Typically Cost System Can Be Classified As Direct Costing System Accounting Essay

Critical positions about activity based costing system

Activity based costing system, which developed in the late 1980 ‘s, is a comparatively new technique of direction accounting. It is considered to supply more accurate cost information for directors, but there are besides some statements against it. In this essay, this new technique will be critically evaluated, foremost by discoursing the defect of old traditional costing system compared with activity based costing system, which may do spreading of inaccurate cost information. And so it points out how this new technique tried to work out the job accrued in traditional technique and how activity based bing system innovated the costing system by its new mechanics, with more accurate cost information. However, because nil can be precisely perfect, in the terminal of this essay, the restrictions of the activity based costing system, which may ensue in misdirecting the directors with possible inaccurate cost information, will besides be disclosed.

By and large, cost information, particularly the accurate cost information, is one of the most important determining factors for decision-making in the house. As what said by Cooper and Kaplan, “ determinations about pricing, selling, merchandise design and mix are among the most of import 1s directors make. None of them can be made efficaciously without accurate cognition of merchandise costs ( Cooper and Kaplan, 1988 ) ” . To obtain cost information, a cost accretion system is required to be designed to get by with accomplished production costs and enable costs to be allowed to merchandises in an acceptable mode. Therefore, there are demands for a cost accretion system in bring forthing relevant cost information for decision-making ( Drury, 2008 ) .

Typically, cost system can be classified as direct costing system, traditional soaking up bing system, and eventually activity based costing system ( Drury, 2008 ) . Direct bing system merely assign direct costs to be object, which could do jobs with the indirect cost information. Different from the direct costing system, traditional soaking up bing system allows the assignment of indirect cost, and it seek to work out the job by utilizing an overhead rate ( factory broad ) , which most of them were based on a individual production volume based measuring like direct labor hours or machine hours. It is utile and satisfied the houses during the old period merely when deformations from apportioning mill and corporate operating expense by load rates on direct labor were minor ( Cooper and Kaplan, 1988 ) .

However, unluckily, it could non be using to development of engineering, and the growth of the houses, where they were bring forthing wider and more diverse merchandise ranges, and the input of labor to the production procedure was worsening compared to the start of the century ( Cooper and Kaplan, 1988 ) . It is the alteration in engineering and the production procedure that made it more hard to follow production costs to merchandise lines, with the usage of traditional costing system. As the chief the map of traditional costing system is inventory rating, traditional method ignores costs of activities outside the works by merely delegating indirect cost ( besides could be called operating expenses ) straight to merchandises instead than to activities, which causes job of describing inaccurate cost information.

As operating expenses, for illustration, selling, distribution, technology, factory support operations, and other overhead maps bit by bit become the major beginning of cost in most fabrication companies, the traditional cost system is evidently no longer be suited for the new environment, because it merely merely tends to group all operating expenses and delegating them to merchandises on the footing of volume of end product. Additionally, traditional system seems non to bespeak the grounds why the cost is happened to the house, hence, when the house cut operating expense costs, it is cutting the consequence, but non the cause ( Peter and Turney, 2000 ) . As a consequence, it is more likely to damage the quality of merchandises and services than to cut down costs for good.

Therefore, in the late 1980 ‘s, accounting profession in the universe begun to see a new alternate costing system to avoid the defects of the traditional merchandise ( goods or services ) bing system. The reply suggested to this phenomenon, chiefly by Cooper and Kaplan, was to apportion costs harmonizing to the extent to which merchandises ( goods or services ) really ‘consumed ‘ the clip, activities, and costs of the assorted divisions of the house which ‘serviced ‘ their production, and they referred to as ‘activity based bing system ‘ ( ABC system ) . The logic of ABC system is that more finely structured activity-cost polls with activity-specific cost-allocation bases, which are cost drivers for the cost pools. And this new technique is considered to offer more accurate merchandise costs, through the method of apportioning costs to merchandises by mensurating the cost-allocation bases of different activities used by different merchandises.

Harmonizing to Cooper and Kaplan, the chief theory behind this activity based costing system is that all of a company ‘s activities should be considered merchandise costs, as they exist to back up the production and bringing of today ‘s goods and services. And since about all mill and corporate support costs are divisible or dissociable, they can be split apart and traced to single merchandises. Consequently, based on the analysis above, activity based bing system provides an alternate and more accurate manner of delegating indirect costs to merchandises and services.

