Activity Based Costing
The traditional system of calculation of production costs was established decades ago when most companies were producing a limited range of products, and dominant production costs were the costs of basic materials and labor of production workers. Overhead costs were relatively small, so the distortion of production costs due to inadequate allocation of overhead costs on products were negligible. Costs for processing the information, however, used to be sufficiently high; hence, the application of more sophisticated methods of overhead allocation was unreasonably high.
Currently, companies produce a wide range of products, and labor costs of production workers make up a small part of the total cost as opposed to overhead, whose share is large enough. Therefore, simplified methods of allocating overhead costs to products using as the base work of production workers, whose share is reduced, no longer justify itself, especially in view of the trend that the cost of more complex information processing methods has ceased to be a barrier to their use. Moreover, the intense global competition throughout the 80s of the 20th century, as a result of errors, made bad decisions based on insufficient information more likely and more costly. Over the years, the cost of poor information system has educed the costs of the more modern cost accounting systems, as well as increased demand for more accurate data on the cost of production.
The decreasing cost of information processing has led to the trend that, in the 80 years of the last century, some companies in the U.S. and Europe began to use the functionality of the system of cost accounting. In the series of articles, which were based on monitoring the activities of the emerging systems, Cooper and Kaplan (in Askarany, Yazdifar & Askary, 2010) showed the conceptual ideas underlying them and suggested the term itself, the activity-based costing system (ABC). First, these articles were published in 1988.
Activity based costing is a special model for describing the costs of the firm that identifies and assigns the cost of each stage of work in accordance with the present value of each individual work (Askarany, Yazdifar, & Askary, 2010). This model also takes into account direct overhead costs, contrary to the conventional model of describing costs.
Activity based costing provides an analytical model that describes how specific products or customers use different amounts of services delivered from indirect or additional sources. In the first stage of the model, the ABC costs of purchased resources are linked with the actions and processes.
The costs and time are worth money and typically characterize the results of any process. Quality and time need to be measured; therefore, it is necessary to appreciate them, which is usually an easy process. However, costs are certain form of analytical "design", and they are not always tangible: it is impossible to measure how a stopwatch calibrates the laser tool. Only the ABC model can accurately track all the expenses of an organization: procurement, production, distribution or delivery. Thus, the model correctly made ABC a major element in assessing the cost of internal components based on a balanced scorecard.
However, the definition of the operational costs of the processes is only the first step, after which the managers and employees should act with the goal of costs optimization. Activity -based management include those features that enhance efficiency, reduce costs, and improve assets utilization. ABC tends to either increase capacity or reduce costs in such a way that less physical, human and working capital resources are required for the production of products or services (Yahya-Zadeh, 2011). The financial benefits from the management of activity-based system are cost reduction, revenue growth (due to the better use of resources), as well as the possibility to avoid the overhead costs. Building on the productivity of existing resources eliminates the need for additional investment in capital and people.
As it was previously mentioned, activity based costing method is based on the costs generated by performing of certain operations (activities functions). The process of calculating the cost of production (works, services) allows for a phased distribution of indirect costs, and more accurate determination of the cost of products. As part of the ABC method, all operations can be divided into the costs units. The cost center is an organizational unit of the enterprise (brigade, division, section, shop) that performs a specific function, the implementation of which requires certain resources. Cost centers are classified according to the features of the manufacturing operations and the level of hierarchy in the organization and production system of the company. As a rule, industrial facilities include the a couple of groups of cost centers.
Production cost centers are characterized by process set-up, which leads to a qualitative change in the physical-and-chemical properties and / or states of matter, production equipment, qualified personnel, and others. Production cost centers can be divided into major and minor divisions.
Overhead cost centers - organizational units within each business unit, required for support of the process of production, organization and management of production units, departments, workshops, and the overall production.
Total economic cost centers comprise of the managerial administrative departments of the enterprise. In practice, general administrative costs correspond to the level of the hierarchy of the organization; they are unconditional, not dependent on the specific operating parameters, which determine the cost of the period. Costs are directly related to the period of the financial results and are accounted within the general cost of production.
Servicing cost center includes the objects of household, socio-cultural sphere, and health centers.
In accordance with the method, indirect costs are allocated to the common sites of occurrence; they are projected consistently to the more detailed cost center further are split up based on the direct place of manufacture. Terms of allocation of indirect costs from one level to another are developed on the basis of economic, technological, economic entities, and relationships cost centers.
From a mathematical point of view, the indirect costs are a multi-dimensional vector characterized not only by the volume (unit vector), but also the direction of the target. The set cost center is the coordinate system of the multidimensional space.
The scheme of cost allocation is based on the nature of the costs and interdependencies between the cost centers. The base for allocation of indirect costs is set by identifying the correlation between the change in the physical distribution base index and the change in volume of the indirect costs of production, and performance of work or services.
