Reasons for Absorbing Overheads on Pre-Determined Bases
Overhead cost per unit is based on estimates. Therefore, it is almost unavoidable that at the end of the accounting period an under-absorption or over-absorption occurs in the overhead actually realized. The estimated cost of overheads and level of activity may not match what was actually realized in the period under consideration. The predetermined cost per unit is charged at the end of the period profit or loss. Hence, it is essential to check the amount under- or over-absorbed (charged) and make an adjustment in the accounts (Davila & Foster, 2005).
It is the prerogative of Management to know the level of expenditure on overheads. If left unchecked, the amount spent on overheads can increase every accounting period, which may eat into the profit of a company. This may also have a negative bearing on competitiveness. Managers need to know both the overhead expenditure per cost center or department and the overhead costs per unit (Davila & Foster, 2005).
The following reasons highlight why it is crucial to determine overheads on a pre-determined basis. First, a predetermined rate facilitates reasonable apportionment of overheads during a period when goods are manufactured or sold and services are rendered (Hansen, Mowen & Guan, 2007; and Davila & Foster, 2005). Hence, it improves the usefulness of information because it is prompt. Second, initially determined rates subsequently change the actual overhead costs that are unrelated to variations in inactivity during the accounting period (Chapman, Hopwood & Shields, 2006). Third, determining rates beforehand defeats the problem of future changes in activity levels that have virtually no impact on fixed overhead costs. In a situation where the total manufacturing overheads remain the same for each period, changes in activity levels between periods have the ability to cause a pre-unit fluctuation in fixed overhead costs (Drury, 2007; Schreyögg, Tiemann & Busse, 2006). Last, using predetermined overhead rates allows managers to become more aware of individual product line profitability. It also allows managers to specifically assess the profitability of the business in relation to a particular customer or vendor (Ahrens & Chapman, 2007).
ABC Costing In Light Of Changing Technology
With the changing technology, it is becoming increasingly easy to analyze all the relevant factors that lead to changes in cost. These factors are called cost drivers. The relevant costs can be classified into opportunity costs, avoidable costs and incremental costs (Ahrens & Chapman, 2007). When the cost drivers have been thoroughly analyzed, it necessitates the use of predetermined overhead absorption rates. This makes Activity Based Costing be the most appropriate in this case. Activity-Based Costing is pegged on the in-depth analysis of all the cost drivers that include all the factors that lead to changes in overhead costs (Hansen, Mowen & Guan, 2007).
Activity-Based Systems determine the real cost of overhead before assigning the costs to such activities. Therefore, a company allocates costs to those units that require the activity. The approach appreciates the fact that at any point, the company’s activities will occasion cost, which will vary with production levels. Therefore, the costs should be assigned to the products that require such activities to arrive at a more accurate measure (Chapman, Hopwood & Shields, 2006). The distinguishing feature of Activity Based Costing is that it links the output of the manufacturing entity to the cost of all activities involved in production. Value-added activities could be determined using this approach. The manufacturing entity can proceed to eliminate activities, which are not adding value to the product. This will improve the manufacturing system’s performance (Chapman, Hopwood & Shields, 2006).
With activity-based costing, you take all activities required to produce an item into consideration. This can include R&D, testing, purchasing, set up of machines, packaging, and cleaning and maintenance. These are all necessary to produce an item; however, they may not be taken into consideration when using the traditional method of costing (Ahrens & Chapman, 2007).
Activity-Based Costing leads to the generation of activity rates. Activity rates are vital to management since they enable management to determine with great accuracy the cost involved in production. The management can quickly estimate the cost of producing at a certain level using activity rates (Ahrens & Chapman, 2007). Activity rates are also important in determining the efficiency of production. The management can use these rates to determine which activities add the most value to the production process (Hansen, Mowen & Guan, 2007). The production process can thus be improved by eliminating non-value-add activities. This allows for a flexible process, which companies can modify to reduce the negative effects of some activities. Activity rates also offer management information, which greatly improves their decision-making ability. Hence, ABC can be instrumental to managers at a manufacturing plant, for example, car production (Ahrens & Chapman, 2007).
