Cost systems are methods of accounting that companies use in an effort to determine the value of developing a product in relation to the revenue it generates for the company. Without the cost system, it would be difficult for a company to ascertain whether it is making profits or losses. The most commonly employed techniques of costing are the traditional and activity based. This study may mostly benefit investors, government agencies, manufacturing and industrial companies.
The traditional costing system takes into account the production overheads of the cost driver, for example, the total number of hours needed to come up with a product. The cost driver denotes the element that brings about expenses like equipments, workers and time. Activity-based costing, on the other hand, relates to the activities that must happen in order for a given company to produce an item. Businesses must comprehend the merits and demerits of both systems in regard to their requirements to avoid regression due to costing structures that are unreliable.
Effects of using the ABC system
Majority of companies in business today have come to the realization that use of activity-based costing method is more effective that the traditional one. In the United States, companies that specialize in the manufacturing sector especially mostly use the activity-based design. The system started in the 70s. However, organizations in other sectors prefer the use of the cost analysis approach because it provides a formative foundation for analyzing expenditures.
According to Sullivan et al (9), the approach of ABC helps to solve the problems that are evident in traditional cost analyses systems. In their analyses, the authors advance the idea that the traditional dimension lacks the capacity to provide specific costs of production and other expenses incurred during processing like service-based costs. This point postulates that managers cannot rely on the traditional costing approach because of its inaccuracies. The directors may give biased directions on various commodities. The ABC process is able to help companies to divide activities into components like updating the database, handling complaints, negotiating with suppliers and transferring the costs to them no matter how trivial.
The ABC design may be reliable to use due to its simplicity. It does not utilize arbitrary figures to stipulate costs. It evaluates causal relationships of variables to determine the cost without the likelihood of biases. Once the business managers identify activities of the production, they link the costs of each activity to the product in direct proportions. The method may examine instances of high costs in every unit. It may explore mechanisms of offsetting expenses by liquidating the commodities at high prices to recover expenditures. Examples of companies in the globe that make use of activity-based accounting include:
The Chrysler Group LLC of the USA
The Chrysler Group LLC which is an American automobile firm is one of the biggest users of the ABC model. Financial analysts report that the group saves millions of dollars by adopting this process which it continues to use to date. One of the results that the use of this accounting system has on the business is that it starts outsourcing for the manufacture of different car parts after realizing that the actual costs of these parts is thirty times more than the original estimates in the budget. The company is not only able to bargain for highly discounted prices, but it also saves time that can be utilized elsewhere which is also a factor in activity-based accounting.
Activity based cost systems in the AVL INDIA PVT. LTD
The AVL Textile Company based in India produces textile suits and has more than 25 types of worsted fabrics. This company does not charge overheads on products and consequently, the product costs cannot easily be determined.
According to the philosophy of the ABC method, a product is not usually accountable for the formation of costs, but certain actions can be. Therefore, business managers need to specify a list of actions that may create the appropriate processes. Under the traditional method of accounting for costs, direct materials may include wool, polyester, dyes and chemicals. Direct labor becomes the actual expense. Total overhead production of the AVL Textile Company per quarter can be 36, 896,077 Indian Rupees. The total meter produced can be used as an allocation base as it links all processing overheads to products. The rate per meter refers to the total production overhead costs per total meters. Finally, players in the textile sector charge this rate per meter based on cost of objects like products. Under the ABC theory, five products comprise of A, B, C and E. The evaluation of key activities verifies the view that the product cost comprises of 80% of the direct cost. Key activities may be classified as dyes, spinning, weaving, mending and finishing. Business managers recognize the major overheads as stores and spares, electricity gas, repairs, insurance, depreciation and others. They also identify the cost drivers. The accountants compute the cost or meter of each manufacturing department using given formulas, and they allocate costs of products accordingly.
The accountants of the textile company may compute and evaluate the cost of the products which involve materials and manufacturing overheads. Costs under the traditional system may be significantly lower than those under the ABC system (Schmidt, 19). This approach may be used to design better products in the company by creating goods that meet customers’ expectations and result in profits. It also sends signals on the expected product improvements and the needed service efficiency (Hume, 11). A scientific determination of costs may lead to improved pricing and thus better profits for the organization. It may also be used to identify projects in the supply chain that are not efficient and, therefore, the approach can develop or discard them.
