Wednesday, August 22, 2012

Activity based costing

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I must confess, I do not read scientific journal articles in my spare time for entertainment. Needless to say then, I did not approach the reading of, “Activity-based Costing for the Small Business A Primer”, with great enthusiasm. Although I will not go so far as to say that reading this article has transformed me into a certified scientific journal “junky”, I will admit that I found this article particularly interesting because of its applicability to the material we will soon be covering in class. In essence, this article outlines the advantages a small business owner will gain by using activity-based costing over the more traditional method of costing, absorption costing, for managerial accounting purposes.

After the start-up of a small business the owners find themselves in need of an accounting system to meet the continuing information needs of investors, lenders, and various taxing authorities. An accounting system that meets these needs is in large measure governed by the standards set forth by FASB and the Internal Revenue Service. This accounting system, while important to lenders, creditors, and tax authorities, falls short of providing the managerial accounting information necessary to operate a successful business.

Why does the accounting system described above fail to provide useful managerial accounting information? It fails to provide useful managerial accounting information because it is characterized by absorption costing. Absorption costing takes its name from the manner in which products “absorb” cost as manufactured. Under this system, product costs include only the cost of manufacture and neglect the costs associated with marketing and distribution. Absorption costing can also cause distortions in product costing in accounting periods of low production volume because of the inclusion of both direct cost (direct materials) and fixed costs (factory overhead). If production volumes are low, manufacturing overhead is not likely to be lowered accordingly, or even at all.

Activity-based costing is heralded as an alternative method of costing that compliments the absorption costing method required for external reporting. ABC does what absorption costing does not; provide small business owners with highly relevant managerial accounting information. Unlike absorption costing, which focuses on the cost of manufacturing a product only, ABC expands the focus to include all costs of manufacturing, marketing, and distribution of products. ABC even goes so far as to attribute marketing and distribution costs to products based on the demand that each places on those activities. This is especially important in a business environment where marketing and distribution costs have become a larger part of the total cost of taking a product from raw materials to consumption.

ABC also provides management with information on unused capacity. Unlike absorption costing, which allocates costs based on total machine hours used; ABC allocates costs based on the capacity of each machine. Thus, the cost of unused capacity can be revealed by taking the number of unused hours times the charging rate for each activity. Managers are subsequently able to focus their process improvement efforts on activities with relatively high levels of unused capacity.

I agree with the authors’ assertion that activity-based costing is an ideal supplement to the absorption costing method required by investors, lenders, and various tax authorities. ABC provides managerial information that absorption costing does not. On the other hand, absorption costing provides information to external interests that ABC cannot. Therefore, it is important that both accounting methods be married together to develop an all encompassing accounting system that will inevitably help in creating a successful business entity.

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