Traditional Absorption Costing Versus Activity Based Costing System

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02 Nov 2017

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1.0 Introduction

Standard costing is generally best suited to an organization with repetitive operations and the input required to produce each unit of output can be specified. It is suitable to those manufacturing organization that have repetitive production process. Standard costing are not suitable used in non-repetitive activities because there is no clear basis for observing and recording operations and affect difficult to determine standard. The most effective control is achieved by identifying standards for quantities of material, labor and services to be used in an operation, rather than an overall total product cost (Drury, C., 2009).

According to CIMA Official Terminology (2005) state that standard costing is the planned unit cost of the product, component or service produced in a period. The standard cost may be determined on a number of bases. The main use of standard costs is in performance measurement, control, and stock valuation and in the establishment of selling prices.

There are some elements in standard costing system such as setting standard for each operation, actual costs for each operation are traced to each responsibility center, compare actual with standard performance, investigating variances and take corrective action, and monitor and adjust standard that can reflect changes in standard usage or price.

The purpose of standard costing are providing a prediction of future costs that can be used for decision-making. Standard costs can be derived from either traditional or activity-based on costing system. Providing a challenging target, assisting in setting budgets also are one of purpose for standard costing. Acting as a control device by highlighting those activities that do not conform to plan for manager avoid situation that may be ‘out of control’ and need of corrective action. Standard costing was purpose to simplify the task of tracing costs to products for profit measurement and inventory valuation (Drury, C., 2009).

The advantage of standard costing is can help the functions of the management in planning, coordination, organization, motivation and control. Another advantage is standard costing is can measurement efficiency, fixing prices, formulating policies, facilitates control, decision making, eliminates wastages, inventory valuation, creates cost consciousness, and measure price quotations.

There also having some limitations in standard costing, for example, difficult to establish standard costs lead to misleading results effect by Inaccurate and unreliable standards. Conditions change in business can affect management not be able to keep standards up-to-date. If standards are set too high, it may have an adverse effect on the morale and motivation of the employees and they not be capable of operating the system. Besides that, standard costing is expensive and unsuitable in job order industries and units engaged in manufacturing non-standardised products.

Variance Analysis

According to CIMA Official Terminology (2005) state that variance analysis is the evaluation of performance by means of variances, whose timely reporting should maximize the opportunity for managerial action. Another definition of variance is the difference between a standard cost and the comparable cost incurred during a given period.

Variance analysis is associated with analyzing the difference between the standard costs and actual costs for a given level of output or activity. Variance may be related to materials, labor and overheads. Overheads relate to indict materials, indirect labor and other expenses. Finding out the difference between the standard and actual cost component and analyzing the reasons for the difference is called variance analysis. Analysis of variances may be done in respect of each element of cost and sales namely direct material variances, direct labor Variances, overhead variances, and sales variances.

Variance analysis is consisting breaking down the total variance and use to explain how much of it caused by the usage of resources and the cost of resources that difference from the standard. It can help to reconcile the total cost difference by comparing actual and standard cost.

The main purpose of variances is to provide reasons for off-standard performance. Variance analysis is the process of analyzing variances by subdividing the total variance in such a manner that the management can assign responsibility for the departure from the standard performance. Variance analysis is the foundation for Standard Costing. Variance analysis is to enable the management to improve operations, correct errors, increase efficiency, and deploy resources more effectively to reduce costs.

Variance analysis is a very important management tool to understand the cost behavior and take appropriate actions for controls where necessary. The analysis is used to monitor the areas where cost overrun are frequent to assess if the standard costs fixed for the activity or materials is reasonable or the process itself needs to be closely monitored. The analysis also identifies the areas of efficiency within the processes and can be used for rewarding the efficiency, just like it can be used to take corrective actions for areas with adverse variance. It must however be noted that this exercise must be properly carried out and analyzed before arriving at any conclusions.

One of the major disadvantages of variance analysis is that it a post-facto exercise and generally takes a longer time to assess the impact of the variance and consequently results in delayed corrective actions. This drawback can be effectively addressed by maintaining monitoring and data collecting systems that work more on real time basis as opposed to the traditional systems that provide the requisite data after a delayed gap after incurrence.

