Report on the Reason of Why the Companies Should Implement ABC Rather Than Traditional Cost...

Report on the Reason of Why the Companies Should Implement ABC Rather than Traditional Cost System

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Report on the Reason of Why the Companies Should

Implement ABC Rather than Traditional Cost System


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Acknowledgement

I would like to express my deepest appreciation to all those who provided me the possibility to

complete this report. A special gratitude I give to, Ms. Tanzina Haque, Associate Professor,

University of Dhaka, whose contribution in stimulating suggestions and encouragement, helped

me to coordinate in every problem especially in writing this report.


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Executive Summary

Activity-based costing provides a more accurate method of product/service costing, leading to

more accurate pricing decisions. It increases understanding of overheads and cost drivers; and

makes costly and non-value adding activities more visible, allowing managers to reduce or

eliminate them. ABC enables effective challenge of operating costs to find better ways of

allocating and eliminating overheads. It also enables improved product and customer profitability

analysis. It supports performance management techniques such as continuous improvement and

scorecards. It is because; the company should implement ABC rather than traditional costing

system.


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Table of Contents Acknowledgement ........................................................................................................................................ 2

Executive Summary ....................................................................................................................................... 3

Introduction .................................................................................................................................................. 5

Objective ................................................................................................................................................... 6

Methodology of the Report ...................................................................................................................... 6

Activity Based Costing (ABC) ......................................................................................................................... 7

Benefits from ABC that management can obtain ......................................................................................... 8

Reason of using the Activity Based Costing rather than the Traditional Cost System ................................. 9

Steps to Implement ABC ............................................................................................................................. 10

Recommendation ........................................................................................................................................ 13

Conclusion ................................................................................................................................................... 14

References & Bibliography .......................................................................................................................... 15


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Introduction

Activity Based Costing (ABC) is a system based on activities that links organizational spending

on the resources to the products and services produced and delivered to customers. This system

is more beneficial than the traditional costing system. It is because; in the Activity Based Costing

(ABC) the company can be able to get more benefits than it can get from the traditional costing

system. On the other side, in the Activity Based Costing (ABC) the company can be able to

know about the actual part of the system and how much it is required to perform in the level of

overall activity.


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Objective

The objective of this report is to find out the reason of why the company should implement ABC

rather than the traditional costing system. The objective entirely is to describe about the whole

beneficial system of the ABC so that it may become so clear about its using perfectness than the

traditional costing system.

Methodology of the Report

For the fulfillment of the report, the whole theoretical discussion has been used and it is the most

perfect way to describe about the whole system of the Activity Based Costing (ABC). Besides,

the steps of the implementation of the Activity Based Costing (ABC) also has been shown so that

it may be become more clear for the perfect formulation and implementation of the Activity

Based Costing (ABC).


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Activity Based Costing (ABC)

Activity based cost (ABC) is a systems that trace indirect and support expense accurately to

individual products, services and customers. An activity based costing (ABC) system recognizes

the relationship between costs, activities and products, and through this relationship assigns

indirect costs to products less arbitrarily than traditional methods.

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more

logical manner than the traditional approach of simply allocating costs on the basis of machine

hours. Activity based costing first assigns costs to the activities that are the real cause of the

overhead. It then assigns the cost of those activities only to the products that are actually

demanding the activities. The activity based costing (ABC) is an approach to the costing and

monitoring of activities which involves tracing resource consumption and costing final outputs.

Resources are assigned to activities, and activities to cost objects based on consumption

estimates. The latter utilize cost drivers to attach activity costs to outputs.


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Benefits from ABC that management can obtain

1. Product cost determination under activity-based costing is more accurate and

reliable because it focuses on the cause and effect linkage of costs and activities in

the context of producing goods.

2. Fixation of selling price for multi-products under activity-based costing is fair and

correct because overheads are allocated on the basis of relevant cost drivers.

3. Control of overheads consisting of fixed and variable becomes possible by

controlling and monitoring activities. Linkage between cost and activities are clearly

identified in activity-based costing and thus provides opportunities to control

overhead costs.

4. Sufficient information can be obtained to make decisions about the profitability of

different product lines.

5. Fair allocation of overheads occupies a considerable portion in the total cost

components.


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Reason of using the Activity Based Costing rather than the Traditional

Cost System

Activity-based costing (ABC) emphasizes that activities consume companies' resources and

driver costs (rather than volume alone drives costs). As a result, the companies benefiting the

most from ABC would be companies with a significant amount of overhead pertaining to a

diversity of activities in providing goods (or services) to customers whose demands also vary. In

other words, if your company has little overhead cost and manufactures almost identical products

requiring similar attention for each product, the need for ABC probably isn't there.

The overhead that we are referring to is not limited to manufacturing overhead. Some customers

also demand activities that drive up the administrative overhead and the selling expenses. The

idea behind ABC is that the customers and products that are causing the manufacturing and

administrative overheads to occur should be assigned those costs. If there is the diversity of

products and customers (some require costly activities and some don't), it isn't fair to simply

spread all of the cost of all of the activities to all of the products and customers on the basis of

just one activity, such as machining hours. The non-machining overhead costs should not be

assigned to products and customers that don't require the other activities. The products and

customers that demand the other activities should be assigned the cost of the other activities.

Again, if your company has little variation among products and customers, and most of its

overheads are related to just one activity, such as machining hours, using machine hours to

allocate the overhead costs is probably satisfactory. However, if you manufacture products that

are not uniform in the attention and activities necessary to serve the customer, you should learn

more about activity-based costing.