ABC system establishes a relationship between common disbursals and the activities which generate these costs, and perceives defects of traditional bing system of covering with operating expenses ( Innes and Mitchell, 2000 ) . Figure 1.1 shows how the activity based costing system designed to supply merchandise cost information. The first measure of set uping the ABC system is to placing the major cost activities that taken topographic point in a house. Then by given the activities that have been identified, cost drivers should be chosen in the following measure. With ABC system, cost drivers are based on the degree of activity at the house ‘s capacity instead than on the budgeted degree of production as in traditional system, hence, the ABC system could accurately mensurate the assorted merchandises ‘ ingestion of activities. The 3rd measure is to make cost pool for each activity in ABC system. This phase of bring forthing cost pools for the nucleus activities could assist houses looking for chances to better their patterns and could, in bend, lead to the potency for cost decreases. Finally, activity costs are attributed to be objects based on cost driver rates, which are calculated by spliting a period ‘s activity costs driver volumes, and the accurate cost information could be passed to the directors for decision-making.

Tracing to merchandises

Making cost pools

Determining cost driver

Indentifying activities

Figure1.1 the basic mechanics of an ABC system

By set uping such a technique, ABC system foremost introduce bing system with more accurate cost information by delegating costs harmonizing to the activity based on measurings of resources used ( Innes and Mitchell, 2000 ) . Figure 1.2 given below more visually indicates that how ABC system creates a different method for get bying with operating expenses, avoiding the defect of traditional costing system. In phase 1, operating expense costs are charged to activity based cost pools in ABC system, alternatively of sorting overhead cost by production sections ( in traditional system ) , which is more decently linked relevant cost with its merchandises. ABC system relies on a greater figure and assortment of cost drivers, in other words, ABC system uses both volume-based[ 1 ]and non-volume-based cost drivers, which could besides be called activity cost driver based rate[ 2 ]. Because utilizing merely volume-based cost drivers to delegate non-volume related operating expense costs can ensue in the coverage of deformed merchandise costs. See an illustration of one activity – puting up a machine. Set-up resources are consumed each clip a machine is changed from one merchandise to another. As more set-up resources are consumed, the figure of set-up, instead than the figure of units produced, is a more appropriate step of the ingestion of set-up activity ( Drury, 2008 ) . Furthermore, as shown in the phase 2, with ABC system, costs are assigned to be objects based on their usage of activities and usage activity cost driver based rates, but non harmonizing to simple volume based overhead rates ( Innes and Mitchell, 2000 ) . As the multiple specific cost driver rate is more accurate than singe volume-based cost driver rate, hence, directors could acquire more accurate cost information under ABC system.

Traditional costing system

Stage1: overhead departmentalisation Stages2: Tracing to merchandises ( by soaking up rates )

Production volume based following cost into

Operating expense

Cost

Departments overhead rates merchandises lines

Activity based cost system

Stage1: overhead cost pooling Stage2: Tracing to merchandises ( by cost driver rates )

Activity based activity cost tracing costs into

Cost pools driver based rates merchandise lines

Operating expense

Cost

Figure 1.2 Difference between ABC system and traditional system in handling with overhead cost

Second, ABC system innovates bing system with more accurate cost information where costs are assigned to be objects ( Peter B. and B. Turney, 2000 ) . ABC system assigns activity to be objects based on the activity drivers that accurately measure ingestion of the activity. An activity driver is a step of the ingestion of an activity by a cost object ( such as a merchandise ) . As a consequence, the ABC system corrects the inaccuracy of the traditional system by taking the activity driver that could accurately mensurate cost ingestion by each merchandise.

In a amount, based on the treatment before, it could be confirmed that ABC system is by and large superior to traditional costing system, describing more accurate merchandise cost information by its invention. To get down with, it occurs because ABC system have a better apprehension of what factors drive operating expenses, by utilizing more activity drivers and more types of activity drivers ( Innes and Mitchell, 2000 ) . ABC system points out the fact that many operating expenses, conventionally classified as fixed costs ( such as buying, and set-up ) , are in fact susceptible to fluctuation, non in response to volume alterations, but in response to alterations in the activities which cause their incurrence. ABC information, which clearly links these operating expenses to the underlying resource consuming activities through the selected cost drivers, pinpoints how such influence can be exercised through determinations which affect the cost driver volume. Thus the director are provided with a greater overhead cost visibleness, a clear indicant of overhead cost causality and can therefore exercising more effectual procedure cost control ( Innes and Mitchell, 2000 ) . This could be concluded as a cardinal benefit of ABC system and an of import grounds for why ABC system supplying more accurate cost information.

