Traditional Costing Methods vs Activity Based Costing (ABC)

Traditional Costing Methods vs Activity Based Costing (ABC) In this report I will attempt to discover whether it is feasible as a company to change the Traditional methods of costing we currently use to the more modern Activity Based Costing methods, looking at the benefits and drawbacks of changing and whether it is worth implementing these new costing methods to our company as a whole. Introduction / Background As a small local engineering firm we currently use the Traditional costing method where we apportion Production overheads on the basis of direct labour hours. Does this give a fair and accurate representation of the true cost of expenditure each product consumes or should we as a company convert to the Activity Based Costing system or ABC as I will refer to it from here in, where we first assigns costs to the activities that are the real cause of the overhead and then assign the cost of those activities only to the products that are actually demanding the activities. Would this give a fair and more realistic look at the way we cost jobs. In this report I will look at both methods and determine whether we as a company should change the way we cost our jobs and if we do change to the ABC method of costing, what the conditions are of implementing this to us. Traditional Costing Methods Currently we adopt the more traditional way of apportioning our production overheads which involves the overhead rate being calculated using direct labour hours, machine hours, or units, in our case using direct labour hours. The advantages of using this system are: Simplicity the calculation of overhead rates is relatively straightforward; They are widely understood in business; They are not expensive to operate; Until the late 1980s they were seen as fairly accurate; They are still being used after many decades. The weaknesses of traditional costing systems are: Their reliance on arbitrary rather than cause-and-effect allocation of overheads; Their inability to give accurate product costs in multiproduct companies; Their failure to analyze non-manufacturing costs. (Traditional costing system. A Dictionary of Business and Management. 2006. Encyclopedia.com. 19 Nov. 2010 . ) Currently using the traditional method of cost accounting we are allocating the factorys indirect costs to the items manufactured on the basis of direct labour hours, By using only labour hours to allocate the manufacturing overhead to products, we are implying that the labour hours are the underlying cause of the factory overhead. Traditionally, that may have been sufficient for the companys external financial statements. However, in recent decades the manufacturing overhead has been caused by many other factors. For example, some customers are likely to demand additional manufacturing operations for their products. Other customers simply want great quantities of product. If we want to know the true cost to produce specific products for specific customers, the traditional method of cost accounting is inadequate. ABC was developed to overcome the shortcomings of the traditional method. Instead of just one costing such as labour hours, ABC will use many costings to allocate our indirect costs. A few of the costings that would be used under ABC include the number of machine setups, the pounds of material purchased or used, the number of engineering change orders, the number of machine hours, and so on. So do we continue to use this system because it is simple to use and has been used for decades or do we want a more accurate analysis and breakdown of the way we allocate costs. Activity Based Costing (ABC) Activity-Based Costing (ABC) is an Information System developed in the 1980s to overcome some of the limitations of traditional cost accounting and to enhance its usefulness to strategic decision-making. ABC systems are designed and implemented on the premise that products consume activities, activities consume resources and resources consume costs (Sprow, 1992). ABC systems assign costs to activities based on their consumption of resources, and then activity costs are assigned to products or services in proportion to a selected measure of their individual workloads (Anderson, 1993; p. 7). ABC systems examine all processes (or activities) that are actually relevant to the production of a product and attempt to determine exactly what portion of each resource is consumed i.e. which activity a particular product uses. (M. Gupta, K. Galloway / Technovation 23 (2003) 131-138) Why the need for ABC, you may ask; Nowadays managers are facing global competition and increased productivity in new manufacturing environments. Companies attempt to become customer focused and concentrate on quality products at competitive prices. Under these circumstances, many firms are interested in determining various costs more accurately with the objective to integrate manufacturing and marketing strategies. Various costing systems are used to provide an increased accuracy about product costs, product mix, pricing and other investment decision- makings. Some experiences reveal that the distortion in reported product costs and, in turn, product pricing could be reduced by using activity-based costing (ABC) (A. Gunasekaran, M. Sarhadil Int. J. Production Economics 56-57 (1998) 231-242) What are the benefits then of this new and modern way of costing, is it really the way forward for us. It wont eliminate costs but it will give us detailed information about the way we are consuming them, thus helping us to isolate problem areas with the view to rectifying why the costs are so high in these areas. ABC costing is a good tool where different customers require different needs. Its an unwritten rule respected by many in the business world that you generally treat your best customers the best. The problem is, do you really know who your best customers are, or do you think you know? The majority of business people have the false perception that the best customer is the one that accounts for the largest portion of your income every year. This is not always the case for the simple reason that the same customer may be responsible for the biggest part of your expenses also. Studies have shown that 20% of all customers virtually provide all the profits of a company. Another 60% break even and the remaining 20% only reduce the bottom line. Wouldnt it be nice if you had the names of that 20% of headache-inducing customers that are literally more trouble than theyre worth? To determine how much a customer is costing you, you must first identify the activities that relate to each customer and determine the total cost absorbed by those activities. These activities or c ost drivers should be considered then to measure the level of activity absorbed by each customer. The ultimate purpose of implementing ABC is to separate these activities into individual cost drivers. Then, all you have to do is measure each customers participation in the specific cost. (The ABC Portal is  © 2002 Offtech Computing Pty Ltd.) So with our customers needs being different in terms of specific shelters and designs we could cost jobs more accurately to each customer. Looking at the draw backs to the ABC costing system, we would have to take into account the data collection process for this new system could prove to be very time consuming along with the capital expenditure on this new system and its subsequent running costs. Employee resistance must also be taken into account. This is a major obstacle in implementation of an ABC system. Such resistance is natural as the most common objective is to give a reduction in overhead costs, and in almost all circumstances this could result in a reduction in personnel. So to break it down the advantages and disadvantages of ABC are; The main advantages: Assesses costs of individual activities, based on their use of resources Enables accurate costing of all activities to be obtained throughout an organisation. Easy to identify where high (and low) costs are being incurred and the cause. A valuable tool for both business and process improvement Helps with future product planning e.g. the cost of all activities associated with a product or service can be accurately determined before it is launched. This can then help with determining pricing, and any associated expenditure. Disadvantages include: It may be difficult to set up and establish, particularly if an organisation is using more traditional accounting methodologies. (barriers to change) Can be time consuming if all activities are to be costed May provide too much detail obscuring the bigger picture. Can lead to employee and possible management disharmony.