Cost accounting start as a manner to keep path of the true cost of service or an item by finding the indirect and indirect costs required to finish that service or give that item. Overheads cost are known as indirect production cost. They comprise all the costs of manufacturing excluding direct labor and direct material. They are obtained for the benefit of all items produced, hence, the total amount of overhead apportioned can just be an approximate. They comprise indirect labor, indirect materials and any other indirect cost that cannot be associated directly to a particular product. They are also known as factory overhead, manufacturing expenses or factory burden (Chapman, Hopwood & Shields, 2007).
ABC is a costing approach that recognizes costs that are incurred due to the activities which arises within the institution and for every activity, a cost driver might be apparently identified. Those expenses that are incurred or driven by the same cost drivers are classified together into cost pool. These cost drivers are then applied as the grounds for charging up the cost of each activity in the product. A cost pool can be defined as a collection of cost or expenses that might be charged up to products by the application of usual cost drivers (Collins, 1991). A cost driver is any activities or activity, series that occurs within an institution, which makes the cost to be experienced. The essence of ABC is that actions or activities are the cost drivers and not the products.
Traditional cost accounting was there before the emergence of ABC. Cost accounting worked extremely well for service or item based businesses to give the accurate cost of production of a particular item or completion of a particular service. Decades ago, traditional cost accounting measures were created when the direct labor costs were important and accounted for the main segment of production cost. Standards were created for controlling and tracking direct labor activities, and direct costs were apportioned across output units. Those standards were suitable for institutions that incurred mainly variable costs and mass raised a narrow series of products. Nevertheless, nowadays indirect costs are a big portion of total cost and labor is widely fixed in many organizations.
These indirect costs are experienced in order to have resources required to give a large variety of activities, each having distinct cost drivers. A number of these indirect costs are committed costs applied to take on the capacity to implement these activities. Even though management has the power to influence the degree of spending for these devoted costs in the end, the total amount of capacity taken on and associated expenditure is fixed in the short run (Grieco, & Pilachowski, 1995). This contributes to either overspending and overcapacity or bottlenecks and limited capacity. As a result, more comprehensive system that give detailed, exact details regarding the performance of these costs, and that help organizations in handling these committed resources are were highly needed.
An alternative managerial viewpoint and its related measurement structure, known as activity based costing, was introduced to overcome some of the key failures of traditional costing for enhancing administrative decision-making. The aspect of the activity based costing (ABC) was developed in the US, primarily in the manufacturing industry in 1970s and 1980s. Robert Kaplan and Robert Cooper brought activity based accounting theory to light. In 1988, in Harvard Business Review they published the body of knowledge. They defined ABC approach a method to provide solutions of traditional cost management structure.
This is the conventional cost accounting structure are mainly not able to identify correctly the true costs of procedures. As a result, quality professional and management are not able to make sound choices or reach a decision based on the misrepresented information. ABC, on the other hand, objectively allocates costs based on the effect relationship and cost. In 1987, W. Burns and Robert Kaplan in one of their books they published the ABC knowledge with the primary aim on manufacturing a situation where productivity and technology enhancement have minimized the direct cost and raised overhead and indirect costs (Cooper & Kaplan, 1991).
The growth of ABC is as a result, of the change in the cost based of several manufacturers over the past decades. In previous periods, a lot of manufacturing was labor intensive. Overheads were a comparatively small element of the total cost and all other costs were largely outweighed by the variable cost of direct labor. Traditional absorption costing was very exact in these situations. Currently, several manufacturing companies’ procedures are automated. The fixed overhead cost of depreciation is currently a crucial element of the total cost. In addition, work forces have been largely minimized (Grieco & Pilachowski, 1995). This refers to that the variable cost of direct labor nowadays is a much littler amount of the total cost. Traditional absorption cost method has emerged to be misleading and inaccurate result product costs. This has greatly led to poor decision making.
