Activity-based costing

Activity-based costing (ABC) is an accounting method for businesses to gather their operation costs more accurately. ABC is designed to assign cost by focusing on individual activities such as the fundamental cost objects. Therefore, this system enables business to decide which products are profitable.

Absorption costing is stock costing methods in which all variable manufacturing costs and all fixed manufacturing costs are assigned to products either by direct tracing or by cost allocation. In this case, currently WWonka plc uses this method to absorb those overheads.

The selling and distribution cost per order = total overhead/ number of customer order

= £990000/ 9000

= £110/order

Moreover, on ABC costing basis, firstly, we have to assign each cost to individual activities.

Cost driver

Cost(£)

Cost drivers Unit

Unit cost

1)Invoice processing

290000

a)number of invoice

58000

9000 orders

£6.44 per order

b) number of line

232000

25000

£9.28 per lines of invoice

2) Packing –a)small

£27 per order

b) Large

£34 per order

3)Delivery

200000

a)General

150000

1000 journeys,

(6 large or 12 small)

£150,

(Large £25/Small £12.5)

b) Specific

50000

350000 miles

£0.142857 per miles

240000

9000 orders

£26.67 per order

Order A:

Cost driver

Cost drivers Unit

Cost of order A(£)

Lines on invoice

3

3x 9.28 + 6.44 =£34.28

Package size

small

£27

Specific delivery distance (miles)

10

12.5 + 10 x 0.142857 = £13.9

£26.67 per order

£26.67

Total = £ 101.88

Order B

Cost driver

Cost drivers Unit

Cost of order B(£)

Lines on invoice

9

6.44+9.28 x 9 =£ 89.96

Package size

Large

£34

Specific delivery distance (miles)

48

25+48 x 0.142857 = £31.86

£26.67

£26.67

Total = £182.49

To the management of WWonka:

The report begins with an overview of the strengths and weaknesses of the ABC approach. Activity based costing system recognized all the activities that cause costs, included delivery, packaging. Under ABC, the company is able to calculate the cost of the resources used in each activity, and these costs will be more accurate compare the traditional absorption costing method. For instance, Product X is a low volume item which required a small amount of labour hours but many special machine setups and testing. Under the tradition costing model, it will allocate overhead cost by spreading it over a number of labour hours and will result in a low overhead cost because of the low labour hours, although it ignores the demand for setup and testing. However, ABC will overcome this problem by assigned overhead costs with all the activities that were involved. As a result, it helps to identify where high or low cost is incurred within the product mix. After the business analysis the data obtained from ABC costing, managers will have a better understand of unit costs. They can then decide their future product or operation planning. ABC system could help businesses to improve, as activity based management (ABM) involves focusing eliminating waste and reducing defects. Therefore, companies could improve profitability by monitoring total life cycle and performance.

Another advantage of using ABC system is that it focus to gain a competitive cost advantage over competitors, such as bench marketing allow firm looking externally, and examine how others businesses achieve their outstanding performance and. This facilitates improved performance by comparing different level of performance with similar sector. As a result, companies can easily identify expensive activities that can be for re-engineering.

On the other hand, the main limitation of ABC is that the implementation of systems requires management to identify and measure each cost drivers, so the company have to take the risk of spending too much time and money on gathering data. “An activity-based costing (ABC) system offers greater accuracy in production costing but requires more resources to generate this information” (Hansen, 2007, p85). Furthermore, an effective ABC system is difficult to set up and establish, especially when companies are using the traditional costing system method, because they are normally reluctant to use ABC at the first time, so they are likely to fail on assigning those indirect costs into activities and break down the ABC system.

Lastly, companies can see the results of ABC instantly but it takes a lot longer to experience the benefit from the system. Also, the activity cost rate needs to be updated regularly to ensure accurate result. The costs allocated within each activity are very complex and difficult to determine, and over concentration in one measure can lead to a negative effect on the whole costing system .Therefore, ABC system is costly to operate and it might be complex to understand for companies who just started using ABC.

After gathering data under the ABC for WWonka plc, we could now analysis the data by comparisons. The chat below indicates the costs assigned by each cost drivers under the ABC approach for both order A and B.

According to the chat above, the cost allocated to lines on invoice in order B are twice as much as the cost of order A. Since order B has a higher line of invoice than order A, therefore the costs allocated at this activity are expected to rise with a higher line of invoice. Furthermore, Delivery also indicate a huge different between these two orders. Delivery cost varies with the distance of delivery, and delivery distance for order B (48 miles) is much longer than order A (10 miles). As a result, the costs of delivery for order B is significantly higher.

