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Analysis of Activity Based Accounting

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Introduction

Activity-Based Costing (ABC), a tool for cost management, has recently gained popularity, is based on a simple idea: in an enterprise, overhead (or operating expenses) are measured by a number of activities needed to successfully perform manufacturing and business processes. The total cost of a product is the sum of the costs of activities that are the real cause of the overhead include establishing vendor relations, purchasing, receiving, setting up a machine, running the machine, disbursing, reorganizing the production flow, redesigning the product, and taking a customer order (Turney, 1989). By design, ABC provides not only relatively accurate cost data, but also information about the origin of the cost (Cooper and Kaplan, 1988).

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In ABC, the manufacturing overhead are assigned to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. It permits the very important distinction between resource usage and resource spending (Cooper and Kaplan, 1992).

Traditional cost models apply resources to products in two ways. So called direct costs like material and direct labour are attributed directly to the product and other resources are arbitrarily allocated to the product, typically through the mechanism of direct labour hours, labour dollars or machine hours. Sales, marketing and administrative costs are not included in product costs. But, Activity Based Costing (ABC) does not change the way material and direct labour are attributed to manufactured products with the exception that direct labour loses its special place as a surrogate application method for overhead resources. Direct labour is considered another cost pool to be assigned to processes and products in a meaningful manner, no different than any other resource.

The primary task of activity based costing is to break out indirect activities into meaningful pools which can then be assigned to processes in a manner which better reflects the way costs are actually incurred. The system must recognize that resources are consumed by processes or products in different proportions for each activity

Activity Based Costing Advantages

• More accurate costing of products/services, customers and distribution channels.

• Better understanding overhead for everyone.

• Utilizes unit cost rather than just total cost.

• Integrates well with Six Sigma and other continuous improvement programs.

• Makes visible waste and non-value added.

• Supports performance management and scorecards.

• Enables costing of processes, supply chains and value streams.

• Here mirrors way work is done.

• Support facilitates benchmarking.

• One of benefit of ABC is, it enhance the strategic decision making for managers in a company .They can bring new information that they haven’t noticed before so they can take better decision about cost.

• Help the manager to understand where there are lot more cost and prod it breaks action as we can see in power drip packing in labour and maintenances.

Advantages of switching to machine hours as an overhead recovery base:

1. With machine hour rate, the Cylinder manufacturing company (CMC) can accuse almost all operating expenses on the basis of machines.

2. With the help of under absorption of machine overhead, CMC can find the idle time of machine. Then, can try to reduce it.

3. It is useful to increase efficiency of machine, because CMC can use it effective way and all overheads depends on it.

4. It is a scientific method to calculate factory overhead cost.

5. By this, CMC can firstly calculate total production cost, after this, it is very easy to calculate selling price of any product.

6. If we absorbed overheads on the basis of machine hours, CMC can get more meaningful and accurate product cost compared to labour hours.

If we look at the Cylinder manufacturing company case study, then we will find the following overheads based on machine hours and labour hours.

For overheads based on labour hours

The Budgeted labour rate = ?149.825 per dlh

Total overheads for Standard products = ?149.825 per dlh x 2,500 dlh = ?374,562.5

Total overheads for Specialised products = ?149.825 per dlh x 1,500 dlh = ?224,737.5

Overheads based on machine hours

Total machine hours=6500.

Total overheads to be distributed=?599,300

Budgeted overhead burden/machine hour=599300/6500 =?92.2 pounds.

Total Overhead burden for standard products=92.2*3500=?322,700.

Total Overhead burden for specialized products=92.2*3000=?276,600.

If Cylinder manufacturing company uses machine hours for overhead calculation instead of labour hours, then the output will be more accurate. It is quite easy to find the machine hours correctly than labour hours. As the machine is in automated system, from a machine they can find the correct information about the total machine hours used by a product. Moreover the efficiency of all machines are all most same but it’s vary a lot for labours, because all human beings efficiency is not same.

In the case of labour hour the difference between overheads for standard product and specialised product is high. But for machine hours it is relatively low. But we know, specialised product needs more machine hours than the standard products. Therefore, the gap should be low. So, we can say absorbed overheads on the basis of machine hours give more accurate output than absorbed overheads on labour hours. Then the manager can know the cost of sell more accurately and select correct pricing for the product and maximizing the profit.

Comparison among three accounting methods:

Here, I will be working through the provided data three times. Firstly, I will show how traditional cost accounting methods might deal with them; secondly to look at the multiple volume based overhead method; and, finally, I will illustrate the ABC method using all of the data in great detail.

Traditional allocation method (direct labour hours basis):

The direct labour hour rate is

total overheads

total number of labour hours

599,300

4,000

?149.825 per dlh

The overheads recovered are:

Direct labour hour rate x number of direct labour hours per product

For Standard products, the calculation is: ?149.825 per dlh x 2,500 dlh = ?374,562.5

For Specialised products, the calculation is: ?149.825 per dlh x 1,500 dlh = ?224,737.5

Multiple volume based allocation method:

This method has an advance on the traditional allocation method in that it does make some allowance for activities to influence the absorption of overheads. In the case of Cylinder manufacturing company, two absorption rates to apply here: the receiving department overhead rate, and the “other” overhead rate

The reasoning here is that, the organisation I am simulating is using a two rate basis of apportioning overheads: firstly, a material handling overhead rate is used to assign overhead to a separate cost centre on the basis of the number of number of stores orders; secondly all of the other overheads are assigned using a general machine hour rate on the basis that the number of machine hours far exceeds the number of labour hours.