Additionally, by cognizing that what activities costs aids in placing of import activities-those with greatest potency for cost decrease, this new method of activity cost could besides let directors to pattern the impact of cost decrease actions and to later corroborate that salvaging were achieved ( Innes and Mitchell, 2000 ) . Consequently, ABC system seeks to assist houses derive more competitory advantages through better operating expense cost ascription in a quickly altering concern universe, and enables better control of operating expense costs, and therefore enhances the value for money, through greater apprehension of the factors that drive them, at the same clip, reviewing direction accounting by its development.

In add-on, by supplying more accurate and elaborate merchandise information and procedure costs, ABC system as a valuable accounting pool, can be utilized by direction in decision-making procedure ( Innes and Mitchell, 2000 ) . It enables better selling and investing determinations as a effect of more accurate and dependable merchandise costs ; and it is able to assist directors to do better-informed direction determinations refering the existent merchandise pricing, merchandise volumes, market sections, merchandise lines, and mark costing. As a consequence, ABC system exerts a far-reaching impact on direction accounting of houses, and recently usage of ABC has shifted more form merchandise bing to assisting direction with a better apprehension of costs and facts that influence these costs, which can be listed as followers.

ABC system could take to betterment of the decision-making in the house, particularly, for the long term determination. Kaplan, Cooper, and Shank all link ABC system to the support three cardinal countries of strategic decision-making within the house: foremost, because of the greater truth of merchandise bing brought by ABC system, it enhances dependability of the cost information, assisting the house to find sensible monetary value for their merchandises in order to escalate market competition ; second, it improves the decision-making by altering the merchandises range and mix through the publicity, demotion and discontinuation of bing lines ; third, it could hold effectual influence on the development and design of new merchandises. In add-on, when usage in ABC information will be the top managerial policy and hence, there is the indicant which it gives of long-run variable cost ( Johnson and Kaplan, 1987 ) which is the most relevant cost information for long term determinations.

However, despite of the advantages of ABC system, there are still some bounds to ABC system ‘s ability to describe accurate merchandise costs, in other words, under some state of affairs, ABC system may non truly supply troughs with accurate cost information. The job accrued because there are ever some activities non straight associated with merchandises or clients. Activities that sustain a works, for illustration, are really hard to delegate to the merchandises. Such activities may include cleansing, securing, and landscaping the works ECT. It is reasonably easy, nevertheless, to delegate cost to these prolonging activities. The cost of an dismay monitoring service, for illustration, can be assigned straight to the works security activity. The cost of a landscaping service can be assigned to the landscape gardening activity. But we can non delegate the cost of these activities to merchandises straight. We do non landscape merchandises, and it is non possible to obtain information about the landscape gardening cost of each merchandises. ( Peter and Turney, 2000 )

Not merely the activities straight associated with merchandises may do job in the truth of cost information, some other jobs with ABC system could besides increase the possibility of describing inaccurate cost information. ABC information is historic and internally orientated and hence deficiency of direct relevancy for future strategic determinations. With the ABC system, the basic cost information is derived from traditional accrual based costing processs. The terminal merchandise, as a consequence, may endure from the flightiness of temporal allotments such as depreciation and development. ( J.Innes etc, 2000 ) And another job accrued with ABC system may impact the truth of cost information is the choice of cost drivers. Sometimes it is hard to happen drivers with a direct relationship to each operating expense cost. There is a uncertainty that whether even a really elaborate division of costs into a big figure of cost pools will of all time accomplish a perfect homogeneousness within each pool.

As a consequence, after the popularity of ABC system in the 1990s, in the undermentioned decennary, many studies reported usage rates of ABC was about merely 50 per centums. However, harmonizing to a recent study about 384 fabrication and service companies worldwide taken by Williamson Stratton ect. , the ABC to go on to offer houses of import value from strategic and operational positions. ( Williamson Stratton,2009 )

In a decision, although, ABC system seems to hold some jobs in placing activities and choosing cost drivers ect. , it still benefits the houses by supplying more accurate information for merchandise pricing, at the same clip including more accurate profitableness analysis and betterment of cost control ECT. And activity based bing system continues to be a logical, acceptable and comprehendible footing for bing work.