Activity Based Costing: Definition, Advantages, And Disadvantages - An Essay.

What is Activity Based Costing?

Activity based costing may be defined as one of the concepts which is being used by the cost and management accountants in their day to day operational activity to allocate the indirect cost of the business processes to different activities, divisions and products as the direct cost is generally allocated in the ratio of the sales of the company. It is one of the widely accepted costing technique in the industry whereby the total pool of resources are being allocated to the different activities and divisions and then these activities are allocated or distributed to the cost objects which are further being allotted to the cost drivers (Appelbaum, Kogan, & Vasarhelyi, 2018). The cost driven can be defined as the base on the basis of which the entire cost is being booked and charged. The units of cost driver define as to what will be cost charged to each activity or product, more the no. of units, more will be the total cost. Furthermore, costs can basically be divided into 3 parts namely fixed cost, variable and semi variable. Some of these costs are divided on basis of area (like rent), some of basis of machine hours (like electricity) and some of the basis of labour hours. There can be many other allocation bases which can be used (Bae, 2017). This method is effective in utilising the minimum available resources of the company in the best possible manner.

Activity based costing has been playing an instrumental role in the cost control mechanism and has been continuously helping the cost and management accountants all across in increasing and improving the effectiveness and efficiency of the cost. Some of the major advantages has been listed below:

1. It helps in proper determination and accurate costing of the products thereby leading to the proper analysis of all the costs heads and also the individual product costing.
2. Since the market is extremely competitive and there is always a price pressure, activity based costing helps to price the product in a better and effective way.
3. It leads to realistic preparation and presentation of the financial data and reports, or else in the absence of the proper data on costs, wrong information will be captured and passed on to the shareholders and the investors(Axelsen, Green, & Ridley, 2017).
4. The process of activity based costing is also effective in showing the inefficient activities and the same can be eliminated or even outsourced. This will lead to cost savings for the company and shortening of the processes.
5. The correct computation of the overheads as well as the costs can lead to better cost control measures and also lowering of the manufacturing overheads.

Besides the advantages the system of activity based costing also suffers from a number of disadvantages which have been listed below:

1. It may not be cost effective for the small companies as the cost of implementation of the activity based costing is not cheaper and thus the organization may not be able to afford the same(Arnott, Lizama, & Song, 2017).
2. It also requires the expertise of the professional people who have the knowledge and skill base of costing and the costing terms like cost centres, cost allocation, cost element, etc. and the same may be a bottleneck for many of the organizations.
3. For activity based costing to be fully accurate and give effective results, the input data must be accurate and there should be no ambiguity. Thus, the quality of the data is one of the bottlenecks.
4. Activity based costing reports can only help the management in determining the cost and prices of the goods at which it needs to be sold. Since it is not in conformity with the Generally Accepted Accounting Principles, therefore another report needs to be prepared for external reporting purposes(Werner, 2017).
5. The results which are derived from activity based costing can lead to conflicts within the organization as the same may not be in line with the traditional costing results used by the managers and based on which the past performance was being measured.

The above topic of activity based costing has been discussed and analysed using the two research journal articles. The first of which is “The Measurement and Management of Unused Capacity in a Time Driven Activity Based Costing System” which has been written by Hasan Özyapici  and Veyis Naci Tanis  and the second journal article is “The Value of Activity-Based Costing in Competitive Pricing Decisions” written by Warlop Luk, Eddy Cardinaels and Filip Roodhooft.

Activity based costing has a number of benefits especially in the manufacturing industry as the industry has heavy price competition due to a number of competitors and the new entrants entering into the sector every other day (Eddy, Filip,R, & Warlop, 2004). The first journal paper discusses broadly on this topic and how the activity based costing benefits over the traditional volume based costing approach as the old traditional method leads to biased allocation of the costs and sometimes the product or the division or department which is not loss making seems to be loss making because of incorrect pricing. ABC costing has this advantage of removing or eliminating the irrelevant competitor feedback from the competitors and thereby affect the decision making process (Delone & Mclean, 2004).

