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Allocation of costs are important as they give value of inventory or stock for external reporting reasons, for planning and scrutinizing the cost of activities and procedures, and for several short term and long term policy decisions. It tries to identify costs related to design, production and distribution of products and services.
Activity based costing is a system that first accumulates overhead costs for each activity of an organization and proceed to allocate the costs of activities to the products, services or other cost objects that caused that activity. The link between an activity and the cost object must be established through identifying the cost drivers for each activity.
The cost drivers are measured by the number of transactions involved in the activity. It can be defined as the measure of the use of a shared activity by each of the products or services. The system identifies parts of high overhead costs per unit and so directs attention to finding means to minimize the costs or to charge more for costly products or services.
Traditional cost systems allocate overhead costs to products or services mainly to distribute the costs for financial reporting costs. It usually allocates indirect costs to the products or services in two stages: firstly, the indirect costs of the individual production process are established and secondly, the indirect costs of the different production processes are assigned to the individual products.
Steinway piano is entirely formed by hands of craftsmen and technicians, with locally available raw materials but no machine or modern technology used like wood, rims, wires etc. The production process is simplified and the costs associated are materials and labor costs i.e. the amount charged by technician and the craftsmen. There are no machines used or technology applied; hence the piano is not a good candidate of the ABC system as the direct costs can be easily allocated to the product. Therefore, traditional systems of cost allocation can be easily applied, as the direct labor costs form a greater percentage of the total production cost.
The ABC systems are mostly applied where technology is highly used, hence the productivity advancements have greatly minimized the direct costs of labor and materials, and instead the indirect costs have increased. For instance, increased automation has minimized the labor costs, but depreciation has increased which is an indirect cost. More so, where the total amount of labor has greatly decreased and significant increase in total overhead costs, as well as the manufacturing industry is complex demanding double allocations foundations.
However, in Steinway piano indirect costs are few and can be easily identified, as mostly it deals with the direct costs of materials and labor, which can be easily allocated through traditional systems. At the same time, the number of pianos can be easily known, without having to use ABC system to identify the cost drivers putting into consideration that the system is expensive and complicated in simplified production process, with most of the costs being direct.
Similarly, the system doesn’t treat fixed costs as if they were variable hence it’s a bit beneficial to managers when planning , but great care should be taken as the method omits so many factors
ABC VERSES TRADITIONAL COSTING.
Traditional costing systems fail to acknowledge that the number of activities performed in an industry are the main causes of costs and there are unique cost drivers behind them, rather than being general. However, ABC systems focus on the activities executed to produce a given result i.e. it tries to establish the cost drivers behind each activity. It tries to determine the amount of resources used by an individual product as well as by the activities and processes that distribute the products and services to clients, so as to establish the cost and the performance of an industry.
Traditional systems do not clearly reveal the total cost of each activity and identify the cost drivers of each individual activity as well as underlining the exact unit cost of every activity. More so, it doesn’t precisely allocate costs to assorted activities and processes involved. Therefore, it is unsophisticated allocation method which produces inappropriate and incorrect data for planning and monitoring the performance of a company.
However, the ABC costing has a number of benefits. These include: establishing the most and the least profitable clients, products and channels, and establish the factors that contribute or detract financial performance. It also gives exact forecast of costs, margins resource demand related with variance in production quantity, company composition and the supply expenditures, as well as providing administrators with cost acumen to achieve improvements and enhance the negotiating strength with the customer. Managers can also expand their market share by placing their products well in the market.
However, ABC system is mostly concerned with conversion of indirect costs into directs so that they can be easily distributed over various processes and products, this criterion treats fixed costs as if they were variable. This is wrong as in computation of gross margin you need to classify costs as either being fixed or variable. This implies in calculating profits, there are no fixed costs as they have been translated into variable.
Therefore, this will interfere with accurate planning as fixed they have to be incurred whether there is an additional unit of a product has been produced or not. In a way we can conclude that the ABC system can also be misleading in a way and great caution should be taken when masking decisions after using the system, for its results should be clearly understood and interpreted.
In addition, the traditional system assigns costs to products using the predetermined unit based output rates, while the ABC system assigns overhead to activity cost pools and assigns costs to products using cost drivers. The cost drivers must accurately measure the resources used by a certain activity and should have the associated information readily available.
ABC is not a replacement of the existing cost system rather it acts as supplement, and it has its own limitations such as its expensive and there are arbitrary allocations made. However, in terms of its results it’s highly recommended. Its application depends on whether the products vary mostly in quantity and whether the products are plentiful, diverse and require various sustaining services.
Therefore, before a company decides which system to execute it should put into consideration the complexity of their production process and the overhead costs involved. For a complicated process implies double allocations of costs, while a simple production process calls for a single costing system so as to cut on the costs. The traditional system takes direct labor hours to be the relevant activity base while machine hours are the appropriate activity base for ABC system.
In our case of Steinway piano, though the production process is not complex as most of the direct labor costs form a large portion of total manufacturing costs as there is need to use the ABC system at least once, so as to know the amount of resources each activity consumes and the cost drivers behind each activity.
Hence, one can clearly know the number of pianos to manufacture so as to maximize the margin while reducing the total costs. This is recommended because there are other kinds of pianos being manufactured, therefore creating a competition in the market implying that there is need to check on the customer bargaining power to expand the market share. These issues are not addressed when using the traditional system making it difficult to know the distribution costs of the pianos and other related costs.
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