ABC nowadays analyses cost as long term and short-term variable costs. Short-term variable costs are similar to variable costs in the traditional absorption costing approach. These features are volume pertained, and they change equivalently according to the volume of the production. Under the traditional cost approach, fixed cost equates to the long term variable costs. In ABC, those costs changes with activity though there is a time lag. For instance, if the number of products reduces salaried production engineers will not be made redundant instantly, but they might be if the reduction continues (Tan, 2003).
The principles and benefits of ABC
The ABC system generally works on these principles;
One of the main guidelines of the ABC is identification of the key activities in an institution. Another key guideline of the ABC is the identification of the cost drivers. These elements lead to the occurrence of costs or determine the extent of the costs of the activity. Volume associated costs drivers are mainly applied for costs, which changes with the production levels in the short term. Here are examples of some costs plus their cost drivers.
Activity Cost drivers
Car fuel cost Number of kilometers
Mailing Number of mail sent
Material handling Number of production runs
Assembling of the costs of every activity into costs pools stands another guideline principle of ABC. The number or the amount of the of the activity’s cost driver it produces measures the product usage of a particular activity. Regarding the usage of the services given, the service costs are apportioned to the production sector. ABC and absorption costing are same in various aspects. Overheads are apportioned to production cost pools or centers, and direct cost go immediately to the product in both system. The distinction occurs in the way that overheads are absorbed into products.
Benefits of ABC
ABC considers product complexity. The costs connected to products relate to the production situations in which those outputs are generated. In ABC, complex and short run products may pull consequently higher levels of unit cost compared to the simple and the long run products. Therefore, this aspect would have substantial results in the measurement or comparative product profitability compared to absorption costing method.
Another benefit of ABC is that it promotes a more realistic method to stock policy. ABC does not advocate for the development of finished products stock as is in the case of absorption costing. Under ABC, the over recoveries that promote stock increase in absorption costing do not rise to the same level because due to a greater proportion of the costs are taken as variable instead than fixed. In addition, in ABC costs are largely related to activity degree. Those costs that are under marginal costing and absorption are traditionally considered as fixed in total might be taken as variable in the long run for the case of ABC. As a result, ABC promotes the measurements of competence levels of administration purposes.
ABC is regarded as a more equitable approach for determining costs of products. The products that uses the activity and cause the cost to be realized, bears those costs related with the output activities in a relative equitable manner. These override the negatives in absorption costing where common overheads are spread out over the product series applying more unrelated approaches to the manners costs are generated. Furthermore, ABC includes stock control. Those components that would be subject to managerial control are identified by ABC, and closely reflect what is going on in the production environment. It costs that management can easily achieve.
A traditional approach of costing accounting does not take into consideration various costs connected with a service or product. This hinders management capability to exactly determine production levels and price the product. However, ABC considers the non production and production activities that are involved in the development of a product. It clearly differentiate the cost of administration from the costs of production, enabling for a more exact image of the true cost of developing a product based on definite production costs.
A number of elements need to be addressed so a to execute ABC successfully in an organization. To begin with, new tools and technique and efficient change management progression must be there before executing an ABC system. The significance of this procedure is to ensure there is full support of the system from all levels of management. This comprises of having the top management championing the initiative together with acceptance with junior levels managers.
The change management procedure requires to specifically addressing individuals issues or problem that will develop in the implementation of the new ABC system. This will address commitment the commitment of the current system that various departmental levels may have and their reluctant to change. It is also crucial to address the consequences of the new system based on compensation systems and performance measurement. New performance metrics might require to be devised or the current ones revised, regarding the information received during the ABC system execution.
Efficient communication at all levels of an institution for the necessity of change is very vital. An institution requires communicating the shortcoming of the existing costing system, the consequences of these distortions in the managerial decision-making and how ABC costing guidelines can be applied to give information that is extremely relevant in decision making in the institution. In addition, the results of the new system on the rewarding and evaluation of individual employees need to be communicated effectively. Execution of the ABC system requires to be proved on the cost benefit analysis, just as the same manner with any other investment.
