Difficulties encountered in writing Activity Based costing assignment/assessments?
Activity based cost accounting assignments are usually lengthy and time consuming as they involve collating analysing, demarcating and assigning costs. Cost accounting is a subset of the diverse field of accounting and helps assessing costs associated with production. This information is ultimately used by the management in exercising cost control and manages the same in the future and hence is complex in nature.
Activity Costing Based system requires some amount of rethinking as one has to keep aside what they have learnt in the traditional form of accounting. Students need to break down the business activities into separate components and many find it difficult to analyse and create demarcations for the same. The information required for segregating activities is not readily given in the problems as is the case in real life scenarios and students really need to apply their minds well to get past this stage and move ahead in creating the assignment solution.
This forms the basis of costing system and hence if students are not clear with their concepts at this stage they could go wrong entirely. Once activities are identified the next step would be to allocate costs to the same and this too would require precision. Assignments under this subject would entail such problems are students are being trained to deal with real scenarios in the corporate world.
Calculations are just one aspect of any accounting assignments, understanding the theories and applying the correct concepts go a long way in making sure that students are calculating using the relevant and right numbers.
Further, many a times students are expected to work on software and the skills pertaining to the same need to be learnt. Notably many students, who haven't taken accounting as a core subject initially like those from the science background, find it difficult to solve assignments independently.
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ACTIVITY BASED COSTING
The Activity-Based Costing concept refers to a different way of accounting for manufacturing activities. It pays attention to activities performed to manufacture a product. Costs are associated with the activities and not directly to products. It works on the assumption that costs emanate from activities and that activities result in costs and products are produced based on activities. Each product requires a certain set of activities and thus each activity becomes a cost for producing that product.
The traditional method of assigning costs to products entails assigning costs to organisational units such as a particular department within the organisation or to a plant. Under the Activity Based Costing system works on the principle and every activity consumes resources and hence a cost is incurred. Thus Activity Based costing has gained more popularity as it is considered more appropriate and logical as opposed to the traditional approach which over simplifies cost allocation. In traditional accounting two activities might be requiring the same level of direct costs but the difference in requirement of overheads like marketing costs may be different.
The approach to Activity Based Costing begins with identifying each activity which goes into producing various products. Costs are assigned to each of these activities and then the cost of products is determined based on which activity they require. For example a product which is mass based would use equal amount of labour and raw materials as a customised product. However a product which is customised may require more marketing or engineering time. This delta does not get accounted for in the traditional costing system. In-fact as a company expands its portfolio of customised products; the activity based costing system would provide a better picture of the company's financials as indirect costs are allocated more accurately.
Activity-based Accounting, also called Activity Based Costing (ABC) assigns overhead costs to products by allocating it on the basis of its relationship with the manufactured product. It first divides the costs into different buckets which are called cost pools. Post this the cost drivers are identified (cost driver could be machine hours, units produced, units sold). Once both cost pool and cost driver are detected, then the cost is allocated based on the cost driver rate.
Traditional cost measurement systems depend on volume (units sold/produced) to allocate indirect or overhead costs to products while the ABC system classifies cost into five broad levels of activity which include batch-level activity, unit-level activity, customer-level activity, organisation-sustaining activity, and product-level activity.
Robert Kaplan came up with this concept of Activity Based Accounting. In the 1970s the ABC method was introduced to solve the problems that occurred while using the traditional methods of costing.
Traditionally, accountants used the percentage method of assigning indirect costs to products. As organisations started producing a wide variety of products, the percentage method proved inaccurate as all products did not incur the same percentage of expenses. For example, in case a machine is used extensively for one product (let's say Product A) but is also used for other products subtly, the overhead cost of the machine should be charged more to Product 'A' and lesser to the other products the machine is used for. Therefore, Activity Based Accounting gained importance. Instead of using the same percentages to allocate costs across different types of products, ABC tries to identify cause and effect relationship to assign costs accurately.
Activity-based costing enhances the costing process. It divides the value into many different cost pools instead of accumulating all values in one company-wide pool. It is done on the basis of activity. Then it assigns this cost based on the actual utilisation instead of by volume. For example, the production cost would be allocated on the basis of machine hours.
Though this method is extensively used in the manufacturing sector, it can be used in Financial Institutions as well as they could be dealing with different types of financial products and the majority of the cost are indirect.
HOW IT WORKS
Let us try to understand how ABC works with the help of an example:
Consider that we are trying to determine the total cost incurred on automobile parts.
- Identify the cost pools, which in this case would be - machine setup cost, packaging cost, selling cost, production runs.
- Assign cost drivers to each cost pool - for machine setup cost it would be units, for production runs it would be hours, etc.
- Determine the cost driver rate which would be the total cost in the cost pool divided by the total cost drivers (Total setup cost/Total number of units produced).
- We can now use the cost driver rate in determining the cost of the product. If 100 units of Product A is manufactured and the cost driver rate for machine setup comes to $4, then the total machine setup cost allocated to Product A would be $400. Similarly, the other overhead costs would be calculated depending on the specific cost pool's cost driver rate and the total expenses for the product would be determined.
ADVANTAGES & DISADVANTAGES
Advantages of ABC method are:
- ABC is an accurate and reliable form of costing which determines the cost based on cost and effect relationship in the cost occurrence.
- It helps in evaluating investments in new technologies
- Since ABC method determines the cost relationship, it helps in identifying the non-value adding services and can help as an effective tool in controlling/eliminating such costs.
- It helps in better decision making as the cost assigned would be accurate, and profitability can be more reliably determined using this method.
- ABC method is quite expensive and complicated. Determining cost pools and cost drivers are relatively more complex than traditional accounting methods
- This method treats fixed costs as a variable which sometimes leads to wrong decision making.
- Being costly and complex to implement, it is not useful for smaller firms.
Activity-based costing ensures that each product gets a share of the cost depending on the proportion in which the activity or cost pool is used for the product. Implementing ABC system gives better control over the costs of the organisation. It is an advantageous methodology in this era of conglomerates. Along with helping in making major financial decisions, it will also help in proper pricing which would help to survive the massive competition in the market. Accurate costing would lead to better pricing, and that would help get more buyers and stay ahead of the competitors.