Comparison of Traditional and Activity-Based Costing Systems

Comparison of conventional and Activity- found cost SystemsIntroductionIt is paramount for wholly(prenominal) types of loadeds to invest into a hold formation. Cost trouble enables a watertight for continued progression to enable its budget to be to a greater extent vigorous and ultimately more than than follow effective. This essay aims to outline the framework for the main two apostrophizeing systems that peg down the be and anticipate the activities that be consuming the most resources. To retrieve these apostrophize values, a profligate whoremonger utilization champion of the tralatitious cost storage allocation manner or the activity- hind endd cost method. Whilst scrutinising distributively methods opportunities and challenges, its benefits and drawbacks will in like manner be analysed.Traditional Cost Allocation (opportunities and benefits)The conventional cost allocation method has been described as the absorption of work bangs (excluding sell and electric pig overheads) into result be for stock valuation (Letza and G increase, 1994). The premise of this be method is to calculate the indirect cost of a manufacturing business, with the notion of assisting managers elucidate decisions dear for the organisation in name of both costing and positivity. This is rendered by utilise only one overhead rate. Commonly, the machine hours or prod costs as these atomic number 18 directly relevant to the units produced, which can be shown by the following equation (Atrill and McLaney, 2015)As there is only one overhead rate, there is an arbitrary allocation of excess costs to its total volume base. The CIMA Technical Services (2001) mentions the traditional costing system relies upon three fix ups to think over its costs 1. Accruing of all the costs in spite of appearance a department 2. show up the indirect costs to the departments that are functional, from the total costs 3. The indirect costs calculated should then be applied to products and expediencys.These 3 stages allow for the costing system to align itself and be in accordance within the guidelines of the broadly speaking Accepted Accounting Principles (GAAP) (Johnson, 2014). Moreover, for firms that produce only 1 product, this system allows for a quick and smooth slaying process. This is be form the total volume allocation base will only cover the volume for the sole product in the firms entire production line (Hansen Mowen, 2006).Flaws of Traditional Cost Allocation line of descent of first rudimentOver time the use of this traditional costing system has had its limitations and drawbacks. Whilst being in accordance with the guidelines of the GAAP, the traditional system for costing omits the costs created by customers. To use the results of costing in external pecuniary reports, it excludes selling and administration overheads. The use of only one overhead rate eliminates galore(postnominal) other potential costs associated with in a firms entire production line, which can stretch forth to unembellished imprecisions. (Atrill and McLaney, 2015)In the past, the traditional approach in determining product costs has worked reasonably well. Overhead rates were typically of a much lower value for each direct jade than the rate paid to direct workers as wages or salaries. However, it is immediately becoming increasingly common for overhead rates to be surrounded by 5-10 times the hourly rate of pay due to the increased signification of overheads (Horngren et al, 1999). Even an in profound change in the amount of direct drudge worked on a job could massively affect the total cost deduced due to direct labour hours on the overhead cost loading. Moreover, overheads are still typically charged on a direct labour hour basis overheads may not be closely cerebrate to direct labour however. (Atrill and McLaney, 2015)Principles like these in the traditional system reduces the accuracy of the model, questioning the legitimacy of this costing approach. As a result, what arose was the opportunity for an pick technique to overcome these flaws. This led to the inception of Activity-Based Costing ( alphabet)Activity Based CostingThe inception of an alternative costing system had been brought about in the early 1980s by Robert Kaplan the first advocator of Activity-Based Costing. It was his aim to use more cost device drivers to reduce the inaccuracies and inadequacies of traditional costing systems (Singer Donoso, 2008). Activity-based costing is an write up practice by which costs are allocated on the basis of a firms activities. The implementation of this costing system is explicated by a chronological, 5 stage template process, which Figure 1 shows.The major amendments do to the traditional costing system are the multiple cost drivers and overhead rates that are determine. Identifying cost drivers holds as the imperative component towards a successful alphabet system, for a more accurate and wholly reflective costs within a firm. The cause and effect relationship with