Activity based costing (ABC) for the General Healthcare Group in the UK
The ABC system’s use in UK’s hospitals usually classifies costs into four categories. The design assigns cost drivers to the four categories. Major unit level costs involve diagnoses or therapeutic actions determined through production and economic dimensions. Film used in radiology may act as an example.
Accountants relate batch level costs for the General Healthcare Group to a group of activities. Components like patient billing and recording can be associated with patients in the form of a batch level expense based on items like the numbers of diagnoses made. The officials connect product rates of expenditures to a service channel despite the amounts of batches. These factors may include diagnostic equipment and facilities and program marketing (Ball, 17). The equipments may be assigned using a formula related to the number of patients’ days and meetings.
Production sustaining costs that cannot be linked to a particular product may include marketing, administration and personnel. The basis of ABC systems can be linked to information. Many healthcare providers implement cost systems that capture the basic ABC concepts. At the unit level, discrete activities like transport and appointments in hospitals may be unavailable in other systems.
Service unit outputs for the General Healthcare Group can be derived from the billing or pattern of items. These activity drivers may be feasible. Nursing is an essential paradigm to the society but the UK government does not invest a substantial amount of its monetary resources to healthcare. However, as automated patient care documentation becomes more available, tracking of patient activities performed by the nurses continues to be necessary and, therefore, highly reliable data may be realized. Batch and product level costs may be captured and integrated in decision support systems.
Overhead allocation takes place at the production sustaining level (Landsburg, 37). Certain units assume the nature of service organs with activity objectives based on medical reports and controls. Researchers in this area need to gather new statistics to improve cost scales.
In healthcare, departmental productivity may be accurately determined. Activity costing matches productivity, therefore, making the ABC system appropriate. Hospitals align the healthcare process to assess the net worth of the individual care factors. The application of the cost driver concept to the clinical decision making process enables new data to be generated (Sullivan et al, 34). The services offered by the General Healthcare Group are evidence based, and the data may become invaluable to the caregivers. This factor may in turn bring about adverse reactions that may involve additional costs. Merging the costs of services of a similar category may help in the identification of the worth of the first cost driver.
The administration of the group assigns physicians of the General Healthcare Group in the UK with the unit costs of general tests and drugs. If the physician knows the true downstream cost, the fact may prove to be essential especially in cases where the weighting of the cost may lead to adverse effects. Hospitals may use the ABC system to model activity changes and obtain valuable insight regarding their effects (Wenz, 25). The approach is also necessary in the supply chain management as doctors use to identify unnecessary procedures and eliminate them.
It is important to note that while the ABC system is applicable in accounting; it should not replace the existing overall accounting system of the company. The company must also be able to calculate the relationship between cost and time. This aspect refers to a time-driven activity-based costing. The essential elements to consider when integrating TDABC to ABC involve expenditures per time unit required to provide money to every organizational unit and the timeframe each company activity requires for transactions, commodities and clients. A company is able to determine whether the time spent and the cost incurred is worth the investment, and whether it is easier to outsource for ready-made products at a given instance in the course of the process of production (Yunker, 23).
Companies that specialize in customized products have to be careful when using the ABC system especially if they base their prices on historical costing. Any given company can make huge losses due to the use of the ABC system as the cost difference may not be reflected even in the traditional costing system. All in all, with the correct application and interpretation of data, the activity-based costing system, comes with its own set of advantages.
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Hume, John. The London Assurance Company and the Marine Insurance Market of the Eighteenth Century, Manchester, UK: Manchester University Press, 2011. Print.
Landsburg, Steven. Fair Play: What Your Child Can Teach You About Economics, Values and the Meaning of Life, New York, USA: Free Press, 2010.Print.
Schmidt, Robert. International business and trade, New York, USA: New York Press, 2008. Print.
Sullivan et al. Economics: Principles in Action, New Jersey, USA: Pearson Prentice Hall, 2011.Print.
Wenz, Peter. Take Back the Center: Progressive Taxation for a New Progressive Agenda, Massachusetts, USA: Massachusetts Institute of Technology, 2012.Print.
Yunker, James. Economic Justice: The Market Socialist Vision, Maryland, United States of America: Rowman & Littlefield, 2010.Print.