Journals Article

In order to further understand about this topic, we had study on few journal articles that about the Standard Costing and Variance Analysis for us to conduct some research and make some comparison. The first journal article we are using is Standard Costing and Budgetary Control in the British Iron and Steel that written by John Richard Edwards, Trevor Boyns, and Mark Matthews. Second journal article is A Third Generation of Activity-Based Costing written by Mohammad Namazi. Third journal article is Activity-Based Variance Analysis is a New Tools for Cost Management written by Jonas Gerdin. Fourth journal article is Cost Accounting in Auto Manufacturing Companies in Germany and the United States written by Robert Jinkens and RamMohan R. Yallapragada. Last journal article is Management Accounting Practices in the British Food and Drinks Industry written by Magdy Abdel-Kader and Robert Luther.

2.0 Summary

(1) Journal Title

Standard Costing and Budgetary Control in the British Iron and Steel Industry

Author / (Year)

Edwards, J. R. & Boyns, T. & Matthews, M. (2002)

Data Collection / Data Analysis

- Researchers were lists the company re-nationalised in 1967 and also identifies those covered by survey.

- Researchers identified whether the nationalized companies owned or controlled 22 integrated works and 42 other steel works, number of labours in their iron and steel activities, percentage of the total manpower, and the percentage of the production of most main steel products.

- The combined profits, capital employed, return on capital employed and capital expenditure derived by "Benson Committee" reveal a collapse in profitability which sets out financial statistics, covering the preceding decade, for the 14 companies renationalised in 1967.

- 14 companies also compared the dates whether when they adopted standard costing and budgetary control.

Research Result / Findings/ Summary

- Leaders of iron and steel companies had themselves become increasingly concerned with their industry’s performance by the 1960s, and Development Coordinating Committee was set up by the Executive Committee of the British Iron and Steel Federation (BISF).

- Productivity became low because of the iron and steel industry was over-manned and the utilization of equipment poor.

- Some parts of the industry were still relatively healthy in financial, but losses were being incurred at 4 works were the Iron and Steel Board (ISB) had concentrated a large part of approved investment.

- The profitability of the iron steel industry was also unfavourably affected by the more stringent pricing policy implemented by the ISB.

- The adoption dates at United Steel Companies Ltd (USC) with those of the remaining companies surveyed shown a dramatic discrepancy. No other company adopted techniques until 1957, whereas all the companies surveyed adopted one or both of these techniques within the next 11 years.

Prepared by:

Yap Ruey Jia

(Student’s name and signature)

(2) Journal Title

Performance-Focused ABC: A third generation of activity-based costing system

Author / (Year)

Namazi, M. (2009)

Data Collection / Data Analysis

- Kaplan and Cooper conventional activity-based costing (ABC) has been the subject of hundreds of article.

- This system been implemented in service and manufacturing organizations, for managerial functions include accurate cost determination, product mix decisions, product price calculation, and consumers’ profitability analysis.

- In 2004, time-driven activity-based costing (TDABC) introduced by Kaplan and Anderson.

- TDABC is to address some of the problems encountered by enterprises using conventional ABC.

- TDABC has at least five significant differences.

Research Result / Findings/ Summary

- Result is describing the focus of any ABC system, which differentiates ABC from traditional cost accounting system.

- To address these shortcomings, this article showed that a performance-focused ABC system (PFABC) to provide an integrated ABC information system that can be employed.

- The concept of "practical capacity" of resources in terms of time uses by TDABC and determines the total time spent in a designed department.

- This new system is based on a nine-step process for each cost object.

- Result is showed that in PFABC, actual costs rates are separately determined for each of the firm’s activities, primarily from the existing information system based upon actual data and according to the resources and its cost behavior.

- The most useful information for evaluating management’s operation is related to determinations of productivity for given activities.

- PFABC is a more complete model than the conventional ABC and TDABC because it considers multiple relevant elements for each activity and compares actual with standard operations.

- Result is describe ten advantages for TDABC, include easier and faster building of accurate models, can be run monthly to capture the economics, enables fast and inexpensive model maintenance and so on.

