The basic goal of planning for any profit organization is to achieve maximum profit with limited resources. During the process choices must be made on how to allocate resources and model their costs

by typ003 (student)

University Degree Business and Administrative studies

Question 1

Planning

Planning is one of the most important and fundamental parts of running a business (Topfer 2011). The basic goal of planning for any profit organization is to achieve maximum profit with limited resources. During the process choices must be made on how to allocate resources and model their costs (Graves 1999).

Therefore cost information is used in various types of planning. For example when planning to start up a new business cost of capital is considered, in marketing plan cost of promotion activities is needed to keep it within budget, in financial planning cost of sales is used to project revenue, and etc.

Cost information is especially important in manufacturing companies as it will directly affect cost of goods sold and in turn overall profit margin. Thus, when formulating a production plan cost like material used, direct labor, manufacturing overhead (Goosen 2008), and other variable production costs must be identified and minimise.

Besides that, cost information serves as a basis when estimating costs in future planning. For example when planning to add a new product in the product mix, we can calculate the estimated cost that will incur based on historical cost information. Then it is used to determine the profit-making capacity and decide whether the plan should proceed.

Control

As an interrelated process with planning, the control process also uses cost information to access performance and keeps cost in check as planned (Cagwin and Bouwman 2000). Cost information in control process also serve as input for better plans in the future.

In today’s competitive market, a business’s profit-making capacity is steered by its efficiency of controlling. This is especially true for a manufacturing company where costs are sensitive to the overall profit. In order to maximise efficiency in the use of labor, materials, machines and plants, cost control is implemented.

Basically cost control programs uses information derived from cost accounting to improve net margin for the company. These cost information includes input costs of each step of production and fixed costs such as machine depreciation (Investopedia n.d.).

Pricing

In modern open markets, competition is very strong and the pricing are defined by the market competition and the product’s competitiveness (Garrison and Noreen 1999). However, it is not feasible in the long run for a company to sacrifice its profit in order to compete with a lower price. Since profit should not be bargained, costs became the target function that can be influenced by a company to reduce price. (Pesonen 2001)

Thus, when setting price for a product, the input cost of the product like product development, testing, and packaging have to be taken into account. Other than that, the life cycle of the product will also affect pricing as it usually costs more in promotion during new product offering stage. Besides that the business context also influence pricing because to setup a brick and mortar shop to sell the product incurred more costs compared to an online offering (Tanner and Raymond 2010).

ABC vs Functional Based Costing

In the traditional cost system, a single unit-level basis is used to track indirect costs such as direct labor or machine hours used to manufacture the product (weygandt et al 2005). In this approach, the cost of overhead increases with increased volume of units produced. Such costing system would create inadequate cost information in today’s global and technological environment as direct labor in manufacturing significant decreases while large amount of machinery usage increases (Rattanaphaphtham and Ussahawanitchakit 2010). This cost allocation would mislead managers in decision making on product price as the relationship between product and ...

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ABC vs Functional Based Costing

The main problem a traditional costing system faced is undercosting and overcosting. As mentioned earlier, the system uses a single unit-level measure as an overall cost driver which tends to assign costs to products based on an arbitrary average basis. It does not meet the cause-and-effect criterion desired in cost allocation. Thus, products that require customization and more resources to build are not assigned its fair share of cost, resulting in undercosting. On the other hand products that are fairly easy to build and require fewer resources are assigned with higher costs which it should not bear, causing overcosting. Using these inaccurate cost information in pricing decisions may cause unintended predatory pricing or over pricing.

ABC has been accepted as more accurate in the costing and pricing of products than traditional cost accounting (Hilton et al. 2008). In ABC, cost is first allocated to all the activities performed to manufacture a product, and from there to the product based on how much each product uses the activities (Hilton et al 2008). In this way managers can have a clear picture of what cause costs and modify the activities to reduce cost of product in an effective manner.

