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Do You Know Your Abc’s
The key to success in any business is being able to minimize costs and maximize profits. The best way to minimize cost is to identify exactly were cost come from. By understanding how costs are actually allocated in the business process it is possible to identify the most profitable segments of the business as well as the most profitable customers. The Activity based Costing method is the technique that will most accurately define costs.
Activity based costing deals with the correct apportionment of overhead costs. The ABC method is becoming increasingly more important in business today. A few reasons for the importance of ABC are that overhead costs are constantly increasing, it is common for firms to have diversity in product production and product customization is on the rise causing production specialization.
The ABC method is superior to its rival volume based costing which assigns overhead cost on only one factor such as machine hours. Consider two job orders that use identical machine hours. One order requires additional activities such as machine rearrangement and extra testing and the one can be processed with no changes. It would be in accurate to apply overhead cost equally on one factor such as machine hours when one of the orders requires costly additional activities. Total cost in the end would be the same whether using the volume method or the activity based method but the ABC method allows for cost to be more accurately displayed thus allowing for proper pricing and planning.
“Activity-based costing is a costing approach that assigns resource cost to a cost object based on activities performed for the cost object. (1)” First off an activity is action that is made in order to complete work and a resource is an economic factor that is used to complete activities. “Cost of resources are assigned to activities based on … resource consumption cost drivers, and costs of activities are assigned to cost objects based on … activity consumption cost drivers. (1)” First a firm must determine its resource consumption cost drivers which are activity categories that consume resources; an example of such is running machines. Once the resource consumption cost drivers are determined they can be broken down into activity consumption cost drivers, an example of such is machine hours. Once these cost objects are determined rates for the activities can be calculated and overhead per unit of activity can be measured.
Implementing the Activity Based Costing method in a business offers many advantages. ABC offers more precise product cost which allows for more accurate product profitability measures. By having a better understanding of the amount of profit a product offers firms can more competitively price goods. Firms can make better decisions on the value of the production lines, and more costly production practices can be minimized. ABC highlights areas were process improvements are needed. By having improved product cost the cost estimations are closer to actual which allows for enhanced budgeting and planning.
Although there are many advantages to using Activity based costing some limitations exist. In some cases cost allocation must be done on a volume base because it is impractical or impossible to trace by activity. Examples are the cost of the computer system that manages factory operations or the factory manager’s salary. A second downfall that can arise with ABC is the significant amount of time and money it usually takes to introduce new systems into a business. Most of the time the initial expenses incurred by the addition of an ABC system is justified in the long term by the value added to the firm from the information that ABC provides.
Once the decision has been made to implement activity based costing it is important to have close cooperation between manager’s, engineers and accountants to achieve success. It is a good idea to involve as many employees as possible to allow them to become familiar with the new system. Retain the old system as a parallel system for the time being. Should any problems arise it is important that the firm is not left without a foot to stand on. Begin with a simple design and progressively add more steps in as employees adapt to the system. Educate employees thoroughly, when people are introduced to concepts early there is less chance they will be overwhelmed in the future. Offer incentives for quickly learning the system, nothing motivates people like rewards. By following some of these guidelines it will create a smoother transitional period and reduce the overall cost of introducing the new system.
References
1) Blocher, Stout, Cokins, Chen. Cost Management: A strategic Emphasis. New York, NY: Mcgraw-Hill/Irwi, 2008
About the Author
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