Furthermore, some improvements can be made to the cost allocated with delivery. At first, the company should operate under the ABC system, so that they could eliminate the extra cost for longer journeys. According to the case, each general delivery journey cost £150 and it can either carry 6 large packages or 12 small packages. I would suggest WWonka Plc should expand their delivery department, for instance they can purchase new delivery vehicles that could carry more packages. By doing that, company would benefit from economic of scale by spreading the cost of delivery over multiple orders.

The pie chat above represents the proportion of selling and distribution cost allocated with each cost drivers. As we know, the most significant cost in WWonka Plc is packing, where 26% of the total overhead is from packing. It could be argued that WWonka Plc should cut cost on the packing department. If the major expense is labour cost, they should reduce the number of full time employees. However, to maintain fulfilment of the high seasonal orders over Christmas, the company would have to employ more part time workers during these periods. Another possible option for WWonka is to outsource the packing department. By outsourcing externally; the company could save money and focus on others core activities. Also, outsourcing is more flexible and it allows for seasonal or cyclical demand. As a result, it could reduce overhead costs and improve efficiency for WWonka Plc. To conclude, after WWonka Plc had analyzed the data obtained through activity-based costing and determined which activities are cost effective, it can then decide what improvements can be done to increase profits. The implementation of these changes is known as activity-based management (ABM).

ABC system can be used in almost any industry, and work most effectively at large and complex companies, since there will be more benefit for companies operating with diverse products and channels. Consequently, ABC has grown recently because companies are producing and selling more products to differentiate themselves from their competitors. As we know, each product has different demand on resources such as raw material, testing and process. So the cost of each product cannot be measured by a simple costing method that assigned cost to only one cost-pool such as direct labour hours. However, under ABC method, it allows overhead costs to be linked to different activities, so all costs have the cause and effect relationship with their respective cost drivers. “For each activity cost pool, ABC systems seek a cost-allocation base that has a cause-and-effect relationship with costs in the pool” (Bhimani, Horngren, Datar, & Foster, 2008, p348). As a result, using the ABC system could result in more accurate production costs. Companies that use ABC information for decision making are utilizing Activity-based management (ABM). The data gathered from the ABC approach enables them to decide which products could increase their profitability and focus on cost reduction. Therefore companies can create a much more accurate budget and improve on their product mix.

Moreover, ABC works more effectively if businesses identify all activities that use resources and determine which activities are necessary for each product. After companies assembled the data, they have to pay attention to determining all the elements of each activity cost, because many costs may be hidden. Also, ABC system requires more data gathering and analysis to ensure the costing system works effectively. The improvement in gathering the information makes it more cost effective to implement a costing system.

Finally, the introduction of technology to manufacture consequently decreases the amount of direct costs for companies. For instance, computer-integrated manufacturing (CIM) has reduced direct labour cost. On the other hand, the technology would increase indirect cost because managing a more complex production system requires more resources for supporting, such as testing and set up costs. Regarding the increase of the indirect cost, if we allocate it on the basis of direct manufacturing labour under the traditional method, the result gathered will not accurately reflect how resources have been used by different products. However, under the ABC approach, the cost of each product will be assigned to a number of indirect cost pools and because of that, we expected the cost of each product is more accurate compared to the existing costing method. Consequently, ABC might indicate that the production of some products is more complex than others. For example, it might require more specific activities like planning or assessment and so the cost of making it is much higher than the traditional costing system. As a result, the company would possibly have to negotiate a higher price for complex products to ensure they do not make a loss. Therefore, ABC method is most effective for complex companies with a range of products and activities involved.

“A key difference between ABC/M and the journal ledgers and traditional techniques of cost allocation is that ABC/M describes activities using an “action-verb-adjective-noun” grammar convention...this gives ABC/M its flexibility.” (Cokins, 2008, p3). This explains that using ABC/M, the managers and employees can have a greater understanding of the terms used and subsequently view activities differently and more favourably.

Bibliography

Luce, T (2003), Management Accounting, (5th edition), Continuum, Chapter 9, Budgetary Control, p209.

Hirsch Jr, M L (2006), Advances Management Accounting, (2nd edition), Thomson, Chapter 2, Issues Confronting Management, p 79-81

Weetman, P (2003), Management Accounting: An Introduction, (Third edition), Prentice Hall, Chapter 18, p.519-520

Bhimani, A, Horngren, C T, Datar, S M, & Foster, G (2008), Management And Cost Accounting, ( Fourth Edition), Prentice Hall, Chapter 11, p.342- 357

Cokins, G (2001). Activity Based Cost Management: an executive's guide. New York: John Wiley and Sons. p.8.

Hansen, D R (2007). Cost Management: Accounting & Control. Ohio: Cengage Learning. p.85.

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