Advantages of Activity Based Costing

The study researches on the topic as to determine how much cost system is significant in decision making where limited information is available with accountants for price fixation purpose. Due to competitive market it is very difficult task to determine the correct price of output because it directly effect to the price of the product however as per market norms cost system plays a minimal role and usually the price is output is completely depends upon the market feedback which do not consider accounting data for decision making purpose. However from the in depth study of the traditional system one thing that is clear that in the multimarket setting, these system of costing gives an incorrect result where the product dealt in heterogeneous market and when the cost of the product is either under allocated or over allocated which gives a biased result. Due to all these inefficiency the firm may suffer accounting loss which affect their financially position which are actually profitable in the business environment (Jefferson, 2017). In 1999 Briers et al. examine the major impact on biased costing system in the multiproduct market and analysed that biased accounting data may led to improved pricing decisions and benchmark report received by the company but it did not involve any direct competition not they examine through the ABC system to review the effectiveness of the result. However, later on to check the reliability one test were conducted in the experimental market conditions with 2 hypotheses being assumed were the price and profit of the product are optimum when the business house receive informative and positive market feedback rather than in informative and negative market feedback. As per 2^nd hypothesis the benefits of ABC system over the biased cost data setting fall as and when the firm receive informative and positive feedback. Here in the given experiment, 2 groups of participants were made consisting of 131 management accounting and cost accounting qualified students who were given cost data and instruct them to allocate the data using two different cost system that is the traditional costing systems and the ABC costing system. In ABC system the allocation of the customer costs was done with the help of 3 activities namely ordering, delivery and software handling. Then the system allocate the cost of activities across 2 market segments based on the respective cost drivers like number of orders, deliveries and software handling. At last the result were reviewed by expert to check whether the primary objective that is to see the impact on the profits over ten different periods and to check the reliability of the system (Guragai, Hunt, Neri, & Taylor, 2017). From the averaging of 1^st five result it was concluded that that the interaction between the market feedback and the accounting report on allocations have neither effect on market nor on pricing decisions. Hence the 2^nd hypothesis was proved wrong and resulted in competition are effective where competitor exist and the information is limited. If the companies allocated their indirect cost among appropriate activity under accurate cost delivers it gives the reliable and competitive cost information for the product. Hence the price become more competitive at market place and helps in correct price fixation of the output.

Disadvantages of Activity Based Costing

In the second case study, it is discussed that how to manage nd measure the unused capacities in the companies by taking the help of time driven activity based costing. In current day there are many companies all over the globe which are working 24 hours a day and it might be difficult for them to evaluate what are the unused capacities and which increases the overall cost. To examine the unused capacities, they should be considering 2 new concepts which are real and compulsory unused capacities. The main focus of the research paper is to increase the efficiency of ABC and TDABC system by measuring the actual unused capacities per shift (Kim, Schmidgall, & Damitio, 2017) (Schoenberger, 2016). The prime objective of this research to dismiss or employed the employees to other productive areas based on the per shift rather than looking at unused capacity throughout the day.  This is very difficult through traditional system of costing because of their rigidity. Hence the many companies were looking for more advanced methods that can give more efficient results to them in cost management. In care of ABC system the major drawback was the selection of the cost drivers for the allocation of the costing element within appropriate segment and did not optimised the limited resources that the management of the company had which is shown in the given case.

The time driven activity based costing is the undated version of ABC costing that was introduced to eliminate the limitation of the existing processes. The main significance of this approach is managers are able to recognise what are the resources and what is the amount of resources that will be required to complete a given activity (Dan, 1995). There are two major element are there for the implementation of TDABC which are the cost per unit of resources required and what is the number of units of those resources being consumed by the customers, activities or services. The primary objective of this costing system is to improve the efficiency in costing of goods accurately in the competitive environment and even consider those costs which get eliminated or ignored under the ABC system. Apart from all it all takes into account the time and number of resource units required to complete the process. Here the cost per unit is calculate by considering the practical capacity of the resources. For example the machine actually works for 40 hours a week as per records but the machine effectively work only for 80-85% of this which amounting to 32-34 hours per week. Hence for the effective cost allocation it is necessary to consider practical and effective capacity (Naci & Hasan, 2012). The 2^nd important element is the calculation of the number of units of resources being used. For this the manager conducted interview the employees or do estimates through direct observation procedures. In many organisation to get the appropriate estimation employee survey was done. However these interviews and serves not given the exact result but provide a rough estimate. By the extensive study of these two element we can get the reliable allocation keys.

