ActivityBased Costing Essay Research Paper Brief Introduction

Activity-Based Costing Essay, Research Paper

Brief Introduction to ABC

Activity-Based Costing (ABC) started as a methodology that recognises the need to understand how costs actually relate to individual products and services (Cooper & Kaplan, 1989) that later resulted in a more refined system of allocating overheads to products and services, according to the demand of each activity.

Homemade Pty Ltd – Food (Dikolli & Smith, 1996:47-55) was a pilot project where it took part in an ABC feasibility study during the mid 90s. This company has been chosen for this study because it has met some of the prime criteria of ABC. The criteria are diverse product or service lines, high overhead, large distribution costs, (Downes, 1996:49) to name a few. Homemade manufactures 170 types of finished stock and is a market leader. It relied heavily on labour and incurring high overheads in processing food in terms of machinery, salespersons’ pay and occupancy of factory floor. Three other companies are selected to observe ABC implications in their systems to see if there is difference or similarity as compared to Homemade. These companies are NASA’s Lewis Research Centre (LeRC) – Government, Tampa Electric – Public Utility and Mobil – Oil & Gas (see as attached at Appendix). They have fulfilled the following prime criteria and have already gone through the phase of actual happenings when they adopted ABC into their costing systems.

1. Product / Service Diversity & Customers

Companies with more diversity in products, the harder it is for them to trace the source of profitability, especially when they are catering to various consumers. For example, LeRC conducts research and development in both aerospace and aeronautics, specialising in micro-gravity science, aero-propulsion and space systems. Its internal customers include government agencies, defence affiliates and the Congress itself. Without ABC, the sources and uses of funds are hardly visible, (Walters et al., 2000) because it is difficult to measure its employees’ time spent on a given activity. Similarly, Mobil supplies more than 30,000 lubricants to retail customers and their costing system could not address cost to produce each product individually. (Kang, 2000)

2. High Overheads & Large Distribution / Marketing Costs

Large companies usually incur high overheads than of direct costs because they spend more in distribution and marketing costs. Indirect costs, such as promotion costs, outlet manager’s wages and depreciation of machinery are not accounted into the cost per unit of product or service. For instance, Mobil produces and supplies more than 30,000 lubricants, and operates lubricant affiliates in more than sixty countries with forty manufacturing locations. Its wide coverage is to market its lubricants to the consumers. Therefore, it will be incurring high overheads. However, the cost per unit lubricant will not include the salaries of salesmen selling it. Without ABC, these extra costs will not be accounted for and cost per unit will not be accurate. Similarly, Tampa Electric uses six generating plants to cater to 550,000 customers: commercial, residential and industrial including the extent of urban and rural. The overhead and distribution costs incurred during the transportation of electricity to these places are not accounted in the cost per unit of electricity because in traditional costing, these costs are represented by resource drivers.

After the implementation of ABC, it is obvious to see that some of the decisions made in those companies have been changed. These changes are made to better reflect product costs, identify unnecessary costs that reduce profitability and clearing any extra work contributed from unstructured costing system. Common decision points can also be categorised under several groups.

1. Cost Allocation & Pricing

Non-value added costs are identified, therefore been reduced. Sales are no longer to target volume, but for the purpose of profitability. ABC allocated overhead costs according to their activity drivers instead of volume drivers. Specific activities that are contributing to non-value added costs could be separated. For example, Tampa Electric discovered that testing of meters in house versus the field would save approximately $50,000 and replacing residential meters is considerably less expensive than repairing them. For pricing purposes, the price per unit can be maintained the same while reducing costs to generate substantial profits. Mobil will be able to produce thousands of product and package combinations without increasing the costs that affect the profitability level. Homemade prepared cross-functional expenditure analysis to detect any ‘hidden’ items in the general ledger and a five-stage decision process has been developed to define activities according to their nature, either for activity-based management (the process dimension) or activity-based costing (the cost dimension) purposes. (Dikolli & Smith, 1996:52)

2. Add / Drop Product / Service Lines

Unprofitable product lines can be dropped and new lines added. By removing these lines, it can eliminate very much of the cost subsidies such as electricity, raw materials and direct labour that have been incurred during the making of product or service. Mobil has closed multiple manufacturing facilities with excess capac