Sky's the Limit

Part 2

(Total word account for Part 2 – 750 words)

Given the rapidly changing environment, there is an active interest and a sense of urgency growing among organizations to understand their costs and the factors that drive these costs. The days of the monopolist are long gone; businesses are now facing challenges of competition and a huge pressure to reduce costs. As firms are attempting to stay competitive in the market place, managers are soon to realize that they need more accurate and relevant cost information to support effective decision-making.

Traditional costing systems were developed over a decade ago, while direct labor was valuable and made up the majority of production costs. There was little automation back then and most companies manufactured a narrow range of products. It traces indirect costs to products or services through a predetermined overhead rate. The allocation is based on the assumption that products consume all resources in proportion to their production volumes. However, it has been argued that the use of volume related cost drivers where no correlation exists to assign the overhead cost to products or services could lead to cost distortion.

Activity-based costing (ABC) emerged in 1980s with an aim to achieve a more accurate calculation of product costs. ABC recognizes that many of the overheads are unaffected by changes in production volume. It focuses attention on activities that consume resources by using appropriate cost drivers to illustrate the cause and effect relationship. These costs attached to each activity are then allocated out to products or services according to their use of the activities. ABC helps managers to obtain greater understanding of cost behavior and allows them to analyze different aspects of their business in detail. It is a more sophisticated allocation approach compared to the traditional costing method.

Critique of costing systems

The main advantage of using traditional-based costing is that it is relatively easy to apply. A single volume-based overhead rate is employed for the assignment of all overhead costs, but for the very same reason, this also means that it is not always going to be as accurate as ABC. The problem with assuming all overheads are proportionate to production volume could result in significant under or over costing due to an increasing product complexity and diversity of today’s business environment. Traditional costing also negates other cost drivers and fails to account for certain non-manufacturing costs that may contribute to cost of the product. However, it complies with external reporting requirements for its simplicity and consistency.

ABC is identified as a more accurate costing approach because of a larger number of activities and multiple cost drivers being used to capture the real cost of products