The most significant point of this essay is to explain and analyse the key elements of a new method of absorption which is the Activity Based Costing (ABC). ABC became popular in the early 1980s mainly because of the dissatisfaction of many companies that used traditional ways of overhead absorption, so it is important to discuss about this method and be able to understand if it meets the requirements of the companies. Certainly, the way overhead costs are allocated to products, have an impact on the pricing and design decisions for these products.
Our study and analysis will examine this new method of absorption starting with a definition of the modern business environment, continuing with the comparison of the traditional absorption method with ABC and the stages of allocation process. Benefits and drawbacks of ABC will also be included into this essay.
Every business organisation operates into an environment that gets more competitive and more complicated through the passage of time. To remain competitive a company must meet the requirements of its customers seek cost savings use advanced technology and try to establish technology advantage. These demands have a significant impact in the change process of a business. Some factors that influence this change in a business are:
The first and probably the most important factor is globalisation. A business in order to compete in the market has to reduce its costs and to be more customer focus by offering them quality products at competitive prices. In the last few years global competition has greatly increased and so the businesses must meet the expectations in the global market.
The fact that resources are limited, especially cash. Businesses no longer have the ability to borrow money so easily from banks and so they cannot easily finance new product projects.
The increase in the use of high-technology systems. High- Technology is required in any type of organisation in order to maximise the production efficiency. Also, more sophisticated information systems were developed which enabled the organisations have better planning, controlling and decision making. In addition many businesses proceeded with the purchase of high-tech machines and this makes the job more difficult as employees must possess specialised knowledge so as to contribute to the increase of the efficiency.
Lastly, the requirements of clients have increased due to the use of the internet. Customers seem to be more informed and demanding. With the use of the internet they can more easily compare the prices of products / services and choose a combination of low price and high quality.
In order to meet the needs in the above fast changing environment, it became essential for businesses to develop new techniques and procedures. Especially in their cost accounting methods with special emphasis on overheads whose growth over time made them a significant element of the cost of products/services. At the same time for some products direct labour and material costs became a relatively smaller fraction of the overall cost of producing them. Moreover, in today's modern business environment, companies produce a wider range of products. The increase in the diversity of products means that products "consume different overhead activities in dissimilar proportions". (Page 352)
All the above contributed significantly to the need for more accurate cost information for products/services. This need resulted in the emergence of the activity-based costing (ABC) in the 1980's. More accurate cost information helps the organisations to make better management decisions with reference to their operations, product design and pricing policies.
Traditionally, businesses used to allocate their overheads by using the absorption costing method. The methods used by the traditional absorption costing models to allocate overheads to products, were rather simplistic in their approach and the results given were relatively inaccurate, not giving meaningful product costs and leading to management decision errors. In terms of modern business environment the need of a modern way of allocating their overheads is imperative. ABC is a new method which held the privileges of a modern business environment. ABC can be defined as a method which its main purpose is to assign indirect costs to products. Traditional absorption systems and ABC systems involve the two stage allocation process but it seems to have some differences such as:
At the first stage, the traditional system tends to allocate overheads to production and service departments. Afterwards, it reallocates the service department costs to the production departments. Lastly, overheads are pooled by departments known as cost centres. On the other hand, ABC allocates overheads to cost pools.
At the second stage, both traditional system and ABC allocate costs from cost pools. The traditional costing systems trace overheads to products by using a small number of second stage allocation bases (or overhead allocation rates). Direct labour and machine hours are normally used. The term 'cost driver' is applied suitably by the ABC system in contrast to the term 'allocation bases' that is used in traditional systems. Many different types of second stage cost drivers are used in ABC such as the non-volume-based-drivers. A good example for this is the machine set-up activity in a manufacturing company. The more the set-ups, the more the resources consumed. The use of the non-volume-based driver means that the company for the assignment of the set-up costs will use the number of set-ups rather than the number of units manufactured. This will give a more accurate measure/ allocation of that cost.
Apart from these differences there is one last difference between the two systems. The traditional costing systems normally allocate the service costs to production centres whereas the ABC system tends to introduce different cost drivers rates for support centres and assign the cost of support directly to cost objects without any reallocation in production centres. Furthermore, the ABC system uses different features that rely on a bigger number of cost centres and a bigger number and diversity of second stage cost drivers. Using these features, ABC is becoming more accurate in the measure of resources.
There are four steps in applying Activity based costing. Firstly, the overheads have to be grouped into cost pools. Cost pool is an activity that uses resources and for which overhead costs are identified and allocated. In the second step, cost drivers have to be identified. A cost driver is a factor which influences the level of cost (a unit of activity that consumes resources). In the third step there is the calculation of the overhead absorption rate and finally, in the fourth step there is the absorption of the overheads into the product.
It is a fact that each method of absorption used by a company has advantages-benefits but also some disadvantages-drawbacks. Starting from the benefits, ABC presents four main advantages which are the following:
The most important advantage is that ABC is more accurate in accordance of the product line costs. That accuracy gives the ability to the managers to use more accurate cost information and it prevents them from making wrong decisions.
Another important advantage of this method is that it is easily understood and used by the employees of a company. This impacts very positively on the productivity within the company and it enables the managers to devote the time gained from the use of this method, in another area which needs their attention. That means that ABC can eliminate the wastes of time in productivity and maximise the efficiency of the company.
In addition, ABC provides to managers a clear view of understanding and identifying the cost behaviour. This enables managers to estimate cost in a better way than the traditional absorption system and therefore the company may have better profitability.
Finally, ABC can remove the unnecessary items from the product line. Those items do not contribute to the improvement of profitability of the company and therefore they have to be removed. This is achieved without increasing the prices and makes it a valuable advantage of this method.
As a relatively new method ABC has some drawbacks in terms of execution and implementation of a company. These drawbacks are:
It is a method that requires special and specific procedures for data collection, which can prove a time-consuming process for a company and this is an important drawback since companies seek time-saving methods.
Another disadvantage which may occur when using the ABC is that it can provide too much detail. In many occasions, too much detail can be characterised as useless and can cause confusion to the employees of the company as it may be difficult for them to distinguish what is important and what is not important.
Finally, Activity Based Costing is expensive to implement as it is a large project and requires a relatively large number of resources. This is a major drawback for this method as many companies, because they cannot afford to use it, are not prepared to abandon the traditional absorption costing systems in favour of the ABC. Only larger firms can afford to use this method.
It can be seen from the above discussion that the ABC system is ideal for organisations which operate in a highly competitive environment, have high diversity of products and relatively high non-volume related overheads/indirect costs. It gives more accurate information about the overhead allocation and the overall costing of products. This inevitably has a significant company-wide impact on operations, pricing and product design decisions.
As a conclusion, it can be argued that the ABC system is a useful tool in the hands of the management of both manufacturing and services organisations. It gives more accurate cost information which helps the organisations to make better management decisions with reference to their operations, product design and pricing policies.