Theoperation of a business involves several activities in an on theorganization. The success of the activities of a business contributesto the overall operational success of an organization. At the sametime, the overall cost of an organization is based on the costs thataccrue with the individual activities. Therefore, every businessorganization runs its operations by incurring costs of theseactivities. This drove the development of a system that allocates theorganizational costs to each of the activities as they are incurred.To explore this system, this paper will discuss Activity-BasedCosting (ABC) and examine how it is used to improve the profitabilityof an organization. Moreover, this paper will compare the ABC methodwith the traditional costing methods.
Activity-BasedCosting (ABC) is a method of costing that allocates costs tospecified business activities in an organization. The costing methodidentifies the activities that drive the costs of an organization andassigns the overheads and direct costs for each of them. According toLangfield (2009), the ABC system approaches the costing process bymonitoring the activities of an organization to reveal theconsumption and outputs for every activity. Through the monitoring,the resources of the organization are assigned to the activities asthe cost objects based on their consumption. Through the ABC model, acompany can evaluate all the products and activities in the wholeorganization in terms of costs and determine their contribution tothe profitability of the firm.
ABCConcepts and Implementation
Inthe ABC system, there are a number of concepts and terms that requireto be understood by the organization in order to successfully utilizethe system. To understand the ABC model, it is important todistinguish between the costs and outputs so as to implement thecosting method in every activity. These concepts include the shortterm costs, long term costs, direct costs, indirect costs, fixedcosts, variable costs and cost drivers.
TheABC model identifies both the short term and long term costs andallocates them to an activity. The short term costs are the costs inan organization that accrue for a short period of time, mostly forone year. The short term costs do not exceed more than one accountingyear and may recur as the business activity recurs (Bradtke,2007).For instance, electricity costs for the production of goods andservices are short term costs. On the other hand, long term costs arecosts whose expenses accrue for over one accounting period. Thesecosts relate to the activities and processes that persist for morethan one year.
TheABC also identifies both the variable and fixed costs. Variable costsin an organization are the costs that change with the change in thequantity produced. According to Bradtke,2007),the variable costs increase as the quantity of the output isincreased in the production process. Similarly, the variable costs,reduce when the outputs of an organization reduce. On the other hand,fixed costs are the costs that do not change with output. Onceincurred by an organization, the fixed costs do not vary withactivities or output. According to the ABC model, both the fixed andthe variable costs are identified for every activity and allocatedaccording to the production.
TheABC system also incorporates the direct and indirect costs into theallocation of costs to activities. Direct costs are the expenses thatare identified on the production of a product, or a service.According to Kaplanand Anderson (2013),these costs refer to labor, raw materials and the expenses thatdirectly relate to the primary production process. On the other hand,the indirect costs or the overheads are the expenses incurred tofacilitate the storage, distribution and sale of the product. Forinstance, the sales and distribution costs of the product or aservice are the overheads incurred to a product. According to the ABCmodel, these costs are part of the allocated costs of the activitiesas they contribute to the cost driver.
Tobetter implement the ABC model in an organization, the definition ofa cost driver is important. A cost driver is an activity or a unit ofactivities that result in costs in an organization (Kaplan& Anderson, 2013).For the variable costs that are short term in nature, the costdrivers may be the machine hours, number of raw materials or thedirect labor hours. However, for long term costs, the cost driversare not based on the volume of output, but on the transaction that ismade by the departments that supports the incurred costs. For theimplementation of the ABC model, the costs are allocated to thedepartments as the cost drivers.
ABCApplication to Improve Profitability
ABCmethod improves the profitability of in an organization by providinga mechanism for determining the product cost and the overhead costs.Through the model, an organization is able to determine the revenuethat should be generated in order to cover for the costs. This isbecause the ABC model provides the information that is necessary forprice determination for maximum profits. According to Kaplanand Anderson (2013),the determination of profit requires complete knowledge of the coststhat every product attracts in order to apply the appropriate marginpolicies. This is facilitated by the ABC model by determiningspecific costs that accrue to specific activities and products.Through the cost drivers, the business is able to analyze theexpected costs and so adopt appropriate pricing mechanisms.
TheABC method improves the profitability of an organization by helpingthe organization to minimize costs. The method allows the managementfor an organization to identify the areas that can be changed orredesigned for reduced costs (Horngren et al, 2006). It is possiblebecause the ABC model focuses on the cost drivers and the activitiesinvolved in each cost unit. According to Langfield (2009), thereduction of costs in an organization involves identification of suchcosts and application of the appropriate policies to reduce theirlevel. Therefore, the management will apply the ABC model to identifythe specific cost drivers. Moreover, the ABC model provides theelements of cost in each activity that is fundamental to theproduction process. This way, the management can evaluate each costdriver to identify the drivers that can be eliminated withoutaffecting the overall output of a firm.
