Activity Based Costing
2.1 Traditional costing system
Before going into detail on the activity based costing method, here is a brief presentation of the traditional costing system and say how it differs from ABC.
The traditional costing system traces indirect costs to products/services through a single, or a few rates. Firstly, indirect expenses are assigned to production and service departments. After that, the costs from the service departments are moved to production departments. Separate rates are made per department and indirect costs are assigned to products/services through direct labor or machine hours. What we will see with ABC is that this method differs so that activities are ...view middle of the document...
It is meant to be a management tool and not a new accounting or costing method for products/services/customers. In one way or another, they are more or less stating the same things. Therefore, we can see ABC as a map/plan that helps organize and estimate costs in a company, and this is how I will see it throughout this thesis.
2.3 ABC step by step
If a company has a good costing system it can design products and services that meet the expectations of their customers and that are profitable for the organization. Furthermore, this system can signal when there is a need of quality improvements, efficiency and speed and it can enhance the learning of employees. It can guide product mix and investment decisions, price negotiations and supplier selection, as well as structure distribution and service to the target markets. Accurate cost information is necessary for strategic decisions and operational improvements.
Cost systems provide three functions:
- Valuating inventory and measuring costs of goods sold for financial reporting
- Estimating the costs of activities, products, services and customers
- Giving feedback to managers and operators about process efficiency.
Traditional costing systems still work fine for the first function, since external stakeholders do not care about cost distortions and do not take into consideration marketing, sales and distribution costs, which are in fact very important.
However, managers do not get enough information from the simple costing systems. This is where ABC comes in. A relatively simple model should give accurate activity and process costs in the range of 5-10%, while the traditional systems cannot even do that, as claimed by Kaplan and Cooper (1998). An ABC system is supposed to give managers a reasonable economic map of costs and profitability of activities/products/services/customers. It needs time to grow, receiving years of feedback, learning and adaptation.
The ABC model does not really differ between a service and a manufacturing company. This is because in the manufacturing companies, ABC regards the ‘service’ component of the firm. Those are the services provided to the manufacturing process, as well as marketing and sales. When we present the different steps of activity based costing, we will take into consideration both manufacturing and service firms.
2.3.1 Step one – identify activities
When using the ABC method you see the company as a set of activities, such as work assignments and so on. Every task that is performed in a company can be named activities. These activities vary from company to company since the companies are different. Some examples of activities in a consulting company for instance are planning an assignment, performing the service, securing the quality, following up the assignment performed, and etcetera. For another firm it could be set up machines, purchase materials, process customer orders and issue cheque books.
In step one, look at what...