Prepared by:

Tham Hey Wah

(Student’s name and signature)

(3) Journal Title

Activity –Based Variance Analysis: New tools for cost management

Author / (Year)

Jonas,G.(2004)

Data Collection / Data Analysis

- Olympic company used to illustrate activity based variance analysis.

- This company is manufacture 2 different type of jackets which is alpha and beta.

- The data shows that Olympia company plan to manufacture and sell 9000 units of alpha and 3000 units of beta.

- An analysis of some of the work performed at Olympia company led to identification of 3 activities machining, material handling, and pattern making.

- Different cost is assign to three different activities which includes variable activity cost and fixed activity cost.

Research Result / Findings/ Summary

- Result is showed the activity based costing Variance analysis is differ from traditional variance analysis in many aspects.

- The researcher is using different analysis stages of allocation research to prove that the activity based costing Variance analysis is differ from traditional variance analysis.

- Even Activity based cost adopt same approach to cost allocation as traditional methods , but the development of activity hierarchies with different levels of allocation bases implies cost variances are more relevant indicators of favorable or unfavorable cost behavior compare to traditional unit based cost.

- The comparison of Activity based system and traditional variance analysis shows that traditional overhead variance analysis provides no useful information for management to making more valuable decision. Moreover, they are always irrelevant and misleading while the activity based variance information is offer new opportunities for overhead cost information.

Prepared by:

Goh Seek Yin

(Student’s name and signature)

(4) Journal Title

Cost accounting in auto manufacturing companies in Germany and the United States.

Author / (Year)

Jinkens, R., & RamMohan, R. Y. (2010)

Data Collection / Data Analysis

- There were using two automobile manufacturing companies from the Germany is Diamler-Mercedes Benz (MB) and Volkswagen (VW) and from the United States is Ford and General Motors (GM).

- The Data of these four companies are collected for six year from 2001 to 2006.

- The researchers conduct a research about comparison of the U.S and Germany automobile cost accounting system by using several financial ratios.

- Several of financial ratios are cost of goods sold/sales, operating profit/sales, earning per share, sales turnover of assets, operating profit/plant assets, debt/equity, plant assets/total assets, and return on investment.

Research Result / Findings/ Summary

- Result is showed that the Germany cost accounting system (GPK) is different from the cost accounting system that using by U.S.

- The Germany system consists of a modified ABC system, and fixed manufacturing costs are not charged to the product costs. However, the U.S costing systems are follows the traditional GAAP format where by fixed manufacturing costs is treated as product costs.

- The researchers found that the ratio is almost the same when compared the financial ratios of the four companies, except in four aforementioned areas (the average sales turnover ratios, average operating to plant assets, average debt/equity ratios and average ratios of plant assets to total assets).

- This study cannot provide any evidence in which costing system whether the traditional U.S. system or the German GPK cost system is superior in product costing.

- The comparison of the financial ratios of the four companies in this study showed that, in many areas, there is no significant difference between the two costing systems.

Prepared by:

Chan Wai Shan

(Student’s name and signature)

(5) Journal Title

Management accounting practices in the British food and drinks industry

Author / (Year)

Abdel-Kader, M. , Luther, R. (2006)

Data Collection / Data Analysis

- Benchmarking and Self-Assessment Initiative is managed by Leatherhead Food Research Association and supported by the Ministry of Agriculture, Fisheries and Food and the Department of Trade and Industry.

- The Ministry of Agriculture, Fisheries and Food and the Department of Trade and Industry aimed to improve the competitiveness of the industry by increasing the awareness and use of practical business improvement techniques.

- The researchers select the companies which are SIC UK industry code of "15" (manufacture of food products and beverages); employment of at least 30 people; and being active and independent companies for inclusion in the sample.

- The broad set of management accounting practices are budgeting, performance evaluation, costing, decision-making, communication and strategic analysis.

Research Result / Findings/ Summary

- The results show that traditional absorption costing systems have long been subject to criticism that the system do not accurately measure costs for decision making purposes.

- This study does not support any of advancement of such techniques would lead to their wide adoption for instance regression for separating fixed and variable costs in the food industry.

- This study supports support activity based costing (ABC) has been developed and promoted and target costing and the "costing of quality" was introduced as tools for confronting increased competition.