Customer Profitability Analysis
Customer profitability analysis can be defined as an evaluation process, which focuses on assigning revenues and costs to sections of the customer base rather than assigning costs and revenues to the actual departments, units or products that consist the producer’s corporate structure. Therefore, setting about profitability in such an angle may at times give important insights into how every gradation of the process of manufacturing, designing and ultimately selling a service or a good generates revenue while incurring costs.
This CPA analysis is used by business as a way of streamlining the process hence generating the highest level of returns and efficiency while providing low level of costs. This may result to organizational resources being used for more uses that are profitable. It is viewed as the application of sectioned reporting whereby a customer group is addressed as a segment. It is mostly useful when combined with the ABC approach, which determines the activities that are executed for each group thereby assigning costs established on suitable drivers (Cooper & Kaplan, 1991).
In general, CPA is aimed at providing a lead for actions to be undertaken trough a customer relationship management i.e. CRM. The main goal is to find out profit margin produced by every customer. However, it is often clear that a minimal number of customers produce high portions of the profit while the others only contribute very little. Therefore, this ranks the customers in the order of their profitability.
Therefore, if the profitability analysis explains it clearly that the company is looking down upon some few customers to acquire most of its profits, then measures are taken to expand and diversify those customers’ base hence the company stand at a minimal risk in case one of its major customers withdraws. As customer profitability analysis ensures that each facet of the business performance is functioning in a manner that enables the production of maximum profits, CPA can help to analyze factors, which could have negative effects on the future flow of profits of the company. This allows the company in determining the percentage that every group or individual customers make out of the whole client base, normally in terms of the revenue that is generated.
There are several benefits of using CPA in businesses including uncovering opportunities for profit improvement programs and aimed cost management as well as providing a good basis for bonus plans, pricing decisions plus discounts to customers. Moreover, it attempts to open up hypotheses for targeting strategies and segmentation based on profitability and cost profiles.
Customer profitability analysis merges analysis of the costs incurred while serving customers through various channels with the production costs analysis based on the customers’ demands. For instance, activities, their costs and their drivers are classified as customer level, order level, market level, enterprise level or channel level. It assumes as its opening premise, therefore the viewpoint that the difference is because of a combination of behavior within the supplier (client) organization as well as on customer side, and the variation of economic value of the customers (Berger & Nasr 1998).
A good customer profitability analysis looks closely at the amount of the company’s resources are committed to produce services and goods for a particular clients. The key factor is to identify if the maximum profit is being gained from the current usage of those resources or if there exists a way to allocate a section of those resources to other purposes while also satisfying the customers. Reallocation of resources makes it potential to involve in responsible cost allocation that in turn beefs up the business over the long term.
The CPA Process
There are very major element that require to be regarded
Revenue per customer
This includes sales commissions, credit notes and discounts or rebates.
Total unit costs of the business, especially overheads,
The CPA process takes four steps.
Subtract direct costs for each of the customers (cost of sales or cost of goods) so as to name out their contribution margin.
Understanding what the client(supplier) does to meet the customers’ needs, that is, identify the different activities that go into serving the customers trough finding out where the costs element are and also developing an elementary process-flow diagram showing the customer interactions.
For each of the cost group, (call center and sales force) find out the activities that drive costs. First, the costs that are easy to categorize are identified, and they are related to particular activities.
Finally, the overhead costs that are computed in step 3 are subtracted from the contribution margin computed in step one.
Diagrammatically it can be illustrated as follows;
Implementation of ABC to Analyse Customer Profitability
The real calculation of customer profitability leads to a broad ABC exercise. Customer profitability analysis relates to ABC by associating individual customer with operational activities and their costs. Beginning with ABC will hence provide you with fundamental insights into customer profitability as going to the extent of explaining the reasons why several customers have different levels of profitability (Cooper & Kaplan, 1991).
