Activity Based Costing – Ultimate Guide (Part -2)

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Activity Based Costing in decision making

Activity based management; shortened ABM uses ABC to make decisions that leads to increase in profits by satisfying the customers.

Activity Based Costing’ and cost reduction

Most companies adopt the ABC system in order to achieve more accurate costs of pricing products and product mix decisions. However, they often reap greater results through use of ABM to pinpoint opportunities to lower costs.

ABC can also help organizations using the value engineering to reduce the cost. Value engineering is the re-evaluation of activities to cut the costs while achieving the satisfaction to the customer needs.

Value engineering requires different teams coming together;

  • Marketers identifying customer needs
  • Production personnel and engineers in designing more efficient products
  • Accountants estimating on the impact on the changes in price

Application of ABC in Different Sectors

In Service Business:The service companies have had challenges with the cost accounting systems as they have been modeled after system found in the manufacturing companies and firms. The problem here is that the manufacturing firms emphasizes on the inventory value, which the service industry do not have in the first place, and use the standard costs that are calculated for direct labor and materials.

The direct labor and direct materials costs are not the majors in the service firms and hence makes it difficult to calculate the standard cost in such a setting.

Nevertheless the service industry needs to have accurate costs for profitability analysis of products. They need to establish;

  • Which products are more profitable?
  • Which products need to be given more emphasis?
  • The trend of profitability of a product over time
  • The product cost as a bases to set prices

But according to Kaplan and copper (1996), the service companies are the ideal candidates for ABC use even more than the manufacturing companies. Their justification behind this is that most of the cost in service organization are indirect as compared to manufacturing companies and can trace important components that have been discussed above.

Indirect costs are likely to have smaller proportion of the total cost. The service industry must also supply most of their resources in the fluctuations and advance in the usage of activity resources by individual services and customers do not influence short term spending to supply the resources. Such costs are treated by the traditional costing system as fixed and irrelevant for decisions. This resulted to situation where the profitability analysis was never considered helpful to be used for decision making. Little has therefore been given tot eh developing costing system such as ABC that accurately measures costs and profitably of individual services.

Privatization of the government owned monopolies; intensive competition and deregulation as well as expanding product range created a need for the service organizations to develop management accenting g systems that enables them understand the cost base and determine the profitability sources for their products, services, customers and markets.

Most service organizations are hence operated using the ABC system of costing in their management.

In Financial Sector: As regulation ended in the banking sector, cot became a more important factor as the banks increased competition levels from one to the other. The banking costs are not customer-driven but rather focus on the number of processed transactions. Traditional volume based costing has become inappropriate in such cases. Banks are now shifting on the concept of users paying for the cost of services used, to ensure that bill is shared evenly. In order to do so, there must be accurate reflection of the services.

The Healthcare Sector: In the past the healthcare providers used to increase their prices so as to increase their profitability and revenues. Today, managed care firms set revenues with their Prospective payment System (PPS). Healthcare providers only need to make good decisions with accurate information on cost to improve their profitability. The PPS improved the sophistication of the healthcare accounting systems. Important information needed by the healthcare and hospitals include;

  • Accurate allocation of administration costs to products
  • Information on cost of various activities
  • Cost of episode of care
  • Comparison of cost over time

All of this information is available from ABC systems.

Insurance Industry:This industry is moving forward in terms of management due to the increased levels of competition. Workers spend time working on a single task, but the time varied depending on the case. The discussion here is on the ABC systems and hospital malpractice insurance. A study has shown that variety of factors lead to malpractices cost and that malpractice risks were tied on geographical locations.

ABC systems are all about management of cost. The service companies using it can reduce and control the costs t make correct pricing and other related decisions, to increase their profitability. The system has the flexibility to provide special reports so as to ensure that management take decisions on the designing, selling and delivering of products and services. The key aspect is that ABC focuses on cost accumulation via activities which helps in minimizing or avoiding the product costs that may come from the arbitrary allocation of the overhead costs.

It is surprising how the management practices and methods have evolved over time, and will continue to change. Organizations are also moving from vertical management to horizontal potion. There has also been a shift from the function orientation to process orientation. Further, management systems are one needed to track information about the horizontal business aspects that have lagged behind the needs of the managers. ABM and ABC fills the information gap by providing operation and cost information that mirrors the progress of such firms and companies, giving the way forward to company success.







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