Allocating Fixed Costs
Allocating Fixed Costs
Activity Based Costing (ABC) is different from the other traditional costing methods. The traditional costing methods, such as marginal and absorption costing methods, has only two absorption basis. These two absorption basis for the allocation of overheads are labor hours and/or machine hours. However, in Activity Based Costing, every cost unit has a separate cost driver to allocate the overheads more effectively and efficiently. The activity based costing is a more refined method of allocating the overhead costs and separate the loss making products from the profit making products. Therefore, as compared to the traditional costing methods, the Activity Based Costing method distributes the overall overhead cost of the organization according to the activity level of the different products to determine the actual production cost of each product. (Martin)
The main characteristic of Activity Based Costing is that it distributes the overhead cost of entire factory or organization to each and every product according to their activity level. This procedure of allocation of overhead cost, identify the management of the business regarding the actual production or manufacturing cost of a single product. Therefore, the management will be in a position to identify the weaknesses in the production process of that specific product for the next accounting year. Another characteristic of Activity Based Costing is that it identifies the loss making products of the organization. For example, if the company is producing three products and the business is generating the profits by using traditional costing methods. In these circumstances, the Activity Based Costing method can be used to find the correct manufacturing cost of these three products. Moreover, by comparing the production cost and the selling cost, the management can identify the loss or the lower level of profits. Another important characteristic of Activity Based Costing method is that it can be used to capture market share. For example, after using the Activity Based Costing method, the production cost of a unit is reduced by $2, then the management will be in a position to take decisions regarding discount offers to the customers as compared to their competitors. (Walther, 2010)
Activity Based Costing method is more suitable for the manufacturing organizations such as textile mills, shampoo factory and the ice cream factory. The organizations which are producing more than one product must use Activity Based Costing to determine the correct cost of the product. For example, if the textile mill is producing different dresses such as, ladies garments and gents garments, then it is obvious that the costs are different for gents and ladies products. Therefore, in these circumstances, the management of the business must implement the Activity Based Costing to analyze and predict the correct production cost of each different product. Similarly, the Activity Based Costing is more suitable for those businesses who are producing the competitive and price sensitive products. For example, the manufacturer of the daily use products such as soaps, shampoo and cooking oils, the profit margin is very low due to the competitive market. Therefore, in these circumstances, if the management is using Activity Based Costing method, then they can spend extra funds on the advertisements of their product to increase their market share. (Hermanson & Edwards & Invacevich, 2011)
‘The Volkswagen Saga’ is a motor vehicle manufacturing company which implemented the Activity Based Costing method in early 1990’s. ‘The Volkswagen Saga’ is a car manufacturing company and they are producing different types of vehicles each year. Therefore, the Activity Based Costing method is the best suited costing method for the company like ‘The Volkswagen Saga’. After the implementation of Activity Based Costing method in the year 1991, the financial performance of ‘The Volkswagen Saga’ started to improve. In the year 1993, the management of the company identifies the correct costs of their different products by using the Activity Based Costing method. By using the number of cost drivers, the manager of ‘The Volkswagen Saga’ identifies the loss making products which were hidden due to the traditional costing methods. Therefore, the management of the business used the results of Activity Based Costing method and reform their production plan for the coming accounting period to maximize the profits. It also helped them to assign competitive prices for their products. (Gurowka)
Just In Time (JIT) Costing method is a new costing technique to minimize the overhead costs of the business. The JIT costing method suggests that the management must not hold any inventory or materials in warehouses. Therefore, whenever the company receives an order, then they must contact their suppliers for the raw material and develop the product. For example, the car manufacturing company ‘Ferrari’ is using the JIT technique to minimize their overhead costs. (Conrad)
Lean manufacturing is a concept to reduce the overhead costs by reducing the wastages of material and the labor hours at the factory. It can also be defined as the reduction of wastages by using the expert employees at the workplace. For example, if the labor is working at the factory for longer period, then it is highly probable that the labor will not waste the material as compared to the new employees. (Lacoma, 2014)
Total Quality Control is another method of reducing the overhead costs of the business. Total Quality Control forces the management of the business to improve the production methods to minimize the production losses. For example, if the management is purchasing low quality of raw material, then it is highly probable that the skilled labor will waste the raw material. Therefore, to improve the production method to reduce the wastages to minimize the overhead cost is the purpose of Total Quality Control. (Kelchner)
References
Martin, J.R. Management Accounting: Concepts, Techniques, and Controversial Issues - Chapter
8: Introduction. Management And Accounting Web Home Page. Retrieved from http://maaw.info/Chapter8.htm
Walther, L.M. (2010). Principles of Accounting: A Complete Online Text, chapter 19 (the
section titled Modern management of costs and quality) and 20 (the section titled Activity based costing). Retrieved from http://www.principlesofaccounting.com/
Hermanson, R.H., Edwards, J.D., & Invacevich, S.D. (2011). Accounting Principles: A Business
Perspective. First Global Text Edition, Volume 2 Managerial Accounting, 37-73. http://textbookequity.com/oct/Textbooks/TBQ_PA_Accounting_managerial.pdf
Gurowka, J. ABC, ABM, AND THE VOLKSWAGEN SAGA. . Retrieved May 19, 2014, from
http://www.focusedmanagement.com/knowledge_base/articles/fmi_articles/middle/volsaga.htm
Conrad, B. The Advantages of Just-in-Time Inventory Systems. . Retrieved May 19, 2014,
Lacoma, T. (2014, May 4). The Definition of Lean Operations. . Retrieved May 19, 2014, from
http://www.ehow.com/about_6666969_definition-lean-operations.html
Kelchner, L. Advantages & Disadvantages of Total Quality Management Strategies. .
Retrieved May 19, 2014, from http://smallbusiness.chron.com/advantages-disadvantages-total-quality-management-strategies-22160.html
