Wednesday, June 29, 2011

Activity-based costing

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The method of Activity-Based Costing (ABC) was developed primarily for solving problems which emerged from traditional cost management systems. Troubleshooting in the management of companies throughout the late 70’s and especially the early 80’s held a constant presence.

The problems generated were mainly from the traditional cost accounting systems’ way of functioning which provided the management with inaccurate data. Where the old cost accounting systems failed badly was in supplying the company’s management with inappropriate information in order for crucial decisions to be taken in the correct and true perspective of a given company’s true position in its market territory. Since this currently accessible “itemized” information could not be provided to a company’s decision making sector, the information provided had an impact which of course distorted the decision which would have otherwise been taken in the light of different and more accurate information.

This misinformation had an adverse impact on a multitude of managerial decisions especially in the multi-product firm sector in respect of long-term, mid-term and short-term consequences such as investments in technology, quantity and specification of product production. The accuracy of data on which management decisions are based in order to maximize efficiency and establish one’s company identity in a competing market through, besides quality, a selection of sound marketable prices applied in the proper time scale to all of a company’s product range, is of paramount importance.

In other words activity based costing pin-points problems by focusing on the activities associated with operating the business. The traditional cost systems haven’t the capability to afford this insight, and so do not touch the subject, only in the case of reports that isolate salaries, benefits, and so on.

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If a manager were told that the cutting of cost was first on the list of priorities, he or she would cut headcount, understandably believing that it might possibly be the only largest cost contributor in the entire company. But today people are not the major cost contributors, it is, in fact, the cost of the activities that people are engaged in which contribute more to the firm’s costs. How often have we heard the lament, the workload is the same although we have cot down staff by ten percent? Activity based costing allows managers to attribute costs to activities and products much more accurately than conventional accounting methods. This method is more than an accounting tool. These tools give you a view of what you have done financially and are fundamental to shareholding disclosure and the statutory reporting. But it is just as equally important to have the ability to be able to translate this cost information into the language of operational units and the business in which it is to be applied. With activity based costing management is in a position get a strong and comprehensive, internal view of the company products or services and customers. Armed with this information, the management of a company is automatically put in a position where financial, operational, and strategic decisions can be made, such as outsourcing and pricing.

Activity based costing identifies the activities that are responsible for costs. It is sometimes calles Transaction costing and its major advantage over other methods is that it can greatly enhance the tracability of overhead costs. This can result in more accurate unit cost data for managers, if placed into the correct hands. Activity costs are passed on to products or services only if the product or service uses the activity, for example activities consume resources, and products or services consume activities and so on. As the number of activity measures increases, activity based costing is better able to capture the underlying economics of the companys operations, and the reported costs of activities, products and services come to light. In addition, activity based costing analyzes all activities that exist in a company in order to support production as well as possible and deliver goods and services as efficiently as possible.

The optimum accuracy in costing can be attained by recognising four general levels of activities within a company, each of which can be further subdivided into specific cost activity centres. These four are as follows;

Unit level activities. These arise as a result of the total volume of production going through a facility. An example could be the consumption of power as a result of the number if hours required by a machine to complete all units on a production line which could be thought of as a unit-level activity. Some companies recognise one unit-level activity centre but most companies recognise two; One related to machine activity and the second related to labour activity.

Batch- level activities. These could include things such as placement of purchace orders, shipments to customers. Costs at batch level are dependent on the number of the batches produced rather than on the number of units made, or sold. The actual cost of, say, placing an order would be the same for one item or 10,000 items, so the total cost generated by a batch-level activity would be the function of the times an order would be placed rather than on the total quantity of items ordered.

Product level activity. These are specific and are related to the support of the production of a particular product like for instance special test routines, machine maintainence inventories.

Facility-level activities. All of these activities relate to the production as a whole and therefore are usually combined into a single activity centre. These costs can include such items as insurance, property tax, athletics facilities for the workers.

Where companies are using Activity based costing as a secondary system they should not add facility-level costs to the products. This can lead to misleading data made available to managers and in turn result in wrong decision making, however, most companies do this whether Activity based costing is their primary or secondary system.

There are various approaches for designing and implementing an activity based costing system. The size of the company and desired outcome must be considered before even thinking about, let alone attempting to make the transition from a traditional cost accounting system to an activity based costing system. Larger firms should consider pilot programs before implementing the new system across the whole organization.

