Activity Based Costing in the Modern Manufacturing Industry

Increased competition across the industries has forced companies to enhance their competitive advantage from various methods, including accounting strategies. In this regard, successful organizations are those that have successfully managed to improve their productivity, reduce their operational costs, and improve on their overall efficiency. The present economic environment is also very competitive and this prompts the manufacturing firms to improve their productivity by applying different methods of reducing unit costs of operations and to increase their revenues (Wang et al, 2010). Globalization and advancement in information technologies have allowed the manufacturing companies to expand and distribute their products in a manner that improves on their overall performance and efficiency. The costing system used by organizations helps them in strategy mapping by providing accurate cost information concerning the products and their customers. Therefore, most companies are steadily shifting their focus from the traditional costing system, to the modern day costing system known as the Activity Based Costing (ABC). Activity based costing is more preferred than the traditional costing method in the manufacturing industry. In the manufacturing industry, more than 50% of the costs comes from material and about 10% come from labor. The rest are classified as overhead costs and they include direct costs such as maintenance, warehousing, quality control, material handling among others. In the modern times, the activity based costing identifies the specific cost drivers before allocating the costs to equipment, operations, product mix among others. This paper reviews how activity based costing is used in the modern day manufacturing industry.

Activity Based Costing is an alternative accounting method that does not trace the overhead costs of the specified activities and products that generate them. ABC is beneficial to manufacturing firms since it assumes that all the products being manufactured assumes some proportionate amount of indirect activities based on labor hours utilized (Rodr & Jan, 2007). Activity based costing can also be used for continuous improvement by providing critical information that supports various transformations in the company. This is possible since ABC maps the company activities and describes their costs structure in terms of activity consumption. Activity Based Costing (ABC) is a method that allows the management to better understand their products and services together with the customer net profitability (Abu-Eker et al, 2012). This management accounting method has been applied for the past three decades as a modern alternative to the absorption costing to provide businesses with relevant information to make value bases and effective decisions. Whereas the traditional costing method tends to rely on volume related drivers, ABC focuses on the cost drivers (the activities that cause the price to increase) (Dalci, Tanis, & Kosan, 2010). Since ABC emphasizes on activities that consumes the company resources, companies with significant amount of overhead are likely to benefit from it. However, the companies with little overhead costs don’t need ABC since their focus would largely be on the volume driving the costs. The logic behind ABC is that customers and products that are causing the administrative overheads to occur should be assigned with costs with the aim of providing effective decision making and improved productivity within the organization (Mansor, Tayles, & Pike, 2012).

The economy of any country is highly dependent on the manufacturing sector since it enables them to have products of various kinds, some of which are exported to gain income. In some cases, a number of manufacturing firms have fallen bankrupt due to their inability to reduce their cost of production and to increase their overall efficiency. Therefore, successful manufacturing industries are those that have managed to overcome the competition by reducing their operational costs and improved on their efficiency (Nachtmann & Kim, 2003). The costs and management accounting concepts used in the manufacturing industries provide cost information for decision making. The rationale for cost management within the manufacturing industry is to provide relevant and timely information to support the management of corporate resources used within the manufacturing systems. In the modern era, manufacturing organizations have been offering greater variety of products by the use of the same distribution channels while servicing different types of clients (Joseph & Vetrivel, 2012). This has created more complexity and diversity in the production system, resulting in more overhead costs that need to be properly managed. This heterogeneity and increase in overhead cost have completely changed the costing structure of the company operations and this has called for a more modern costing system that can adequately address such changes. In such a modern manufacturing environment, the traditional costing system is likely to provide distortion of the unit costs of the products and the subsequent fall of the manufacturing systems. In the modern manufacturing environment, the traditional costing methods would result into cost distortions and this would be higher in those manufacturing units with greater proportions of overhead costs. The traditional costing methods have not adequately reflected other resources and the cost of activities added to the value of production (Dalci, Tanis & Kosan, 2010). Since the traditional costing methods are based on absorption costing and standard costing have failed to measure the company performance since they have not lived up to the expectations of the technological developments of production that characterizes the new era. The activity based costing avoids biased reporting by allocating the direct labor hours on the group. Since the allocation of manufacturing costs depends on the types of resources collected by the organization, the greater the product consumes the resource, the higher the overhead attached to the product base on one particular activity. Within the manufacturing systems, ABC system achieves improved accuracy in the estimation of costing by applying multiple cost drivers that trace the costs of activities to the manufactured products (Joseph & Vetrivel, 2012). In this regard, the cost factor is an event associated with the activity that results from the consumption of the resources of the manufacturing firms. With the cost of the products based on the activities, ABC enables the manufacturing firms to establish the cost of serving a customer to be ascertained individually. In addition, ABC enables the manufacturing firms to enhance their customers’ profitability by deducting the product costs and the cost used to serve each customer. Therefore, the possibility of dealing separately with the customer costs and the product costs enables allows the manufacturing industry to easily identify the customer costs. On the other hand, continuous improvement of ABC provides can effectively provide solutions to various problems that may affect the company (Wang et al, 2010). Since the implementation of ABC can make the employees various costs involved, the employees are in a better position to analyze the costs related to manufacturing various products while identifying those that do not add value and those that add value to the organization. This allows room for various improvements that are deigned to make the organization make more profits instead of losses.