This is one of the leading mobile service providers in Malaysia. Eventually, ABC was implemented in every department in this company. The key reason for this implementation was to achieve price competition since it was gradually losing its market share. The key factor was to minimize costs and the only means to raise market share was by minimizing price charged on their services.
Therefore, for this critical reason, the company had to name the cost drivers in order for TM to identify specifically where this company was losing its revenues to its telecommunication competitors. Therefore, the company had to adopt the ABC method.
Xu Ji Electric Co. Ltd
Xu ji is a company that deals with production of various electrical products. It is one of the listed companies on Shen Zhen stock exchange. This company’s aim was to ensure that they keep step with the changing management ideas specifically those that were productive in the west. Therefore, Xu Ji got interested with the implementation of the ABC. For a productive implementation of ABC, consumer profitability analysis was projected to name out the various cost activities, as well as the manufacturing costs. The market demand for products of cheap prices was increasing, and it actually became absurd for this company to sell its electronics at a lower price since they did not understand the actual cost drivers of every product.
The adoption of activity-based accounting has been increasing over the years in Ireland and the world over. The most dominant users of the accounting techniques are manufacturing firms, which account for more than 50% of the Irish that have adopted ABC (Chapman, Hopwood, & Shields, 2007). However, the adoption rate is still low though gradually rising. Evidence that supports the widespread use of Activity-based costing research findings for the last decade after the beginning of the new millennium finds a rising trend. A survey in seven countries found that the trend was almost similar. The countries are Japan, Germany, Italy, the United Kingdom, the United States, Canada, and France. Canada and France have the same adoption indices in most of the surveys. The United States has about 54% percent adoption rate, which has doubled in about a decade due to the economical strains that came with the financial crisis. Similar results are evident for Italy, Germany, Japan, and the United Kingdom.
Firstly, in Ireland, the proportion of Irish firms that have not considered using accounting based costing is still high. According to a survey conducted by Perce (2004), Pierce and Brown (2004), the adoption rate of ABC was still low at 27.9 % (Cokins & NetLibrary, 2001). The responding companies included about 51.6% of manufacturing firms. Subsidiaries of multinational corporations accounted for about 49.2% of the respondents in the survey. Many firms had decided not to adopt ABC due to the prevalence of out-come based rather process based dependencies between ABC and strategy orientation across the organizations investigated. There was a lucid connection between the approach and perception of implementation of ABC.
ABC has increased in adoption over the years it is widely applied as accounting principle in Ireland and other countries in the world. Different countries and firms have different rates of adoption of ABC depending on the contextual factors that influence their accounting standards. Some of the contextual reasons that influence the adoption of ABC are
Increase in sector competition
The increasing rate of competition among firms in the economy propels them to adopt ABC systems. The most accurate cost accounting system can enable firms to have a competitive edge in the industry in terms of profitability (Drury, 2006). ABC uses both the unit based and non-unit based activity drivers to assign costs to cost objects in the production process. This increases the accuracy of cost assignments and the general quality and significance of cost information. The cost information is useful in a variety of managerial objectives such as financial reporting. It also provides more comprehensive product costing definitions for better planning, control and decision-making.
The need to reduce Environmental uncertainty by firms
There are two kinds of uncertainties influencing the adoption of ABC. First, the internal uncertainty originating from the technical systems in the firm can inhibit the adoption and implementation process. It stems from the varying levels of interdependence of different subsystems (p 100). Second is the external uncertainty that arises from the unpredictable external environmental contingencies. ABC eases the process of co-ordination along the material flows of information and items hence overcoming uncertainties arising from internal interdependencies. It helps manage the differences arising from external differences.
Organizational structure of companies
Non-manufacturing firms are more likely than manufacturing firms to adopt and implement ABC. This is due to the differences in the cost structures. Non-manufacturing firms do not have direct material costs and possibly no direct labor costs. This implies that fixed overhead cost generally make up a larger proportion of total costs. However, in most industrial sector the reason for adoption and implementing ABC are rarely given the firms.