The most basic approach is to use activity based costing in conjunction with a companys current accounting system. In this case, software which has been developed over the years for this specific purpose can be bought to help structure the tiering down from the traditional accounting system to a detailed activity based accounting configuration. The traditional accounting system is still used and the activity based costing structure is an add-on or shadow system to be use when specific information is needed for a management based decision. An off line system can allow an organization to improve its cost information without disrupting their current information and financial systems. This is recommended for small firms or as a first step towards full activity based costing integration for a larger firm.

At the other end of the spectrum, activity based costing can be used in place of the traditional accounting system. Every cost related facet of the accounting system would be reported to the activity based costing structure. In order to institute major organizational change, all employees must fully incorporate activity based costing into their work practices and use it as their primary source of business information. Cost and performance measurement systems and all incentive systems, for obvious reasons, have to be tied to the activity based costing numbers. The advantage of using activity based costing as the sole accounting system is that it will be used consistently for daily managemental decision making and employees will not retreat to their old practices. A traditional accounting system usually cannot report costs by processes because the purpose is to help the accounting department keep the books. The purpose of activity based costing is to help operations do their job by making cost information available at a level that everyone can use for day to day decision making.

The biggest obstacle to incorporating activity based costing as a way of life is employee resistance. Unit managers may be afraid that activity based costing is just a way for senior management to discover detailed information about a department or to reveal inefficient practices that had previously been hidden by the traditional accounting system. The corporate culture must be such that new information is not used against a business unit.

Instead, all company employees should be encouraged to dig up problems and inefficiencies so that all of those practices can be changed and decisions can be made that will benefit the company as a whole. The decision to adopt the system taken, it is essential that everyone should understand and agree that a cost-conscious approach is the companys priority, and activity based costing is the tool to make that possible.

Managers of lower levels should be part of the activity based costing system implementation team as well as representatives from manufacturing, engineering and information systems since all of these people will be using the system coherently. A diversified group also helps achieve a higher level of acceptance and ownership throughout the company. Information on the progress of the new system should be available to everyone at any time. Before any implementation is put into action, it is helpful to convince key employees to give activity based costing a fair chance before they are made redundant. Once the system is in place and employees see its benefits first hand, they are likely to be excited about being involved with the new system. To obtain continued support from employees, management must show that information from the activity based costing system is actually being used to make decisions and track performance on every level. When the new system promotes changes that reduce costs and eliminate inefficiencies, employees should be made aware of how their efforts have positively contributed to the increased profitability of the company. By doing this, employees will feel like an important and inseperable part of the new operation and thus offer less resistance when it comes down to implementing the activity based costing system.

Another important step to implementing activity based costing and getting buy-in at all levels is extensive training. All employees must be educated in the principles and mechanics of activity based costing. Depending on the level of involvement, employees may be trained in the basic concepts of activity based costing, problem solving, information analysis or how to build a new activity based costing system.

Implementation of activity based costing can take anywhere from to 15 months depending on the size of the company or plant. After the new system is in place, the old accounting system should be disguarded as soon as possible if activity based costing is to be used exclusively.

The process for setting up a new activity based costing system is not simple and goes beyond the scope of this paper. A matrix must be established for each product that tracks all activities performed for the product and all of the resources the activities consume. This information is probably not readily available and must be dug up. This can be done through searching existing documentation and historical cost information, workshops, surveys and interviews with the people who do the work. Many statistical measurements must be developed to spread overhead costs to products and processes. Larger companies usually hire a professional in activity based costing to help get the system up and running correctly.

The reason activity based costing produces such significant results is that it changes the culture of the organization. If a companys priority is to make cost conscious decisions and eliminate inefficiencies and unprofitable activities, then all employees must be given the tools, the know-how and the encouragement to work towards that objective. Activity based costing provides visibility to information that was previously hidden in a traditional accounting system especially when companies adopt Just-in-time inventory systems, eliminating inventories and reducing costs.

Therefore, it is my considered opinion that if given the right data and correct incentives to make the required adjustments to corporate culture, employees will have the means and the motivation to work towards eliminating excess costs and to work towards achieving the most affordable product possible.

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