It has been established that the application of ABC has the potential of radically changing the manner in which the management determines a mix of product line, the prices of their products, assessments of new technologies, and the subsequent identification of the location of sourcing components. A case in point is whereby the manufacturing company may decide to change their system into low volume specialty production at the same cost. ABC can easily be used to prove whether the low-volume production cost is better that the high volume production so that the management can make sound judgment on which method to adopt (Joseph & Vetrivel, 2012).

It has also been established that the use of ABC enables the management to establish the impact of sourcing decisions by focusing on the elimination of direct labor and additional required activities. Since manufacturing firms are highly technology adopters, ABC enables them to comprehend the impact of new technology with respect to the cost of production in order to avoid wastage of resources. In this regard, the management of manufacturing industries stands a better chance of improving their product quality and reorganizing their product layout in order to enhance their manufacturing ability (Joseph & Vetrivel, 2012). Since ABC is able to handle such changes effectively, the management is constantly provided with the right data required for economic analysis and strategic decision making. In terms of manufacturing designs, ABC allows system engineers to test different production designs in their bid to reduce costs and improve on the flexibility of their organizations. This is based on the fact that engineering designs uses a number of insertions and thus it is possible for engineers to distinguish between different components.

 

References

Abu-Eker, E., ALsarayreh, M. N., & Jaradat, M. M. F. (2012). Availability of the application ingredients of activity-based costing system in Jordanian tourism companies. Journal of Management Research, 4(2), 150-163.

Dalci, I., Tanis, V., & Kosan, L. (2010). Customer profitability analysis with time-driven activity-based costing: A case study in a hotel. International Journal of Contemporary Hospitality Management, 22(5), 609-637

Joseph, J., & Vetrivel, A. (2012). Impact of target costing and activity based costing on improving the profitability of spinning mills in coimbatore – empirical study on spinning mills. Journal of Contemporary Research in Management, 7(2), 41-57.

Mansor, N. N. A., Tayles, M., & Pike, R. (2012). Information usefulness and usage in business decision-making: An activity-based costing (ABC) perspective. International Journal of Management, 29(1), 19-32.

Nachtmann, H., & Kim, L. N. (2003). Methods for handling uncertainty in activity based costing systems. The Engineering Economist, 48(3), 259-282.

Rodr, E. J., & Jan Emblemsvåg. (2007). Activity-based life-cycle costing in long-range planning. Review of Accounting & Finance, 6(4), 370

Wang, P., Du, F., Lei, D., & Lin, T. W. (2010). The choice of cost drivers in activity-based costing: Application at a chinese oil well cementing company. International Journal of Management, 27(2), 367-380

 

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