A Method for Increasing Cost Estimates - Essay Example

Is Activity Based Costing Fruitful For The Company? A method for increasing cost estimates in which the arrangement or project is diversified into distinct, quantifiable activities is known as Activity Based Costing (ABC). It is a method of apportioning expenses to services and products. It is normally utilized as a means of control and planning. The activities must be well defined so that productivity may be quantified in units. For ABC to be successful, for a company, a systematic analysis, of all the major costs sustained by a major unit of industry is needed. The costs here include in it not only the variable and fixed industry burden costs but also certain variable and fixed administrative and marketing costs. Implementing ABC requires a widespread and intricate process which is not only costly but also time consuming. Thus managers would always try to fid out the advantages of the method before implementing it. There can be discussed, two different dimensions, to analyze the probable benefits of the ABC method. The first is dependant on the probability that ABC will be producing costs and various other outcomes which will considerably differ from the ones produced by the traditional or conventional methods. It is also a possibility that the ABC method may not be a better or more precise method but it is for sure that it will vary in amount. The factors which are concerned with this element are, number or the variety of products produced, the variety and degree of difference of support services used for the varied products, the usefulness of present cost allotment methods, the level to which joint or common processes are used and the growth rate of period costs. The second dimension establishes that though the cost information produced by ABC may be different, yet it will be used by the management for important conclusions. ABC information should be regarded as superior, and the competitive, social and legal environments should allow the managers to be free to use the information. The factors concerned with this dimension are, the freedom of the management to setting prices, the proportion between period costs and total costs, tactical considerations, the culture and climate of cost diminution in the company, and the frequency of study that is sought-after or essential. The ABC methodology is put to use when a project can be differentiated into specific activities. The activities lie at the lowest functional level of a project from which the costs are estimated and the evaluation of performance is done. This methodology is mainly based on the company’s own analysis. In order to track down the possibility of success of the implementation of ABC, the combining and weighting the weights of the above mentioned factors is required. ABC is a means to solve the difficulties of the conventional costing systems. The traditional cost management systems are quite often not able to find out exactly the definite cost of production and the cost of related services. Thus the managers would conclude and make pronouncements based on the imprecise information particularly when there are diverse products. The ABC method seeks to categorize cause and affect relationships to dispassionately allocate costs, rather than, using wide subjective percentages to assign costs. As soon as the cost of the activities is known, the cost of each one of the activities is accredited to each one of the products to the degree that the product makes use of it. Thus the ABC acquaints with the areas of elevated operating cost per unit and directs reflection to finding ways to lessen the costs or to demand more for expensive products. The methodology is not intended to create a ratio- scale figure signifying the virtual benefits of ABC but to construct a methodical study which will help the company managers to talk about the familiar factors that support or discard the implementation of ABC. There are two key questions in the light of which, the management can study the company’s nature. The first being that is it likely for any given organization that ABC will produce significantly different costs from those produced with traditional accounting and is it possible that those costs would be better? The second key question is that will the ABC system’s information which is considered superior; alter the dependant decisions made by the management? There are ten interlinked factors which can guide the management in finding the answers. The initial five factors portray the prospective advantages of ABC as against conventional costing methods and the subsequent five pertain to management requirements and potentials to respond to product costing diversifications. They may be enumerated as under: Product Diversity – This refers to the series or quantity of various products or the different products that the families presented. It should be kept in mind that the trivial variations cannot be categorized as product diversity. The various contemplations in assessing the degree and extent of product diversity are-classifications of the accounting products, served markets, stockrooms, sales, and advertising. For classification of accounting products it is required to know whether the common ledger incorporates various product classifications and whether there is internal information of the attempt to divide margins, sales or earnings by products. To study the market served, it has to be studied whether the market is divided into industrial or territorial groups which buy different kinds of products, is there a chronological or similar organization of the manufacturing departments and whether chronological organization suggests restricted product separation. For stockrooms it is to be studied whether there are diverse stockrooms managing the same catalog classification for diverse products. For sales its obligatory to know if the company sells both manufactured and OEM products. For advertising it is necessary to study whether the company advertises simply its name and a product or it advertises several of its products. Support Diversity- This refers to the variations or range of overhead support that is given to the products. The organization may be the only a cost centre or a manufacturing facility but if it consists of more than one essential product or group of products then variety in product bearing necessities almost certainly exists. An outward glance at the business may point toward little variety, but a deep inspection may expose that genuine activities differ very much from product. To conclude and assess the extent of support diversity, companies need to assess the following questions for them. The questions are: do departmental names contain the name of the products or are they driven by definite products, are the various manufacturing units located within the same costing system, are the products which are manufactured relatively intricate, are there various distribution channels for the various products or do they have different advertising necessities or do they try for different markets, is development and study uniform or oriented towards products, does various material handling process is required for the various