The necessity to increase the size of the firm
Although this factor may not statistically significant, it indirectly increases the number of overhead costs. An increase in overhead costs influences the rate at which organizations adopt activity based costing. This is due to the accuracy with which is able to assign costs on various items in the accounting cycle of the organization. Considering that, most firms want to expand to reach other markets; they have to expand their size of investments in the sector that is likely to come with more overhead costs.
Prospector’s strategies of most firms
Firms have four main characteristic strategies. This is measured according to the way the rate at which the firms change their products and markets. Firms can be prospectors, defenders, reactors or analyzers (Tan, 2003). Most firms have adopted the prospectors’ organizational strategy that has made them dynamic in exploiting market opportunities. This aspect makes them seek more information on a wide range of markets and products. This makes them adopt Activity Based costing because it is the most suitable to this strategy.
Increased multinational membership by firms
Firms, which are members of a multinational chain, are more likely to attain high performance than those that are not. This is because they can attract managers that are more competent, share the knowledge across facilities, negotiate shared purchase agreements with suppliers, obtain, quantity discounts, and negotiate more favorable labor contracts (p 253). For the firms to do this, they will need more sophisticated ABC systems, which provide qualitative cost data. With the growth in multinational business, ABC systems are now more applicable than in the past.
In my own opinion, traditional system of overheads allocation has no defined future. Traditional system has a propensity to give information which even though is accurate is mainly irrelevant, misleading and late. It is hard to uninitiated with its provisions, accruals and double entries. On the other hand, ABC has been adopted to overcome the shortcoming of the traditional system and enhance managerial decision-making. Activity-based costing separates products into activities and allocates all costs connected with completion of the activities. This enables a more exact view of how much a certain unit cost. While, tradition cost accounting allocates costs on the basis of machine billing hours. ABC has increase in popularity as manufacturing expenses have risen in within industries. This increase in ABC indicates that in the next few decades to come most all industries will adopt ABC system.
Why is traditional cost accounting worsening quality managers? ABC is the answer to this question. Nowadays ledgers systems support institutions reporting and institution requirement, but not enough for internal applications or a procedural based decision-making. Traditional costing system is unprocessed and incomplete, misallocates overheads and indirect costs and structurally deficient to enable managers to analyze and measure expenses. Traditional system gives reports that make decision makers and quality managers sad or happy. While ABC methodology make them smarter and educate them in comprehending the true cost, service, processes or products.
Benefits of ABC outweigh that of the traditional system. ABC provides cost details that are substantially distinct than what is given when traditional cost system is in place. May be, a time has come for quality and decision makers to consider adopting away with tradition cost absorption and adopt ABC in determining project profitability. Customer profitability analysis has also been widely applied compared to traditional system in analyzing firms’ profitability. The gradual increase of the usage of CPA, poses a big threat to traditional accounting applicability.
Managers have a key role to play in ensuring that they make constant decisions that require trade-offs. They are required to identify how much should be invested in customers and human resources. In order for the managers to make such decisions, they require to completely analyzing the profits and costs that are expected from any such investment plus the overall managerial incentive present in order to make those investments. The aim of corporate is not to increase customer or employee satisfaction at a cost but rather it is to manage the relationship between the models and the ABC to boost the long-term profitability of the corporate. The customer profitability analysis is one model that enables the managers to allocate corporate resources appropriately. Measuring the understanding of corporate value, the drivers of customers as well as customer profitability can result to an overall improvement of corporate performance.
The use of activity-based accounting has been rising over the years in all over the world. In Ireland, more than 50% of manufacturing firms use ABC methodology. This is firsthand evidence that, in the future, almost all industries will adopt the use of ABC and tradition accounting will have no place in accounting. The increasing rate of competition among firms in the economy propels them to adopt ABC systems. The most accurate cost accounting system can enable firms to have a competitive edge in the industry in terms of profitability. Seems like disadvantages of traditional accounting outweigh its advantages; hence, in future traditional system of accounting will have no place in almost all industries in the world.
