Management accounting provides a business the accounting and other related information, in the best interest to the business, to support its internal decision making. It consists of several processes to include cost-volume-profit analysis, product costing and the activity based costing. Management accounting is constructed and managed within the internal systems of the business. Management accounting is the internal part of a business that the business’s base is formed. It supports the business’s goals and uses its systems to provide the desired results to its stakeholders and customers.
“Management accounting provides information to help managers plan and control operations as they lead the business”. (Horngren and Harrison, 2007, pg. 901) Managers use this information to direct and control the daily operation of the organization. Operations in management accounting also include the business’s equipment and human resources. Management accounting requires managers to provide information to show the business’s performance results and future goals. This information is used within the business but the managers have a responsibility to the external stakeholders of the business to provide them with a trusted investment. Planning is used to choose and decide how the business will achieve its desired goals. Managers must decide the best course of action for the business during this stage. This is the stage where the decision is made whether or not the selling price should be raised or should the business invest more in the marketing of the product. Management accounting is used to control the data on the businesses planned or budgeted costs to the actual costs, as well as, the budgeted labor costs to the actual labor costs. During this control process, managers must compare the budgeted and actual costs, identify the significant variances, conduct an investigation as to what caused the variances, and provide justifiable course of action to rectify the variances.
Planning for the business requires the manager to select a needed course of action and decide how to make the action happen in for the business. Managers must also identify several alternatives of how to meet the course of action and then choose the one that is along the same lines as the business’s mission. The budget is a quantitatively expressed because it shows the resources needed to achieve the goals. The business’s annual budget is prepared by the controller, the manager of the accounting department of the business, will show the expected financial impact of the choices made by the managers to achieve the business’s goals.
During the controlling phase, this is when managers check to see if the course of action chosen is being implemented. Managers will compare the budgeted costs to the actual costs and evaluate the outcome of the results. This information lets the managers know if the chosen course of action is on track or if adjustments are needed. Using this information aids managers in their decisions of what will be the best course of action for the business.
Management accounting uses the practice of cost control techniques. Activity based costing (ABC) is one of these techniques that is commonly used. ABC is an accounting system that is used internally to track the activities of the business. Once the activities are identified, a separate allocation is assigned to each activity. ABC methodology relies on a series of terms listed below:
Ø Cost driver
Ø Cost center
Ø Cost allocation
Ø Fixed cost
Ø Variable cost
The cost driver is a term used to define “any activity that causes a cost to be incurred” (Wikipedia, 2007). Related to the cost driver, the difference between ABC method and traditional methods is the fact that traditional methods consider volume of output to be the only cost driver. ABC takes other cost drivers into consideration, like: maintenance costs, handling raw-material costs, inspection costs, or other indirect costs that may vary for each process.
Another factor that the ABC methodology takes into consideration is the cost center. Such a cost center represents any division, department, compartment of the company that generates direct costs on the one hand, and indirect profit on the other hand. Although these cost centers do not generate direct profits for the company, their existence might be vital for the company’s well-functioning and healthy structure. Therefore, these cost centers should not be regarded only as generating negative aspects.
Cost allocation basically represents the process of establishing costs for each activity of a process, project, or company. It is a term that ABC relates very much to. In fact, ABC method can be considered a modern method of cost allocation.
Fixed costs are obviously those expenses whose proportion is not dependent on the changing proportion of the activity in case. These costs are invariable, they do not change. Of course, they change, but only under the changing of time.
Variable costs are the opposite of fixed costs. These costs are variable in accordance with the size of the activity in case, or its volume. Fixed costs and variable costs compose the total cost that ABC method should establish by its nature.
The ABC system is performed in four steps. Step one; the activities are identified and the total indirect costs are estimated. Indirect costs are those costs that are included in the business’s manufacturing overhead because these are costs that cannot be traced to an individual item in the production. “For example, in a commercial bakery, the direct costs for a line of carrot muffins include the costs of the flour, sugar and carrots. The amount of flour and sugar actually required to make the muffins is used to determine the cost allocation.” (wiseGEEK) Step two; the cost driver for each activity is identified and the total quantity of each driver’s allocation base is identified. This is where the business must decide which activity and function will be used to measure services and or production costs. Step three; the cost allocation rate for each activity is computed. This rate is equal to the estimated total indirect cost divided by the estimated total quantity of the allocation base. Step four; the indirect costs to the cost object are allocated. These costs are the most accurate cost because ABC considers the resources each product actually uses, thus giving a more conclusive cost.
ABC is based on two main principles. The first of them states that in order to obtain the most suitable results through this method, management attention must focus on the total real cost needed for producing a product or service. The second principle states that the same management attention must be used as a basis for full cost recovery. The most suitable products or services for which ABC method can be used are support services, given the units of output they produce, units that are quite easy to identify and measure.