TheABC method also improves profitability by identifying the unnecessarycosts that can be eliminated. This is because the ABC model helps anorganization to identify the most cost intensive products oractivities (Kaplan& Anderson, 2013).By identifying these products, an organization can determine which isthe most feasible products or activities are significant for the firmin terms of profitability. According to Kaplanand Anderson (2013),the higher the cost outlay for a product, the more challenging it isfor the firm to price the product due to the opportunity cost ofcapital. This is because the costs incurred for a product or anactivity ties the capital from being spent on other products. Throughthe ABC model, aim identifies such products and balances theirproduction in relation to other products.
Thebudgeting is an important element of a firm’s profitability. Thebudget allows the management to determine the total costs that willbe expected by the company and the revenues that are to be generated.Through the use of ABC method, the management is able to allocateeach cost to its specific cost drivers (Langfield, 2009). Therefore,the organization can determine the budget based on specific productsand activities. As a result, the company can be able plan forexpected profits by understanding the cost outlays for every elementof the organization. This is made possible because the ABC methodprovides an accurate calculation of the costs of a firm that arespecific to the cost drivers (Kaplan& Anderson, 2013).
Theuse of ABC is significant in the organizational process ofdetermining the most profitable projects to undertake. The ABC modelprovides the costs of a project that is specific to the cost driverson the investment. In addition to the information, the ABC modelprovides accurate costs per project and determines the expected costoutlay. By comparing with the expected revenue inflows from theproject, a company is able to invest in the most profitableinvestment (Horngren et al, 2006). In a similar way, the ABC model isused to evaluate new products that a firm is contemplating toproduce. However, the ABC method is used alongside other investmentanalysis methods such as the NPV and the IRR to identify the mostoptimum investment or profitable product.
TheABC model improves the profitability of a firm by facilitatingefficient and supporting efficiently run departments. Through ABCmodel, the company is able to identify the departments that are notcost-effective in terms of their operations and output. As a result,the company avoids the production of inefficient products orreorganizes the inefficient departments. According to Goektuerk(2007), theefficiency of internal business operation is a key factor towardsincreasing profitability. This is because it reduces wastage anddedicates the resources of the organization to the most efficientdepartments. Therefore, the ABC method helps the organization toidentify the efficient departments and focus the resources of thecompany to them.
Comparisonwith traditional costing methods
Thetraditional costing methods are based on the allocation of overheadcosts to the products manufactured using an overhead rate. The methodallocates the costs of a firm to the units produced by theorganization. Compared with the traditional methods, the ABC iseffective in the costing process for all the types of organizations(Bradtke,2007).First, the ABC method allocates the costs based on the specific costdrivers instead of the allocating them to the units produced(Horngren et al, 2006). The limitation with the traditional costingmethod is that it allocates the costs based on the direct elements ofcost such as the number of hours, output units or the raw materials.
Inaddition, the ABC method solves the limitation of the traditionalmethod to rely on average overhead rates. This means that thetraditional method may not produce accurate information on the costof the organization. However, the ABC method provides a more accurateway of allocating the costs of an activity or a product by collectingthe costs in a cost pool. From this pool, ABC allocates the costs tospecific cost drivers that carry specific costs from the cost pool(Langfield, 2009). This means that the organization will be moreeffective using the ABC method than the traditional costing. This isbecause the organization will rely on more accurate informationregarding the costs of the products.
However,the ABC method is regarded to be complicated compared to thetraditional method costing. This is because it involved longercalculations compared to the traditional method that just uses anoverhead absorption rate. The calculations of the ABC method are doneby determining the costs per a cost pool and mathematicallyallocating the cost to cost drivers (Goektuerk,2007).As a result, the ABC method is more time consuming compared to thetraditional method. Because the traditional method is easier tocalculate, the time taken is less and shorter than the ABC. While thetraditional costing method is easier, the benefits that arise fromthe ABC make the latter the most preferred method. Apart from thebenefits that come along with the ABC, the method is credited forintroducing accuracy in determination and cost allocation.
TheABC method assigns costs to specific activities in a firm byidentifying them as they drive the costs incurred. Through the use ofthe ABC method, an organization is able to assign direct costs intodirect costs per the cost driver. Unlike the traditional method ofcosting, the ABC method allows an organization to allocate theoverheads of a firm to specific cost drivers by assigning costs toactivities. Therefore, the ABC improves the profitability of anorganization by helping the management to set prices for productsthrough the accuracy of the costs of each product. In addition, theABC method facilitates cost minimization and efficiency in anorganization which reflects into policies for improvingprofitability. Therefore, ABC method is a better and a more superiorcosting method for organizations.
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Horngren,C., et al, (2006). CostAccounting: A Managerial Emphasis, 12th edition,New York: Pearson Education
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Kaplan,R., Anderson, S. R. (2013). Time-DrivenActivity-Based Costing: A Simpler and More Powerful Path to HigherProfits.Cambridge, MA: Harvard Business Press
Langfield,S. K. (2009). Managementaccounting: information for creating and managing value.Sydney: McGraw Hill Australia Pty Limited