Besides that, non-value added costs can be identified and minimise so that pricing can be lowered without sacrificing customer perceived value (Weygandt et al. 2005). For example, inventory storing and handling; transportation of raw materials or partly finished products; and redundancies in production-line configurations are few non value added costs that could be reduced.

In conclusion, activity based costing provides accurate, reliable and relevant cost information for managers to improve overall efficiency as unnecessary costs are identified and reduced. At the same time lower cost allows managers to make competitive price decisions effectively. However in companies that involve little indirect costs and accuracy of cost information is not crucial for the success of the company, using a traditional system might be much simpler and costs less than implementing a complex system that will not benefit the company significantly.

Proposal to Adopt ABC System

I. Statement of Problem

The Company is losing market share and profit with intense competition from rivalries. There are no room for price negotiation as the costs of product is higher. An alternate costing system- Activity Based Costing (ABC) should be implemented to address this problem.

II. Implementation & Adaptation

Generally there are four basic steps to implement ABC system.

Step 1: Identify and classify the activities related to the company’s product

An ABC team have to be formed to identify all the activities in the value chain of the company. Activities include purchasing, production, promotion, distribution, and etc. After the activities have been identified they are classified under unit-level, batch level, product level, customer level, and facility level based on which level of the company they support (Hilton et al. 2008). For example, boxing products is a unit level activity and companywide advertising is a facility level activity. The objective is to have a clear view of how the company perform its works and enable the team to trace the costs to goods produced.

Step 2: Estimate the cost of activities

To calculate the total cost of each activity that caused costs, ABC team has to use data collected from employee through interviews and financial data from accounting department (Hilton et al. 2008). For example, for the activity ‘boxing a product’, employee will provide information on time spent on operating the boxing machine, and accounting will provide the data on the cost of the machine and maintenance cost.

Step 3: Calculate a Cost-Driver rate for the Activity

The activity cost data obtained earlier is then used to calculate a cost driver rate. The cost driver rate uses a base that has a causal link to the cost, thus it is used for assigning costs to goods produced (Hilton et al. 2008). For example, cost of running a boxing machine is caused by the number of hours it runs, thus, for this activity a rate should be chosen based on machine hour.

Step 4: Assign Activity Costs to Products

The cost driver rates are now used to assign costs to goods produced (Hilton et al. 2008). For example, if a product uses 1 machine hour for production and the cost driver rate is $30 per hour then the product is assigned $30 for its cost.

For a company to adopt the ABC system successfully there are 3 main areas to focus on.

Organizational Culture

It is easier for a company to adopt the new system if it has a culture that supports change. Generally employees are resistance to change as it involves uncertainties and extra efforts to fit in a new working condition.

Top management have the responsibility to facilitate change by showing that they are serious and the change is there to stay.

Organizational Structure

A company that have complex production process and produces a variety of products in a highly competitive market may find it more suitable to adopt the ABC system. On the other hand, a company which produces a single product or only have few customers may not find it beneficiary to adopt the ABC system.

Technical

Because of ABC system’s complexity compared to a traditional costing system, employees have to be trained to understand and use the system in a correct way. Higher management should also be educated on how they can use the information to facilitate their decision making.

When introducing the ABC system into a company it is suggested to keep it as simple as possible for easy adaptation. That means using spreadsheets until employees are familiar with the new system then only supporting software be brought in.

III. Cost and Benefit Analysis

Cost

Introduction Cost

ABC system can be costly from introduction to maintaining the system (Weygandt et al. 2005). When first introducing ABC to the company, employees have to be trained and educated to fully understand and accept the new system because of its complexity compared to traditional system. Besides that, new computer systems may be needed to support the data used by ABC system. At the introduction stage, company may also need to hire consultants to develop and implement the new system.