products, and does there exist various stockrooms. Common Process- this refers to the extent of similarity of processes with various product offerings. All the activities which are identifiable include processes, encompassing, engineering, manufacturing, marketing, accounting, distribution, quality control, development and research, material handling, and administration. Where there is a higher extent of similarity of processes with products, the period cost that is required by each one of the products cannot be separated by using the traditional accounting system. At this point, the ABC proves to be more effective. The companies should answer some questions previous to conveying a common process price. The questions may be put forth as: if the company testifies profitability by product, are there many expenses which are caught up directly, is there a requirement of varied production processes for varied products, are the material treatment processes clear, has the product organised any shop supprt unit or engeneering unit, is there only one or more distribution channels used, is there any organisation of quality control by the productsand whether the product has organised administration. Period Cost allotment- the prevailing system of costing when allocates or allots period costs in the proper manner, this is known as period cost allotment. The period cost allotment method is a method of analyzing the methodology of allocation to determine whether it is capable of imitating the outcomes of ABC. A major part of or focus of the ABC analysis method is on relating products and period costs. ABC also recommends that many no manufacturing costs, like marketing costs, are also a role of product activity and should be burdened onto the products accountable for their existence. The questions that the company needs to answer are: Is the common ledger which is setup to gather support costs by product by the making use of the product definite department, indirect work classifications, etc, to what degree are indirect costs not recognized by products, how many allocations are used, are they reliable for the most important cost drivers etc. Growth Rate of Period Cost- growth rate of period cost indicates to the growth in period cost found essential by the costing system. ABC has strength to gain changes in the support necessities of products in the course of the express measurements of activity levels. Pricing Freedom- this points to the company’s extent of freedom and power to place prices and thus create product productivity. If a company has more freedom then its product cost is less. Pricing will be done on market flexibility and profits will be maximized. In dominating situations the demand is not elastic and the prices set will be higher. In conditions where there is pure rivalry, many contestants, and good alternate products existing in the market the market forces will determine the prices. Ratio of Period Expense- Preiod Expense Ratio refers to the potential materiality of distortions of product costs directly. The distortions sometimes are so negligible that the management would not take any action for their corrections. Here the distortions become immaterial. Strategic Considerations- these speak of the restraints forced upon the management’s verdict by its implied or overt policies, alternatively, the extent to which policies supersede costs in the process of result orientation. Cost Reductions- This includes the corporate customs, since it influences the association between in-house cost related assessment, and the total cost of the product of indirect units. It includes the nature of in-house cost related assessments and the extent to which assessments depend upon precise allocations of period costs. Analysis Frequency- The frequency, either usual or unique, of product cost studies is known as analysis frequency and includes both the desired and current frequencies. An incongruity between the desired and existing frequencies of study specifies dissatisfactions with the costing system that exists. Points Favoring the Methodology: There may be present certain advantages of the ABC methodology which might make it a fruitful means of accounting in a company. These advantages may be enumerated as under; It understands the way in which the traditional costing system distorted customer and product costs by making use of drivers of unit level. It explains as to why companies which produce a variety and combinations of products have more costs than companies manufacturing only a limited variety of products. It devises a cost system based on activity by connecting resource costs with the activities that the company executes and thereafter with the activities of the cost objects. It determines the suitable activity cost drivers while establishing activity costs to customers and products. It uses the activity based cost system information to develop operations and to create enhanced results about customers and products. It assigns distribution, marketing and selling costs to the customers. It analyzes and manages customer profitability. It also appreciates the responsibility of activity based cost methods for organizations. PointsAgainst the Methodology: The ABC methodology does not include the total principal costs while calculating overhead costs. Thus it doesnot focus on the data incorporated in a company’s statement of income and completely dis regars the balance sheets. Although there is the attracive part of better performance of the ABC system, yet it has these disadvantages to its credit which give this system a negative impression as compared to the traditional costing system. Analysis: Some of the overhead costs are difficult to allot to customers and products, even in the activity based costing system. These undesignated costs are known as business sustaining and cannot be allocated to customers and products because of the absence of a meaningful methodology. This amount of undesignated overhead costs must be brought into existence by assistance from each product but not as big as the overhead cost that the ABC has contributed. Concluding, it can be said that after attending various ABC discussions and reading lots about the ABC methodology, and even after being approached by ABC experts, there may be many managers who might ponder over the thought of implementing the ABC technique and think deeply whether this technique will prove to be useful in improving the competitiveness of their respective companies. These managers or the managerial team require some kind of evaluation method to know whether the probable asserted benefits of the ABC methodology would prevail over the convinced and significant costs of its accomplishment. The emergency analysis model should help the managers to match the characteristics of the company, the products of the company, and the system of costing along with the use of various other factors to make the Methodology of ABC more effective. References http://en.wikipedia.org/wiki/Activity-based_costing http://en.wikipedia.org/wiki/Talk:Activity-based_costing http://myphlip.pearsoncmg.com/cw/mpchapter.cfm?vbcid=7826wledgebase/Finance/ABC.htm http://www.themanager.org/Knowledgebase/Finance/ABC.htm Read More