costs are a manufacturer's production costs other than direct materials and direct labour. Indirect manufacturing costs are also referred to as manufacturing overhead, factory overhead, factory burden or burden.
In traditional cost accounting, the indirect manufacturing costs are allocated to the products manufactured based on direct labor hours, direct labor costs, or production machine hours. However, in recent decades the indirect manufacturing costs have increased significantly and are less likely to be caused by the quantity of direct labor or production machine hours. (This may not be a problem for financial reporting when the amount of inventory is consistently small, but it can be a problem for pricing and other decisions.)

Example:

Some examples of indirect manufacturing costs include:

  • depreciation, repairs and maintenance, electricity, etc. for the production facilities and the production equipment
  • salaries, wages and fringe benefits of the indirect manufacturing personnel such as production supervisors, material handlers, quality assurance, and other factory support personnel
  • factory supplies, outside services pertaining to manufacturing, and other manufacturing related costs

Why does a cost system developed for inventory valuation distort production cost information?

The cost system for inventory valuation may have been developed to provide a reasonable total cost of inventory and a reasonable total cost of goods sold in order to have reasonably accurate financial statements. If a company has small inventory amounts and significant sales, a simple cost system that spreads manufacturing overhead costs solely on the basis of machine hours can result in a reasonably accurate balance sheet and income statement.

While a simple cost system using just one cost driver (machine hours) may result in accurate financial statements, it often fails to provide the true cost of individual products that vary in complexity. For example, one product might require very few machine hours but will require many hours of special handling. The costs assigned on the basis of machine hours alone will be too low in relationship to the true cost of manufacturing this product. Another product might require many machine hours but no other activities. This product's cost will be overstated because the rate assigned via the machine hours will include an amount for other activities that generally occur for the other products manufactured.

A cost system developed for inventory valuation is limited to the cost of direct materials, direct labor, and manufacturing overhead. The total cost of providing products to a customer will also include nonmanufacturing expenses. One customer might require a company to incur additional selling, delivering, storing, and administrative expenses. Another customer might not require any of those activities and their related expenses.



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