Research on Activity Based Costing in Competitive Pricing Decisions

There have been various similarities and differences in the 2 journal articles which have been discussed above. Some of these similarities are:

1. Both the techniques of ABC costing and the time driven activity based costing are agile and show the inefficient activities which are there in the process and aims to eliminate them. Thus, the common objective of both the techniques is cost savings and elimination of wasteful activities(Marques, 2018).
2. Both the studies were done to find the better cost allocation technique and thereby doing correct costing of the material based on the correct indirect costs allocation. Both the studies aimed to overcome the shortcomings of the traditional and volume based costing techniques.

Few of the major differences which were noted in the studies are:

1. Activity based costing majorly focused on the allocation of the minimum possible resources with the organization in the correct manner so as the reduce the impact of poor management of resources and the cost was optimized whereas on the other hand, the time driven activity based costing focused mainly on determining the time taken for doing any given activity and the no. of units of resources being utilised(Vieira, O’Dwyer, & Schneider, 2017). It was a revised and refined version of the ABC costing and aimed to optimise the cost further and make accurate allocation. It is because of this reason that the time driven ABC has been accepted widely by the global companies and is in operation now. It can therefore be mentioned that both the approaches has its own advantages and disadvantages, and it is upon the organization to judge and derive the maximum benefit out of it.
2. The 2^ndmajor point of difference in both the research articles was that the 1^st study also focused on the determination of the correct cost drivers to allocate the costs correctly on the other hand the second case study focused on the better time management processes.

Therefore, both these techniques are applicable and beneficial depending on the type of the company, if the company is facing the time constraint and is having issues with respect to time, they can opt for the time driven activity based costing whereas on the other hand if the companies are facing issues in determining the correct and apt cost drivers, it can opt for the activity based costing. Both these techniques do overcome the disadvantages posed by the traditional costing methods (Félix, 2017).

Conclusion

There have been significant and critical learnings from both the case studies and it will be instrumental in minimising the cost impact and improving the efficiency of operations and the same can be replicated and used by the management accountants all over the world. This will help in improving the profitability of the companies and in making the pricing of product competitive. Some of the major learnings from the 1^st case study has been listed below:

1. The price being set by the industry leader or the conglomerate is stronger than the cross pricing made by the competitors. This is due to the fact that other market players in the industry will be left with very minimal demand in case the rival company lowers the prices again(Lavassani & Movahedi, 2017).
2. The new companies which enter the market often follow the trend which is being used by the industry players. This can be seen especially with the small companies and firms who tend to follow the path of the industry leader.
3. From the study, it was also being observed that the prices being computed by the companies on the basis of the traditional costing methods is highly inaccurate and is far from the optimal prices and therefore the prices are inappropriately charged. Even if the product would have been profitable, the same seems to be unprofitable and the company can see the accounting losses. Due to this, there is a significant impact on both the top line as well as the bottom-line. On the other hand, activity based costing leads to the optimal price allocation and thus, correct price determination can be done. This makes the product competitive as well as profitable in the marketplace. And therefore, leads to increase in sales as well as the accounting profit(Meroño-Cerdán, Lopez-Nicolas, & Molina-Castillo, 2017).
4. Previously, when these methods and techniques of costing were not available, people used to use market feedback for pricing and costing of the goods and where the market feedback was not informative then all those participants using the activity based costing technique were found to outdo the companies using the volume base costing technique.

Some of the key learnings from the 2^nd case study are mentioned below:

1. Time driven activity based costing was the refinement of the old process and aimed to overcome the issues posed by the old ABC costing. ABC costing technique had the issue with selection of correct cost drivers and so TDABC focused mainly on the time aspect and the practical and theoretical capacity of the given machine to calculate the possible or the expected output(Zhou, 2018).
2. ABC costing had different variables to deal in and different companies used the different allocation kept for the same propose and therefore there was no standardization. It is because of this reason that that the accounting reports and the costing reports did not matched. TDABC costing has been instrumental in removing these differences and making the reports standardised and comparable all across the world by using only 2 variable, the time and the no. of resource units per activity. TDABC costing is the refined version and will surely help the companies in better pricing and cost estimation for the product.

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