Non manufacturing overheads absorbed = absorption rate x Total non manufacturing overheads
= €16200000 x 45.42%
Total sales (8,500 + 10,000 + 11,000) x €75 = 2,212,500
Less Production cost (8,500 + 10,000 + 11,000) x €45 = 1,327,500
Less absorbed overheads (7,358,040)
Net profit/loss (6,473,040)
Net Profit/Loss per Unit (6,473,040)/ 29,500 = € 219.42
Activity Based Costing
verheads allocation schedule
Cost element Allocation Basis Allocation Ratio Amount Customer X Customer Y Customer Z
Delivery No of orders 1250:25:6 220,000 214,676.0343 4,293.52069 1,030.44497
Quality Inspection No of Inspections 20:1:0 200,000 190,476.1905 9,523.809524 0
Sales Staff No of sales staff visits 100:12:3 80,000 69,565.21739 8,347.826087 2,086.956522
After sales service After sales visits 4:2:1 100,000 57,142.85714 28,571.42857 14,285.71429
600,000 531,860.29933 50,736.584871 17,403.115782
Profit and Loss Schedule
Customer X Customer Y Customer Z Total
Sales 637,500 750,000 825,000 2,212,500
Less Production Cost 382,500 450,000 495,000 (1,327,500)
Gross Profit 255,000 300,000 330,000 885,000
Less Absorbed Overheads (531,860) (50,737) (17,403) (600,000)
Net profit/loss (276,860) 249,263 312,597 285,000
Profit/loss per unit € 32.57 € 24.9263 € 28.42
Commentary: Indeed, the company offers a high service level to its customers. However, customer X is charged a lower price in comparison to the quality of services rendered. Therefore, the company must revise its pricing strategy such that the prices charged to client X is matches the quality of service provided.
) Cost statement Absorption Costing
Product ABC Product DEF Product GHI
Prime Cost € 32 € 84 € 65
Machining Costs = OAR x Machine Hours €1.20 x 2 = €2.4 €1.20 x 5 = € 6.0 €1.20 x 4 = € 4.8
Assembly Costs = OAR x Labor Hours €0.825 x 7 = € 5.775 €0.825 x 3 = € 2.475 €0.825 x 2 = € 1.65
Factory Costs € 40.175 € 92.475 € 71.45
Profit Statement Absorption Costing
Product ABC Product DEF Product GHI
Sales per unit € 45 €95 €73
Less Prime Costs € 32 € 84 € 65
Contribution € 13 € 11 € 8
Less Overhead Costs (€ 8.175) (€ 8.475) (€ 6.45)
Contribution Margin € 4.825 € 2.525 € 1.55
ii.) Cost Statement Activity Based Costing
Cost element Allocation Basis Allocation Ratio Amount Product ABC Product DEF Product GHI
Direct Expenses Cost Incurred 181,000 32,000 84,000 65,000
Machining services Machine hours 2:5:4 317,000 57,636.36364 144,090.9091 115,272.7273
Assembly services Labor Hours 7:3:2 318,000 185,500 79,500 53,000
Set up costs No of setups 3:5:5 26,000 6,000 10,000 10,000
Order processing Customer orders 1:1:2 156,000 39,000 39,000 78,000
Purchasing Suppliers orders 15:20:21 84,000 22,500 30,000 31,500
Total 1082,000 342,636.36364 386,590.9091 352,772.7273
Profit Statement under Activity Based Costing
Product ABC Product DEF Product GHI
Sales per unit € 45 €95 €73
Less Prime Costs € 32 € 84 € 65
Contribution € 13 € 11 € 8
Less Overhead Costs (€310.636) (€ 302.590) (€ 287.772)
Contribution Margin (€ 297.636) (€ 291.590) (€ 279.772)
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