Operation Cost

Once ABC is implemented, company will notice a higher expense of obtaining cost data as the data required by ABC system is not usually generated by the traditional system (Weygandt et al. 2005). These data may include number of setups, inspections, orders placed, and orders received. After the required data have been collected they have to be checked, entered into the new system, and constantly updated. In some cases, overheads are assigned to individual products which involve a lot of calculation and work (Weygandt et al. 2005).

Maintaining an ABC system means the company have to keep an additional set of accounts for external reporting. This is because ABC is not compliance with normal Accounting Standards like the traditional cost system (Weygandt et al. 2005).

Benefit

Accurate Product Costing

ABC allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods. The activities responsible for the costs can be identified and passed on to users only when the product uses the activity.

Control over Overhead Costs

In ABC overhead costs are assigned under different activities. Managers will have a better means of identifying high overhead costs and subsequently control the activities that generate these costs.

Better Management Decisions

An accurate product costing would aid manager in making pricing decisions more effectively and contribute to company’s profitability. Also, the cost data from ABC is helpful in making decisions such as whether to discontinued or expand a product line or whether to outsource a costly activity.

Facilitates Continuous improvement

It was found that ABC Integrates well with Six Sigma and other continuous improvement programs (Accounting for Management 2011). For example, ABC applications are often used together with Activity Based Management (ABM), Balanced Scorecard (BSC), and Business Performance Management (BPM), which identifies shortfalls in processes and improves overall company performance (Chung and Khan n.d.).

Comparative Cost/Benefit Summary

The benefit of using ABC system clearly overweighs the cost of implementing the new system. In a long run’s perspective, the introduction costs will eventually be covered by returns brought by improved process and better profitability. Besides that operation costs will be reduced once the company is more familiar with the process and can perform the tasks more efficiently. Thus, the ABC program should be implemented to better control the costs involved in production and increase the company’s competitiveness.

Reference

Accounting for Management (2011) Advantages, Disadvantages and Limitations of Activity Based Costing (ABC) System. [Online]. Available from: [Accessed 23 November 2011].

Cagwin D, Bouwman M J. (2000) The Association Between Activity-Based Costing And Improvement In Financial Performance, University of Texas, Texas; University of Arkansas, Arkansas.

Chung H M, Khan M B (n.d.) AN ANALYSIS OF ACTIVITY-BASED COSTING (ABC), Project Report. California State University, California

Garrison R H, Noreen E W (1999). Managerial Accounting. 9th ed. McGraw-Hill.

Goosen K R (2008) Management Accounting: A Venture into Decision-making, Micro Business Publications. Available from: [Accessed 21 November 2011].

Graves, S C (1999) Manufacturing Planning and Control, report. Massachusetts Institute of Technology, Massachusetts.

Hilton R W, Maher M W, Selto F H, (2008) Cost Management: Strategies for Business Decisions, McGraw-Hill.

Investopedia (n.d.) Cost Accounting, [Online]. Available from: [Accessed 21 November 2011].

Pesonen, L T T. (2001) Implementation of design to profit in a complex and dynamic business context, Dissertation. University of Oulu.

Qian, L. and Ben-Arieh, D (2008) Parametic Cost Estimation Based on Activity-Based Costing: A Case Study for Design and Development of Rotational Parts. International Journal of Production Economic, 113: 805-818.

Rattanaphaphtham K, Ussahawanitchakit P (2010) Activity-based costing effectiveness: how does it influence competitive advantage and performance of Thai-listed firms? , International Journal of Business Strategy, Volume: 10 Issue: 2

Tanner J, Raymond M A (2010) Principles of Marketing, Flat World Knowledge. Available from: [Accessed 22th November 2011].

Topfer, S (2011) The Importance of Business Planning. [Online]. Available from:http://community.nasdaq.com/News/2011-02/the-importance-of-business-planning.aspx?storyid=59436#ixzz1eVlb4lBr [Accessed 21 November 2011].

Weygandt J J, Kieso D E, Kimmel P D, (2005)Accounting Principles 7th Edition, John Wiley & Sons