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Using of Activity Based Cost (ABC) in Small and Medium Companies

Submitted Assignment 2015 7 Pages

Business economics - Accounting and Taxes

Excerpt

Activity Based Cost Technique

Introduction

The aim of this paper is to give critical analysis and applicability of Activity Based Costing (ABC) methodology. The paper is divided into three main parts. The first part identifies key techniques and approach in ABC costing. The second part assesses the relevance of ABC, based on current debates and study done. The third and final section assesses the applicability of ABC costing to small and medium sized enterprises.

Key components of ABC costing approach

Costing as part of the accounting system plays a vital role in every organisation and the information that it generates could have critical influence on management decision making (i.e. product and service pricing, outsourcing, production cost, investment etc). With a good cost accounting system, companies could ensure efficiency and/or maximise the wealth of their shareholders effectively (CIMA, 2008).

Traditional Costing Method

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ABC was first defined in the late 1980s by Kaplan and Bruns. It can be considered as the modern alternative to absorption costing, allowing managers to better understand product and customer net profitability (CGMA, 2013). This provides the business with better information to make value-based and therefore, more effective decisions.

According to Chartered Institute of Management Accountants (CIMA) official terminology, ABC costing is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs (CIMA, 2011).

The most obvious advantage of an ABC system is that it provides much more accurate product costs. This is important for pricing decisions as well as for financial statement purposes.

ABC Costing Method

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Resources are assigned to activities, and activities are assigned to cost objects based on consumption estimates. ABC is, therefore, an alternative approach to the traditional method or arbitrary allocation of overheads to products, services and customers.

Changes in the business environment, triggered by global competition and technological innovation, have led to innovations in the use of financial and non-financial information in organisations. The new environment demands relevant information and data about costs and performance within the organisation’s activities, processes, products, services and customers (Carlos and Pete, 2011).

ABC provides more sophisticated and accurate measures for overhead cost allocation to assist managers in making correct decisions. Comparing the traditional costing method to ABC, one sees a reversal of the thought process. With ABC, cost objects are broadened to include not only products and services, but also other objects like customers, markets, etc. These cost objects are seen as consuming activities.

The activity driver is the event that causes consumption of an activity. For instance, each customer may receive a catalogue, whether he orders or not during a period. Preparation and distribution of the catalogue is the activity that is being driven by the number of customers. Activities necessarily consume resources. Thus, preparation of a catalogue will require labour, printing, office space, etc. Thus, activities drive the need for resources and are said to be resource drivers (Walther, 2015).

The activity based costing process

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Activity based costing is a more refined approach to costing products and services than the traditional costing method. It involves the following steps (CGMA, 2015):

-Step 1:Identification of activities involved in the production process. The first step is a detailed study of all business processes and costs. This extensive study will usually involve employees from throughout the organisation.
-Step 2:Classification of each activity according to the cost hierarchy (i.e. product level and facility level). Once a business is understood, the second step is to select the business activities that will be central to the cost allocations.
-Step 3:Identification and accumulation of total costs of each activity. All costs must be assigned to activity pools.
-Step 4:Calculation of total units of the cost driver relevant to each activity. Once costs for each activity have been determined, it is then necessary to unitise the cost pool.
-Step 5:Application of the cost of each activity to products based on its activity usage by the product. The final step is to utilise the activity based rates in determining the amount of activity cost to allocate to each cost object.

Assessing the relevance of ABC

The purpose of ABC was to address key limitations of traditional costing methods, on the ground that TCM was designed for companies that manufactured a narrow range of products and direct labour and materials were the dominant factory costs. Overhead cost was relatively small, so distortions from inappropriate overhead allocation were not significant (Drury, 2008).

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Details

Pages
7
Year
2015
ISBN (eBook)
9783346076595
Language
English
Catalog Number
v506358
Institution / College
University of Wolverhampton
Grade
60
Tags
using activity based cost small medium companies

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Title: Using of Activity Based Cost (ABC) in Small and Medium Companies