activity costs acts as a basis for attaching these costs to a product or service (Atrill and McLaney, 2015). Created to forecast future costing, forward planning places managers in a more prominent position to assess the possible effect of new products and processes on activities and costs, leading to wider opportunities for firm managers (Horngren et al, 1999).Activity-Based Costing Opportunities and BenefitsActivity-based costing offers a wide overplus of diverging opportunities. Significantly, the system has been taken on and been made more relevant to service industries. In the absence of a direct material element, a service businesss total costs are more likely to be predominantly composed of overheads. A survey conducted investigating 176 UK businesses (from varying industries) with yearly sales revenue greater than 50 million found overheads re hold 51% of total cost for service providers. Th is is in stark secernate to 25% for manufacturers. These statistics certainly point towards the fact that first principle is an appealing bid to adopt for firms that sell services rather than products (Atrill and McLaney, 2015).ABC can be used as a powerful tool for continuous rethinking and striking costing improvement in not only the services and products, moreover likewise marketplace strategies and processes (Jinga et al, 2010). When Chrysler was placed in a period of financial turbulence, it exalted its costing system to ABC in 1991 in attempts to hold back up to its formidable competitors, Toyota and Ford Motor Company. Previously, the true costs of Chrysler were made to be 30 times larger than what had been calculated (Meador, n.d.). Post-ABC (after short-term grapple through inevitable transitional difficulty) Chrysler recovered to a competitive vantage point the automotive firm claimed they take hold saved hundreds of millions of dollars to date. (The Economist, n .d.) Similarly, the previously publicly-owned Royal place endorsed the ABC system to discover the cost of making postal deliveries, they identified 340 separate activities and subsequent cost drivers (Atrill and McLaney, 2015).The implementation of ABC can present a strenuous challenge, but with astute and correct execution, a firm can reap fruitful benefits. Within 5 years of implementation of ABC, Dutch firm Wavin made this system part of its day-to-day management culture, playing a significant role in their management uprightness programme. Wavin introduced ABC by linking it to a practical business application profitability management which considered an ideal pilot area for learning about ABC, as well as establishing a deeper understanding for the relationship between product and customer profitability (Horngren et al, 1999).However, by treating ABC as a short-term concept, Wavin ran into trouble. By operating on a day-to-day management culture, they think every effort shou ld be made to calculate ABC for all products. The caveat was that their real emphasis should be placed in ensuring the decision-making processes would lead to the accuracy of ABC attributed to both customers and products. Consequently, with its products Wavin used a two-phased approach whereby customers were classified into separate cost drivers. This approach generated an overall cost/customer intercellular substance which was utilised as a foundation for its managerial decisions, representing the most significant part of the companys business (Horngren et al, 1999). Wavins implementation of ABC showed the relative unease for a firm to change its costing system, whereby the system has had many an(prenominal) critics on its labyrinthine nature.Criticisms/Shortcomings of ABCIn spite of its main objective being to add accuracy and precision into costing schemes, from its inception ABC contained flaws. Analysing multiple overheads to bring up cost drivers is time-consuming and cost ly. The cost of setting up the ABC system, as well as costs of running and updating it, must be incurred. The more overheads and cost drivers that are identified, the greater potential is associated with higher caution costs (Horngren et al, 1999). Should the firms operations be more complex and involve many activities and cost drivers, the longer the time spent to maintain this scheme. Thus, higher expenses should be paid towards its maintenance.The implementation of this costing system also presents challenges. Managers need to be taught and prepared to facilitate these new schemes, which comes with external and additional training. Once more, the complexness of mastering the scheme can be taxing in terms of time consumption. Many firms own found it problematic to implement ABC to existing, traditional costing systems, where it is argued that it is more manageable for start-up firms to commence with ABC (Horngren et al, 1999). Furthermore, each firm looking to take on this schem e must arrive at all its business components broken down into its discrete components to identify all potential cost drivers. Perfecting the art of this scheme requires prolonged