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Steps to Implement ABC

Geared toward compliance with financial reporting requirements, traditional cost-accounting

systems often allocate costs based on single-volume measures such as direct-labor hours, direct-

labor costs, or machine hours. While using a single volume measure as an overall cost driver

seldom meets the cause-and-effect criterion desired in cost allocation, it provides a relatively

cheap and convenient means of complying with financial reporting requirements.

In contrast to traditional cost-accounting systems, ABC systems are not inherently constrained

by the tenets of financial reporting requirements. Rather, ABC systems have the inherent

flexibility to provide special reports to facilitate management decisions regarding the costs of

activities undertaken to design, produce, sell, and deliver a company's products or services. At

the heart of this flexibility is the fact that ABC systems focus on accumulating costs via several

key activities, whereas traditional cost allocation focuses on accumulating costs via

organizational units. By focusing on specific activities, ABC systems provide superior cost

allocation informationespecially when costs are caused by non-volume-based cost drivers.

Even so, traditional cost-accounting systems will continue to be used to satisfy conventional

financial reporting requirements. ABC systems will continue to supplement, rather than replace,

traditional cost-accounting systems.

In most cases, a company's traditional cost-accounting system adequately measures the direct

costs of products and services, such as material and labor. As a result, ABC implementation

typically focuses on indirect costs, such as manufacturing over-head and selling, general, and

administrative costs. Given this focus, the primary goal of ABC implementation is to reclassify

most, if not all, indirect costs (as specified by the traditional cost-accounting system) as direct

costs. As a result of these reclassifications, the accuracy of the costs is greatly increased.


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According to Ray H. Garrison and Eric W. Noreen, there are six basic steps required to

implement an ABC system:

Six Basic Steps Required to Implement an ABC System

1) Identify and define activities and activity pools.

2) Directly trace costs to activities (to the extent feasible).

3) Assign costs to activity cost pools.

4) Calculate activity rates.

5) Assign costs to cost objects using the activity rates and activity measures previously

determined.

6) Prepare and distribute management reports.

Step 1: Identify and define activities and activity pools

An activity is any process or procedure that consumes overhead resources. The goal is to

understand all the activities required to make the companys products. This requires interviewing

and meeting with personnel throughout the organization. Companies that use activity-based

costing, such as Hewlett Packard and IBM, may identify hundreds of activities required to make

their products. The most challenging part of this step is narrowing down the activities to those

that have the biggest impact on overhead costs.

Step 2: Directly trace costs to activities (to the extent feasible)

This step requires that overhead costs associated with each activity be assigned to the activity

(i.e., a cost pool is formed for each activity). For company, the cost pool for the purchasing

materials activity will include costs for items such as salaries of purchasing personnel, rent for

purchasing department office space, and depreciation of purchasing office equipment.


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Step 3: Assign costs to activity cost pools

A cost driver is the action that causes (or drives) the costs associated with the activity.

Identifying cost drivers requires gathering information and interviewing key personnel in various

areas of the organization, such as purchasing, production, quality control, and accounting.

Step 4: Calculate activity rates

After then, the overall activity rates are calculated by dividing the total activity. It is because; in

the overall level of assignment of cost, the activity rate must have to be found.

Step 5: Assign costs to cost objects using the activity rates and activity measures

previously determined

Cost must have to be assigned to the overall cost objects by the using of the founded activity rate

and then the activity measures must have to be found so that there may have no problems in the

internal as well as external system of the costing.

Step 6: Prepare and distribute management reports

A distributed management report must have to be prepared for the overall betterment of the ABC

costing system and it is a must for the overall system development.


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Recommendation

The overall system of the traditional costing has many lacking and which can be removed by the

using of the ABC costing system. Besides, in many parts the company can be able to get more

and more benefits than the traditional costing system. Thats why the company must have to be

more systematic in using its costing system. On the other hand, the overall system of the

company can be more performance based if the activity based costing can be used by the

company.


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Conclusion

Activity-based costing (ABC) systems don't have to be that complicated, particularly if you just

want better allocation of your overhead costs rather than a system to look at the cost drivers or

the activities that your overhead costs comprise. ABC can be pretty straightforward. This is

especially true in a small- or medium-sized firm. Thats why the company must have to be

systematic and technical in using the ABC costing system.


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References & Bibliography

Brimson, A. (1997). Activity Accounting: An Activity-Based Costing Approach. New York:

Wiley.

Cokins, G. (1998). "ABC Can Spell a Simpler, Coherent View of Costs." Computing Canada.

Cokins, G. (1998). "Why Is Traditional Accounting Failing Managers?" Hospital Material

Management Quarterly.

Daly, L. (2001). Pricing for Profitability: Activity-Based Pricing for Competitive Advantage.

New York: Wiley.

Dolan, P. (1999). "Getting Started With ABC." Supply House Times.

Garrison, H. (1999). Managerial Accounting. 9th ed. Boston: Irwin McGraw-Hill.

Hicks, T. (2002). Activity-Based Costing: Making It Work for Small and Mid-Sized Companies.

2nd ed. New York: Wiley.

Horngren, G. (1999). Introduction to Management Accounting. 11th ed. Upper Saddle River, NJ:

Prentice Hall.

Karolefski, J. (2004). "Time Is Money: How Much Are Your Customers Costing You?" Food

Logistics.

Lindahl, W. (1997). "Activity-Based Costing Implementation and Adaptation." Human Resource

Planning.

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