The Materials handling overhead rate is

Total Materials handling overheads

Total number of stores orders

?119,600

460

?260 per stores orders

For Standard products,

?260 per stores orders x 160 stores orders = ?41,600

For Specialised products,

?260 per stores orders x 300 stores orders = ?78,000

The other overhead rate, calculated by dividing the total other overheads by the number of machine hours applied, is:

?599,300 – ?119,600

6,500 machine hours

?479,700

6,500 machine hours

?73.8 per machine hours

For Standard products other overheads cost is,

?73.8 per machine hours x 3500 machine hours = ?258,300

For Specialised products other overheads cost is,

?73.8 per machine hours x 3000 machine hours = ?221,400

Therefore,

Total overhead burden for standard product= ?299,900

Total overhead burden for standard product= ?299,400

ABC Method:

To apply the ABC method, we need to identify cost drivers for two stages:

1 cost drivers tracing the costs of inputs into cost pools; and

2 cost drivers tracing the cost pools into product costs

The workings that follow illustrate clearly how such cost drivers work through the ABC system in these two stages: an initial overhead amount being further subdivided into two parts according the needs of the situation.

Cost of machines driven by machine hours

Standard product = 3,500/6,500*279,500=?150,500

Specialized 3,000/6,500*279,500=?129,000.

Set up and engineering support cost driven by number of set ups.

Standard product = 80/280*200,200=?57,200

Specialized product = 200/280*200,200=?143,000

Material handling cost driven by number of stores orders

Standard product = 160/460*119,600=?41,600

Specialized product = 300/460*119,600=?78,000

Total overhead burden for standard product = ?249,300

Total overhead burden for specialized product = ?350,000

Total overheads for standard and specialised product in three accounting methods are shown in the following table

Standardproduct

Specialised product

DLH

?374,562.5

?224,737.5

Multi Volume

?299,900

?299,400

ABC

?249,300

?350,000

From the above comparisons, it is cleared that multiple volume based allocation method gives more accurate data than daily labour hour method. But activity based costing system is the best as it gives more meaningful data than others, therefore Cylinder manufacturing company should try it for their cost reduction.

How Cylinder manufacturing company can implement activity based costing system:

As we know ABC is little bit heard to implement and more time consuming, because so much informative can be required about lots of items. And there is a cost of buying, implementing and maintaining activity based system.

According to me, in order to implementation Cylinder manufacturing company require a lot of preparation, because as it mention before there are a lot activities and information that needs to be gathered .So before going to implement ABC, Cylinder manufacturing company must be prepared it self by gathering lot of information for understand what exactly they are going to doing. During the setup time of activity based costing, they can temporally use old marginal and absorption account method. Management focus need to be changed on not just the performance but the activities that going into that performance need to be paradise here, the organization should not just focus on one area, the overall view of the company. It has to change the manager view of the company here managers are not just looking at the cost there are going go back to the activities, needs to change their attitude towards those cost activities.

Overall, if the company implemented it properly they understood what they doing with ABC methods and they can see the benefit of the actually using this.

Bibliography:

Cooper, R. (1988) “The Rise of Activity-Based Costing – Part One: What is an Activity-Based Cost System?” Journal of Cost Management (Summer), pp. 45-54.

Cooper, R. (1988) “The Rise of Activity-Based Costing – Part Two: When Do I Need an Activity-Based Cost System?” Journal of Cost Management (Fall), pp. 41-58

Gunasekaran, A. and Singh, D. (1999) “Design of activity-based costing in a small company: a case study” Computers & Industrial Engineering 37, pp. 413–416

Kaplan, R. S. (1988). “One Cost System Isn’t Enough,” Harvard Business Review, January-February, pp. 61-66.

Kelline S. C., Downet, R. G. and Smitt L.G. (2001) “Activity-based costing and higher education: Can it work?” Available at: http://www.iupindia.org/books/ABC%20of%20Activity-Based%20Costing_Cont.asp. [Accessed on May 15, 2011]

Williamson, D. (1996) “Cost and Management Accounting” Prentice Hall. Available at: http://business.fortunecity.com/discount/29/abcworkex.htm [Accessed on May 15, 2011]

Oulu University Library (2000) “Implementation of design to profit in a complex and dynamic business context:Chapter 2. Life cycle analysis and product costing”. Available at: http://herkules.oulu.fi/isbn9514264509/html/x1194.html [Accessed on May 16, 2011]

MBAbullshit.com (2010) “Activity Based Costing Example Part 1 to 8” You Tube. Available at: http://herkules.oulu.fi/isbn9514264509/html/x1194.html [Accessed on May 17, 2011]

References:

Cooper, R. and Kaplan, R. S. (1988) “Measure Costs Right: Make the Right Decisions” Harvard Business Review, September/October, pp. 96-102.

Turney, P. B. B. (1989). “Activity-Based Costing: A Tool for Manufacturing Excellence” Target, summer, pp. 13-19.

Cooper, R. and Kaplan, R. S. (1992). “Activity-Based Systems: Measuring the Costs of Resource Usage ” Accounting Horizons, September, pp. 1-13.

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