- The researchers found that the lower ordering of importance than usage for "Plant-wide" and "Departmental overhead rates" is not surprising and can be attributed to the costing advances related to ABC.

- The researchers found that increase of common multiple cost driver analyses related to ABC perhaps also explains the predicted demise of the fixed-variable costs distinction.

- This study does applied this company’s costing system to provide more accurate cost information for decision making purposes, respondents were asked to indicate how often and how important are seven techniques related to costing systems.

Prepared by:

Kong Fung Chi

(Student’s name and signature)

3.0 Finding

Traditional absorption costing versus Activity based costing system

After read through all journal articles, we found that there are no similar statutory requirements for corporate accountants to provide managers with the management accounting information necessary for decision making in their business operations. Cost accounting is an important integral part of management accounting. Product costing had become an issue in management accounting. It has generated conflict views is the allocation of overhead costs to products.

Traditional absorption costing is claimed to be resulting in an unfair allocation of overhead costs to products. After that, we found that the traditional methods of overhead cost allocation to products is not accurate. Traditional management accounting systems have been criticized because they focus on reporting information related to internal processes with little attention being given to the external environment and the effect of competitors’ decisions and cost structures on current and future processes of the business.

Activity Based Costing (ABC) did not receive widespread adoption. It consider as better method for product costing. According to Sharman (2003) states, an Ernst & Young survey in 2003, there are 98 percent of respondents reported that cost information is distorted due largely to improper overhead allocation. There are about 80 percent of the US companies still use the traditional methods. But, there are also have 20 percent of the companies tried to implement the ABC system. Although, ABC system design is complex but it can give correct and accurate information to managers.

Activity based costing (ABC) and management systems are used for instance and use as a range of tools to assess operational efficiency. Besides that, ABC also uses as a tools to assess the achievement of organizational goals (Asquer, 2003). Many firms are far from adopting most of these innovations yet. ABC is importance of budgeting for planning, budgeting for controlling costs, activity-based budgeting, budgeting with "what if" analysis, flexible budgeting, zero-based budgeting and budgeting for strategic planning at long period.

When ABC and activity-based budgeting (ABB) were cross-tabulated we found that all companies which reported high level of usage for ABC did the same for ABB. It may be that companies start implementing ABC and then them use the activities analysis performed during ABC implementation to prepare their budgets. It is interesting to observe, however, that ABB is seen to be markedly more important and frequently used than ABC. This supports our general finding that budgeting is more valuable than costing.

As can seem from all journal articles are more prefer using Activity Based Costing (ABC) method than traditional method in predict the profit budgeted, budget for planning, controlling cost, and budget for strategic planning for long term period.

3.2 Variance analysis in evaluation in actual cost and budgeted cost

Variance analysis is used to promote the management action at the most early stages, and it also used for the performance by means of variances. Based on the standard cost, after budget has been set, which is useful to compare the actual results against the budget. In addition, variance analysis is a process which used to examine each variance between actual and budgeted, expected and standard costs. This process also used to determine the reasons why budgeted results were not met such as materials costs too high, sales price too low and others.

According to the journal a third generation of activity based costing system by Namazi, M (2009) and Activity based variance analysis, new tools for cost management by Jonas, G (2004), We found out that there have similar between the journal which is they are using variance analysis to compare actual cost and flexible budget. This process is only worthwhile if the budget is realistic. However, in a well-run organization, the comparison between actual and budget is used as the basis for deciding the appropriate action.

By comparing actual cost (AC) with flexible budget (FB), the price variance is determined for flexible budget (FB), the price variance is determined for flexible activity such that AC>FB=unfavourable variance. AC< FB= favourable variance and AC = FB equates to no variance. Thus, manager not only determined each activity cost but also evaluates the result of actual cost with the budgeted cost activity.

Based on the journal Activity based variance analysis, new tools for cost management by Jonas, G (2004), we found out that there are two different types of variances in variance analysis which is budgeted variance and production volume variances. Budgeted variances can differentiate between budgeted and actual figures for a particular accounting category. Budget variances occur because forecasters are unable to predict the future with complete accuracy. As a result, some variance should be expected when budgets are created. Besides, the production volume variances concerning the analysis of fixed overhead cost is also of limited value. Variances indicate whether the facility is utilized in accordance with the denominator level use for the budget. With the efficiency variances, this information can be computed using more relevant measures.