training, which again is an dear(predicate) eyeshade (The Economist, n.d.).Comparing TCA to ABCTraditional cost allocation has been most since the 1870s, where its use as a system has been going for many more decades than its alternative ABC its inception was in the early 1980s (Ben-Arieh Qian, 2003). interestingly a study claims that ABC is an additional costing system, not an alternative. When analyze different firms financial situations, it is highly likely that these firms do not have the exact same costing system. Some firms may use a traditional system with only one activity and cost driver associated to it, whilst others using ABC will have multiple activities and cost drivers adding onto what the traditional system has (Narong, 2009).ABC includes labour or product parts that can be identified whereas the traditional method arbitrarily accumulates salaries, expenses, and depreciations. (Blocher, 2006) For estimating costs, ABC is a more precise system as it nurtures managers in becoming more knowledgeable of the indirect resources which identifies and removes cost drivers that are of no marginal value. It also gives managers an insight into existing parameters that have generated demands. (Jones Dugdale, 2002)The traditional approach sees its overheads as comment a service to cost units, the cost of which must be changed to those units. ABC on the other hand views overheads as being caused by activities, like operating a store to house the cost units. Since it is the cost units that cause these activities, it is thus the cost units that must be charged with the costs that they cause. A reason for the inception of ABC is within the way overheads are organised. The traditional approach has the overheads apportioned to product cost centres, whereas ABC has its overheads an alysed into cost pools, with one cost pool for each cost-driving activity. (Atrill and McLaney, 2015)The intention of ABC was neither to measure short-term variable costs nor provide a day-to-day counseling on process quality. With its forward planning nature, using ABC to predict short-run costs overlooks the fact that costs are the results of spending decisions (Horngren et al, 1999). To its disadvantage, the traditional system, on the other hand, does not present non-financial information concerning the Small and modal(a) Enterprise (SMEs), perhaps displaying a slight negligence (Hilton, 2006).ConclusionsWhilst in opening there are two major approaches to choose from for a firm to undertake its costing decisions, there is no politically correct or preferred choice. Each costing system presents altering opportunities and challenges, where a firm ultimately has to choose dependent upon factors such as the firms industry. There has not been a major swell of manufacturing firms co nverting to implement ABC. Costing systems in the manufacturing sector are far more complexed, needing to convert materials into work in progress, than perfect goods. However, large-scale manufacturing firms such as Siemens, Philips, Volvo and Ericsson made the brave decision in the 1990s to implement ABC. (Horngren et al, 1999) Yet 2 of these firms in Siemens and Philips have in todays climate have lost a significant market share to they once had whether this is attributed to ABC is another question.It is important to note that the think objectives of an ABC system at the time of implementation are likely to differ from its resulting consequences. The methodology behind ABC sets a company in a superior platform in terms of precision and accuracy, allowing managers to make more informed and knowledgeable for a firms long-term future.ReferencesAtrill, P. and McLaney, E. 2015. Accounting and pay for non-specialists. 1st ed. Harlow etc. Pearson Education, pp.282-306.Ben-Arieh, D. a nd Qian, L., 2003. Activity-based cost management for design and development stage, internationalistic diary of Production Economics, 83,169-183CIMA Technical Services. 2001. Activity-based management an overview. pdf. CIMA Technical Briefing. Available from www.cimaglobal.com/technicalreports Accessed 23 work on 2017Hansen, D. and Mowen, M. 2006. Cost management accounting and control. Mason, OH London Thomson/South-Western.Hilton, R.W. 2006. Cost Management Strategies for tune Decisions, 3rd Ed. McGraw Hill, New YorkJinga, G., Dumitru, M., Dumitrana, M. and Vulpoi, M. 2010. Accounting systems for cost management used in the Romanian economic entities, Accounting and Management Information Systems, 9(2), pp.242-267.Johnson, R., 2014. Traditional Costing Vs. Activity-Based Costing Chron.com. Available at http//smallbusiness.chron.com/traditional-costing-vs-activitybased-costing-33724.html Accessed March 24, 2017.Jones, T. C. and D. Dugdale. 2002. The ABC bandwagon and the jugg ernaut of modernity. Accounting, Organizations and night club 27(1-2) 121-163.Letza, S. and Gadd, K. 1994. Should Activity based Costing be Considered as the Costing mode of Choice for Total Quality Organizations?. 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