Differences between Activity-Based Costing and the Traditional Costing Systems
Activity-Based Costing (ABC) differs from the Traditional Costing Systems in the allocation of manufacturing overheads. ABC does not allocate overheads on the simple basis of time like the traditional approach. It instead determines the real cost of the overhead before assigning the costs to such activities. A company allocates costs to those units that require the activity (Hansen, Mowen & Guan, 2007). The approach appreciates the fact that at any point, the company’s activities will occasion cost, which will vary with production levels (Hansen, Mowen & Guan, 2007). Therefore, the costs should be assigned to the products that require such activities to arrive at a more accurate measure. The distinguishing feature of Activity Based Costing is that it links the output of the manufacturing entity to the cost of all activities involved in production. Value-added activities could be determined using this approach. The manufacturing entity can proceed to eliminate activities, which are not adding value to the product (Hansen, Mowen & Guan, 2007). This will improve the manufacturing system’s performance. In contrast, the traditional costing systems link the direct materials cost and labor costs to the product. While ABC employs an hourly costs system in the determination of the costs of each unit, traditional approaches rely on historical measures or average costs of processes similar to the one employed in determining these costs (Hansen, Mowen & Guan, 2007). This may lead to inaccuracies when factors change. Therefore, ABC is more flexible than traditional costing methods. Managers can use this flexibility to predict costs using scenario analysis (Ahrens & Chapman, 2007).
Reasons Top Management May Resist Activity-Based Costing
One of the reasons why management may resist activity-based costing methods is the failure of the implementation team to involve all departments in the process. The non-involvement of other departments in the implementation is likely to lead to resistance (Davila & Foster, 2005). The accountants’ attempts to implement ABC on their own will in most cases lead to resistance due to ignorance of the new system and the lack of input from the other departments that have detailed knowledge of the operations of the firm. The implementations of the ABC system may also encounter resistance since it results in a shift in the measures used by management in their decision-making activities (Hansen, Mowen & Guan, 2007). Hence, management must adopt new methods while determining variables, which they use while making manufacturing decisions (Davila & Foster, 2005). Senior managers will also be to use the information afforded by ABC to evaluate the performance of middle-level managers. Managers are likely to resist this new transparency. Another cause of resistance is that ABC introduces a certain level of rigidity in decision-making. Cost estimation requires leeway. Hence, it is more of an art than a science. Decision-making involves other variables apart from cost such as time and quality (Davila & Foster, 2005).
Why Activity Rates Are Important To Management
Activity rates are important to management since they enable management to determine with great accuracy the cost involved in production. The management can quickly estimate the cost of producing at a certain level using activity rates. Activity rates are also important in determining the efficiency of production (Davila & Foster, 2005). The management can use these rates to determine which activities add the most value to the production process (Hansen, Mowen & Guan, 2007). The production process can thus be improved by eliminating non-value-add activities. This allows for a flexible process, which companies can modify to reduce the negative effects of some activities. Activity rates also offer management information, which greatly improves their decision-making ability (Ahrens & Chapman, 2007).
Would Activity-Based Costing Approach be Unacceptable for External Financial Reports?
ABC would not be acceptable for external reports due to methods employed in determining the allocations. The use of interviews is likely to lead to costs, which are unrealistic or biased in the eyes of the external financial statement user (Hansen, Mowen & Guan, 2007). Objective and verifiable data should be used instead to increase the confidence of users of such statements. The method used in arriving at costs using ABC is also not acceptable by outside parties. The calculation of activity-based costs may exclude some costs, which are not directly linked to the production process (Davila & Foster, 2005).
References
Ahrens, T & Chapman, C 2007, Management Accounting as Practice, Accounting, Organizations and Society, vol. 32 no. 1, pp 1-27.
Chapman, C, Hopwood, A & Shields, M 2006, Handbook of Management Accounting Research, Elsevier Science, New York.
Davila, A & Foster, G 2005, ‘Management Accounting Systems Adoption Decisions: Evidence and Performance Implications from Early-Stage/Startup Companies’, The Accounting Review, vol. 80 no. 4, pp 1039-1068.
Drury, C 2007, Management, and Cost Accounting, Cengage Learning EMEA, New York.
Hansen, D, Mowen, M & Guan, L 2007, Cost Management: Accounting & Control, South-Western Pub, New York.
Schreyögg, J & Busse, R 2006, Cost Accounting to Determine Prices: How Well do Prices Reflect Costs in the German DRG-System, Health Care Management Science, vol. 9 no. 3, pp 269-279.