In conclusion, variance analysis is the best indicator to evaluate actual cost and budgeted cost. It can helps the management to understand the present costs and then to control future costs. Thus, managers can take suitable actions to achieve the desired objectives if there is a variation of the actual performance.

3.3 Role of standard costing and variance analysis

Variance analysis is most suited to controlling the costs of unit-level activities. Besides that, it can also provide meaningful information for managing overhead costs. The overhead costs are fixed in the short-term. In contrast, variable in the longer-term if traditional volume-based cost drivers are replaced with activity-based cost drivers. The replace with activity-based cost drivers better reflect the causes of resource consumption. However, variance analysis cannot be used to manage all overhead the costs of these resources do not fluctuate in the longer-term according to the demand for them. Many organizations have adapted their variance reporting system to report on those variables that are particularly important to them.

Incorporate activity costs and cost drivers can be applied by variance analysis for those overheads that are fixed in the short-term but variable in the long-term (Mak & Roush, Kaplan, 1994). Therefore the variance analysis based on set-up hours will be identical to the variances that were computed when the number of set-ups was the cost driver. Thus, standard costs provide the basis for such decisions and can be derived from a database of either traditional or activity-based system.

Standard costing systems provide cost information for many other purposes besides control and performance evaluation. Standard costs and valuation analysis would still be required for other purpose. At the same times, standard costs and valuation analysis would require for the particularly inventory valuation. Standard costs and valuation analysis also would require for the profit measurement. If they were abandoned for cost control and performance evaluation, standard costs and valuation analysis would require for the decision-making even.

Reference

Abdel-Kade, M. & Luthe, R. (2006). Management Accounting Practices in the British Food and Drinks Industry. British Food Journal, 108(5), 336-357.

Drury, C. (2004). Management and Cost Accounting. London: Thomson Learning.

Drury, C. (2009). Management Accounting For Business (4th ed.). Hampshire: Cengage Learning.

Gerdin, J. (2004). Activity-Based Variance Analysis: New Tools for Cost. Cost Management, 38-48.

Jinkens, R., & RamMohan, R. Y. (2010). Cost Accounting in Auto Manufacturing Companies in Germany and the United States. The International Business & Economics Research Journal, 9(3), 121-126.

John, R. E., Boyns, T., & Matthews, M. (2002). Standard Costing and Budgetary Control in the Birtish Iron and Steel Industry: A Study of Accounting Change. Accounting, Auditing & Accountability Journal, 15(1), 12-45.

Namazi, M. (2009). Performance-Focused ABC: A Third Generation of Activity-Based Costing System. Cost Management, 23, 34-46.

UNIVERSITI TUNKU ABDUL RAHMAN

Faculty of Business and Finance

Bachelor of Business Administration (Hons)

Bachelor of Finance (Hons)

Academic Year 2010/2011

Year 3/ 2

UBAM3013 Management Accounting

Lecturer / Tutor: Ms. Ching Suet Ling

Group Assignment

Submitted by:

Tutorial Group: T 7

Group Member:

Name

ID No

1. Chan Wai Shan

2. Goh Seek Yin

3. Kong Fung Chi

4. Tham Hey Wah

5. Yap Ruey Jia

11ABB05082

10ABB02804

11ABB04959

11ABB03126

11ABB02210

Group Leader: Tham Hey Wah

Contact No: 016-8016875

Table of Content

No

Assessment

Page

1

Introduction

1-3

2

Summary

2.1 Standard Costing and Budgetary Control in the British Iron and Steel Industry

2.2 Performance-Focused ABC: A third generation of activity-based costing system

2.3 Activity –Based Variance Analysis: New tools for cost management

2.4 Cost accounting in auto manufacturing companies in Germany and the United States

2.5 Management accounting practices in the British food and drinks industry

4-9

3

Implication of Results of Study/ Personal Opinion/ Findings

3.1 Traditional absorption costing versus Activity based costing system

3.2 Variance analysis in evaluation in actual cost and budgeted cost

3.2 Role of standard costing and variance analysis

10-12

4



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