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Activity Based Costing (ABC) at Sierra Ltd

Introduction

Increase competition has forced companies, especially the manufacturing companies, to reconsider their accounting methods. The company management practices have changed tremendously in the recent past and organizations are moving from vertical management to horizontal management. The traditional costing methods do not enable the companies to enhance their competitive advantage (Durry, 2015). The costing method enables the businesses to establish the cost of manufacturing their products in relation to possible revenues generated by such products (Hicks, 2008). Therefore, the costing method establishes the overhead of production and allocates such overhead costs to the products. According to Chen and Wang (2007), proper costing system enables the organization to enhance their productivity, efficiency, and reduce their operational costs. When it comes to costing methods, the management has the freedoms to choose from traditional costing or activity based costing (Duh, Lin, Wang, & Huang, 2009). However, these choices have consequences with regards to the success of the organization. This paper is a management report on the possibility of implementing of activity based costing on Sierra Ltd.

About Sierra Ltd

The Sierra Ltd is a manufacturing company that manufactures and sells automotive parts. The company manufactures several lines of products. The clutch and the engine components have few variants and are simple and easy to manufacture. On the other hand, the transmission components have many variants as they are specific to each customer. Also, they require a lot of labor time as well as the machine time due to their complex machine line. So far, the management is not convinced that the current costing system is serving the organization well. Several concerns have been raised concerning the future of the company. The automobile market where the company operates has fragmented in the recent years and this has affected the market forces and pricing (Haroun, 2015). Therefore, there is a need for the company to react to the market forces on pricing since the companies that manufacture one product line has relatively low overheads (Lui & Pan, 2007). Sierra Ltd has been using traditional basis for product costing where the direct labor and materials linked to various product lines are easy to trace to the products. The company has problems with overhead allocation and have used the machine hours a basis for allocating the production overheads. However, this method of overhead allocation seems to distort some of the production costs. Therefore, the company is not achieving their expected profit margins.  In this regard, the company is considering upgrading their system from the traditional costing system to activity based costing. For the past five years, the revenues and profits realized by the company has declined. There is an increased risk of losing to the competitors and running out of the business if the negative trend continues.

Traditional costing  

Currently, the Sierra Ltd uses the traditional costing method. However, most manufacturing companies have currently switched to the activity based costing due to immense benefits they get from such method of accounting (Abu, Alsarayeh, & Jadarat, 2012). The traditional costing approach would not be beneficial for Sierra Ltd since it seldom meets the cause-effect criteria that would help to achieve an accurate cost allocation for the company (Cai, Moore, & McNamara, 2013). The use of traditional costing of Sierra Ltd may lead to inaccurate results due to the rising proportion of the overhead costs. The disadvantage of such distortion of facts is that it can lead the management to make inappropriate decisions that may negatively affect the company (Popesko & Novak, 2014). With the reduced revenues, the inappropriate decisions may bring undesired results that may negatively affect the company.

Activity Based Costing

According to Major and Hopper (2005), the activity based costing (ABC), is a costing and monitoring approach that involves tracing resource consumption and costing final outputs. It is a costing method that is currently used by most manufacturing companies (Siavens, Tornberg, 2002). Activity based costing takes applies the concepts of activity based management (ABM), where the activity driver analysis are designed to increase efficiency, lower costs, and improve the asset utilization.

Unlike the traditional costing method, the ABC accumulates the cost of each organizational activity and assigns these costs to products, services, or the customers (Dalci, Tanis, & Kosan, 2010). Therefore, they have the flexibility of providing accurate reports that are used by the management to make appropriate decisions regarding the products. According to Rasiah (2011), ABC involves the accumulation of costs through activities as opposed to the functional areas. The application of ABC within Sierra Ltd will enable the management to minimize and avoid cost distortions on the production costs (Nachtmann & Kim, 2001).

According to Jones (2014), the ABC is an alternative accounting method that does not trace the overhead cost of the specified activities. Through providing critical information that gives support to various transformations in the company, ABC will enable Sierra Ltd to realize continuous improvement in their manufacturing components. Such tremendous success is evident where the company management better understands their product and services (Mansor, Tayles, & Pike, 2012). In the past three decades, the use of ABC in manufacturing industries has recorded much success (Rappold et al, 2009). Therefore, the same success can easily be replicated at Sierra Ltd since it is a manufacturing industry. Such businesses will manage to make value bases and effective decisions that will be used to better the future. Where the traditional costing method tends to focus on the volume related driver’s, ABC lays more focus on the cost drivers (activities that cause prices to increase) (Arisoy et al, 2006). By focusing on the activities that causes the prices to increase, the ABC enables the management to have the right information on their manufacturing components. Several departments within the company are likely to benefit from ABC as it lays much focus on activities that consumes the company resources.