A classic example is the distribution of shop maintenance costs of the building, at the production sites in proportion to the area occupied by the utility, and the cost of the management of the shop - in proportion to the number of personnel on product lines (Cokins, Capusneanu & Barbu, 2011).
The next step is the distribution of non-composite indivisible cost centers, which directly organize production (production cost centers) into the objects of calculation depending on the properties of the nomenclature of manufactured products, as well as on the characteristics of expenditures of individuals and groups identified. The result of all indirect costs is allocated to the manufactured commodity item.
It is rather important to calculate the cost of production accurately; first, it is necessary to bring order to the system of planning and cost management. The choice of method of cost calculation is largely determined by the specific organization and the existing accounting systems. The most appropriate method to apply the ABC is when simple tools are exhausted. Errors in the calculation of the cost may lead to incorrect management decisions.
Fixed costs, which are considered weakly dependent on the volume of production, are often viewed as inevitable and, therefore, having little control. This is the definition of a limited approach to managing such costs. All cost categories are the result of management decisions. Most of the costs, which were considered constant, for a long time, could be considered as variables in terms of certain factors; this choice depends on management decisions (Schulze, Seuring & Ewering, 2012). The importance of such solutions is growing proportionately share of such costs, the correct interpretation of which has a significant impact, in the long run, while impacting the success of the company in a competitive environment.
The above features can be distinguished as the main advantages of the ABC method. First of all, the main advantage is the precise definition of production costs, the ability to eliminate wasteful spending. This method is also an effective mechanism for cost management and profit optimization as it allows determining the "contribution" of each product, each customer, and each geographic area to the overall financial performance. It gives the ability to control not only of the costs, but also the reasons for their appearance. It can be used as a tool to develop an effective pricing and marketing policies.
ABC method usage also helps to increase the validity of attributing overhead costs for a particular product, and, as a result, to produce an accurate calculation of the cost. It also supports the creation of continuous flow of information obtained within the process of expenses formation.
The above system can significantly reduce the costs of enterprises and improve the relationship between the individual units; thus, it has great potential for the enterprises. The most effective use of the ABC method is in case of highly diversified companies in complex commercial settings, where the share of indirect costs in the cost structure is significant.
The main disadvantages associated with the introduction and use of ABC-method can be seen in its labor intensity, complexity, and significant financial and physical costs of its production. Cost accounting system to the cost (responsibility centers) depends on the existing organizational structure of the enterprise. The scope of the cost accounting system is not limited to any conditions, but the greatest effect on its implementation can be obtained in large industrial complexes with a lot of information processing.
The main disadvantage is associated with the implementation of the cost accounting responsibility centers, it is resource intensive. In addition, the introduction of the system requires the formulation of integrated information systems, resulting in additional investment costs and increasing qualification requirements for personnel to work in the information system (Fritzsch, 2011). As a result, it requires significant changes in the accounting system and improvement of information support systems, which leads to an increase in management costs.
The information reflected by the target costing needs to be arranged in the extra-systemic way, especially at the stage of budgeting and forecasting (Stanley & Confidence, 2013). For this purpose, a register is required, in which the actual (forecasted) and target costing and variance are recorded. A differentiated approach is needed in each case. The use of cost accounting activities will identify underperforming activities and thus facilitate the optimization of staff, thus reducing costs and ensuring the competitiveness of the enterprise. Costing activities have some flexibility in terms of the scope of implementation: the system can be implemented in one division, department or within a single business process or enterprise-wide.
Therefore, the aim of activity based costing is to define accurately the relationship between the indirect (overhead) costs and products. This method allows to track overhead costs by product (while taking into account the dynamics of the overhead costs), as well as determine the cause of expenditures, as well as their weights in the final products. As a result, it becomes possible to control and manage overhead costs. This approach is focusing on business management based on the types of activities (business processes), which together form the essence of the organization.
Activity based costing is a progressive concept that can overcome the limitations of traditional cost accounting system and establish a causal link between the products necessary for the production costs. Many elements of this system are not original and are not new, they have been used in the past. However, the merit of the creators of the ABC concept consists precisely in the ability to combine proven and new ideas and methods into a single set.
In a highly competitive market, one of the main advantages is the lowering of the cost of production. Errors in the calculation of the cost may lead to wrong management decisions: phasing out cost-effective products, or conversely, increasing the output of low margin goods. Application of the technique of the activity based costing (ABC) allows the manager to determine the cost of a product, especially in a situation, where indirect costs exceed the direct costs.
The practice of mass application of ABC showed that the use of activity based costing in its commonly known approach is extremely time-consuming because of its downsides. The activity model requires considerable effort to keep its maintenance (open) state. The benefits of these efforts are inferior costs. That is to say, ABC ideology of accounting assumes a continuous improvement, on a case by case basis. Moreover, the approach is based on a balanced set of indicators while the place is constantly evolving.