Any costing method has its advantages and its disadvantages. Such issues may not be even considered as either advantages or disadvantages, but as issues that are either suitable or not for a certain situation. Activity Based Costing may be best suitable for certain situations, while traditional costing is better for other situations. However, the following lines will present a series of ABC’s advantages.
One of the most appreciated advantages that ABC brings refers to its ability to provide superior information on a company’s cost for producing a product or service. This brings increased efficiency for the decision making process. This aspect is very important, as it reflects on the company’s entire activity and well-functioning.
Other advantages of ABC are:
Ø It provides insight on all elements of cost overhead
Ø It improves product profitability and customer profitability as well due to its total life-cycle cost and performance monitoring
Ø It improves budget effectiveness due to the fact that it identifies the relationship between cost and performance regarding different service levels
Ø ABC is a continuous improvement process and ensures total quality control
Ø It is responsible for linking corporate strategy to operational decision making
Ø It helps identify and eliminate waste because of non-value added activities by providing visibility on them
Ø It also improves the process of making decisions regarding product costs and manufacturing process (Brimson, 2006).
In other words, ABC helps better understand real costs, productivity, product profitability, it helps ensure more accurate pricing, and it helps save time, effort and money that are sometimes allocated in the wrong direction.
Also ABC presents so many advantages; it also comes with a series of disadvantages.
These disadvantages are:
Ø The data required by ABC takes a significant amount of time to collect. Therefore, although ABC helps save time with certain aspects, it also consumes more time with other aspects. In other words, the ABC advantage regarding time saving can be annulated be the same disadvantage, disposed differently
Ø ABC usually requires an ABC software, which is usually quite expensive to buy, implement, and maintain
Ø Due to the waste visibility it provides, ABC is not used by certain managers that wish that this waste passes without being noticed
In opposition to the Activity Based Costing, traditional cost accounting is a method through which manufacturing overhead costs are allocated to manufactured products. This method is also referred to as the conventional method. This method “assigns or allocates the factory’s indirect costs to the items manufactured on the basis of volume such as the number of units produced, the direct labor hours, or the production machine hours” (ACoach, 2007).
The general difference between the two approaches has been presented above. However, the two methods also present a series of specific differences that refer to accuracy, flexibility, targeting unsupported costs, currency, outsourcing, efficiency and cost containment, study achievability, forecasting resource requirements, facilitating “what if” analyses.
Regarding accuracy, the traditional method is not able to provide an accurate estimation of a project’s costs. The sole situation in which the traditional method can provide accurate data is if the factors influencing the current project are relatively constant from one project to another. Given the fact that ABC takes into consideration factors like current hourly costs for each specific activity, the estimates provided by ABC will be significantly more accurate.
Regarding flexibility, given the fact that the traditional method is based on similar studies, its flexibility degree is reduced. ABC is based on features of each project, therefore providing a high flexibility degree.
Another difference between the two methods refers to currency. Because the traditional method is based on similar cases, some of them being obsolete, this method cannot adapt to new circumstances like ABC does, by easily adapting to any changes that might occur.
ABC presents advantages over the traditional method even in an aspect like outsourcing. While ABC is able to estimate costs for any outsourcing model, the traditional method is not able to do so, as it is based on older information.
Also, the traditional method is a top-down method, operating at the top cost level, while ABC is a bottom-up method, which allows planners to make any adjustments on the process. ABC is also a more rapid method than the traditional method, being able to make rapid calculations and adapt to various scenarios.
Businesses use these techniques to make better or more accurate and detailed decisions about what the sales price of products should be, what items customers are searching to buy or need in their daily lives, and what customer service needs or products could and should be offered. ABC does provide an increase in profits and meets the needs of the customer with the business’s product and or services. When a business implements effective costing measures it has a more accurate account of the business’s profits.
Horngren, C. T., & Harrison, Jr., W. T. (2007). Accounting. Upper Saddle River, New Jersey: Pearson Custom Publishing.
What is activity based costing? Retrieved November 22, 2009 from http://www.wisegeek.com/what-is-activity-based-costing.htm
Cost driver (2007). Wikipedia, the free encyclopedia. Retrieved November 19, 2009 from http://en.wikipedia.org/wiki/Cost_driver.
Brimson (2006). Value Creation Group Inc. Retrieved November 19, 2009 from http://www.valuecreationgroup.com/activity_based_costing_benefits.htm
What is the traditional method used in cost accounting? (2007). Accounting Coach online. Retrieved November 20, 2009 from http://blog.accountingcoach.com/taditional-method-cost-accounting/.