Apparently, the economy of any given country is much more depended on the manufacturing industry of the country as it helps the country obtain useful product. There are numerous cases where various manufacturing companies failed to survive competition due to their inefficiencies. Due to such measures, successful manufacturing industries are the ones that have managed to reduce their operational cost while on the other side managed to have an increased efficiency and revenue gain. The costs as well as the management accounting concepts that are used in the manufacturing industry provide relevant and timely information that help in supporting the management of corporate resources that are used within the manufacturing systems (Latshaw & Cortese, 2002). In the modern era, the manufacturing industry has been providing a cost distortion, thus making the manufacturing industries attain a higher rank in the overhead costs ranking in production. Through allocating reporting of direct labor hours on groups, ABC avoids biasness in the costing system of manufacturing industries (Kareem et al, 2012). Since the allocation of the manufacturing costs depends on this type of resource, there is an increased overhead attached to the product based of one particular activity. In such a regard, the cost factor is an event that is more associated with the activities of the manufactured products in the manufacturing systems, The ABC attains an improved accuracy in the estimation of costing by applying multiple cost drivers that can be used to tare the costs of all the activities being carried out by the industry to the manufactured products (Joseph & Vetrivel, 2012).  

Implementation process

To properly implement ABC within the Sierra Ltd, the management needs to follow some basic steps. First, the management needs to identify the activities and processes involved in the production process. These processes need to be analyzed in details as they may comprise of one or more activities (Lucas, 2000). Secondly, the management needs to assign the cost of the activities involved within the production process. This stage involves tracing the cost to the cost objectives and determining why the cost occurred (Sarokolaei et al, 2012). These costs are categorized into direct costs, indirect costs, and the administrative costs. The third step involves identifying the outputs for which the activity segment lies and consumes the company resources. The final step in the implementation of ABC entails the assignment of activity costs to the various outputs by the use of activity drivers. The ABC will provide the Sierra Ltd with accurate information related to the true cost of products, services, activities, customers, and services (Roztocki & Schultz, 2012). Also, the ABC will allow the Sierra Ltd to have a better and a more comprehensive understanding of the overheads and the factors that causes them. Besides, the use of ABC by Sierra Ltd will support other essential management techniques such as continuous improvement, scorecards, and performance management.

Drawbacks of ABC

Despites its successes, the management needs to realize that the use of ABC is time consuming and difficult when compared to the traditional costing (Joseph & Ventrivel, 2012). Also, the activity based costing may be costly to implement, manage, and run within the organization. Finally, some overheads are difficult to assign to products and customers and may still have to be arbitrarily applied to products and customers (Hussein & Tam, 2004).

Conclusion and Recommendation

Evidently, the present economic environment seems to be more competitive for manufacturing companies. The company management practices have changed tremendously in the recent past and organizations are moving from vertical management to horizontal management. The traditional costing methods do not enable the companies to enhance their competitive advantage. Therefore, most manufacturing companies have stopped focusing on the traditional costing system and now embraced the modern day costing referred to as the activity based costing (Chen & Wang, 2007). Unlike the service industry, the ABC is more beneficial to the service industry. The manufacturing market has fragmented in the recent past and there is need to introduce the best costing method that will support the nature of production at Sierra Ltd.

Since Sierra Ltd is a manufacturingcompany and the use of ABC will enable the company to know and ascertain which products consumes much resources and which one does not. The company produces several products with many variants and relatively high overhead. The two main components of Sierra manufacturing are the clutch and engine components and the transmission components. Unlike the clutch and engine components, the transmission components have any variants as most of them are specific to the customers. Their production is quite complex and requires a lot of labor time and machine hours to manufacture.

Currently, the management of Sierra Ltd is faced with the option of lowering their prices to secure a good market share. However, lowering the prices alone may not offer the best solution in dealing with the market forces. Therefore, Sierra Ltd should switch from traditional costing system to activity based costing. In doing this, the Sierra Ltd will be able to trace the direct labor and materials associated with the various components of their product lines and avoid the challenge of overhead allocation. Sierra Ltd needs to stop using machine hours as the basis of allocating production overheads to products as it distorts some of the product cost. Therefore, the company should fully embrace the ABC. The ABC would help Sierra Ltd to enhance their customer’s profitability by ensuring that the products cost is deducted and all the cost that are used in serving customers are related as soon as possible. Therefore, Sierra Ltd needs to move from traditional costing method and apply the ABC costing.

 

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