ABC VERSUS TRADITIONAL COST MANAGEMENT

ABC VERSUS TRADITIONAL COST MANAGEMENT

Introduction

            Effective cost management is one of the major reasons behind the success of any business organization. Companies need to employ the most up to date cost management methods if they are to realize the best returns from relatively lower inputs (Kaplan, 1994). Cost management is important in decision making in any organization. Sound management decisions are made following accurate cost allocation stats. A good example is the allocation of funds to different departments involved in the business operation in different ways. Efficient cost management will show the exact figure the departments need to execute business operations effectively. This, in turn, will lead to the allocation of the exact amount of funds the corporates need to prevent under or over allocation (Ison & Wall, 2007). The result is business operation at their optimum levels with little input.

Cost management is one of the pillars that support saving. Kaplan (1994) claims that by just allocating the exact amount of input into a business, the excess amounts may be saved for future use or even in insurance organizations. The undertaking serves as a backup in case the company suffers severe losses resulting from a declining market or even natural calamities such as floods, robberies, theft and others. The above two instances clearly highlight the importance of cost management to an organization (Ronald, 2008). It is important for the realization of the highest amount of profit while injecting minimal inputs in a business process. The scenario shows the significance of cost management and why it should be done in the most effective. An organization may decide to employ cost management using two methods that include traditional costing method and the more recent ABC costing methods (Ronald, 2008).

Overview of Traditional Costing Methods

            Traditional costing methods are known for applying costs based on a predetermined overhead state (Ison & Wall, 2007). The approaches treat overhead costs as a single entity and as a collection of overhead costs. Traditional costing methods are preferred when indirect costs are lower relative to the direct costs. Several procedures are involved in the traditional costing methods. It includes identification of the indirect cost, estimating the time that the direct cost may be incurred in the appropriate period and moving on to select a cost-driver linked to the cost. The next set of steps involve estimating the number of resources that may be used by the cost driver over a period of time, and finally computing the predetermined overhead rate as well as applying the overhead rate to the products. (Ison & Wall, 2007)

Traditional costing methods have been found easier and simpler to implement and manage than the modern ABC systems. This is mainly because it takes the indirect costs as an average, unlike the ABC system, which accounts for the indirect cost of every single entity involved in the business (Ison & Wall, 2007). It is characterized by some demerits, however, such as the lack of accuracy. Since the indirect costs are taken as an average considering pre-determined costs in the past, the method is bound to have some inaccurate measures leading to over or underestimation. The scenario may present losses to the organization involved (Ison & Wall, 2007).

Overview of ABC Costing Methods

            ABC or activity-based costing methods are a relatively modern approaches to the traditional costing methods (Ronald, 2008). The course involves identifying activities in an organization and assigning the cost of each activity with resources depending on the actual consumption of each organizational activities. The method assigns the indirect costs to each activity and entity involved in the business process, the result is a relatively accurate cost management measure as compared to the traditional methods.

The activity-based cost management method involves assigning an organization’s resources costs to the product and services the organization distributes to the clients…. defines it as a tool used for understanding product and customer cost, effectively and profitably based on production and costing processes (Ronald, 2008). The undertaking makes the ABC method appropriate in the process of making decisions based on strategies such as identification and measurements of potential expansion points on an organization, outsourcing and pricing (Blaug & Mark, 2007).

The system is however characterized by some demerits that are worthwhile to note while employing the method. The setbacks include the expensiveness and time consumption the method is prone to having. Another major demerit for employing the ABC method is the misinterpretation of data (Samuelson, Paul, William & Nordhaus, 2004). The data obtained from traditional cost management varies significantly to that obtained from an ABC costing method. The demerit can lead to misinterpretation of data and consequently making of wrong management decisions (Ison & Wall, 2007). Since the activity based costing method involves accounting for every single entity in an organization, it may lead to large amounts of data that may not even take part in decision-making. According to Samuelson et al., (2004) the result is time wastage, which could have been utilized for more productive means. Despite the minor demerits, the ABC method remains the most efficient costing method due to the following reasons.

Why Companies Should Switch to ABC as Opposed to Sticking to Traditional Methods

Accuracy

            One of the reasons stated above is the accuracy the method employs (Ison & Wall, 2007). Today’s companies and organizations face one major strife; that is competition. Various emerging companies in the economy market offers goods. The commodities are to some extent indistinguishable from the goods produced by competitors. Samuelson et al., (2004) note that to keep up with the competition, organizations need to employ methods of business practices that suit the modern today. Therefore, in the department of cost management, the ABC method will suffice. It provides accurate data that allows one to manage the various product and services that a company supplies (Groenewegen & Peter, 2008). The ABC’S accuracy reduces the amount of risk an organization may incur.

Efficient Costing

The accuracy of the ABC methods is an important factor in the process of preventing over-costing and under-costing. Since the traditional methods are known for estimating or taking the average overhead cost of an entity, errors are likely to occur (Samuelson et al., 2004). The scenario, in turn, results to over-costing and under-costing of the various aspects of production. The under-costing and over-costing might lead to various losses or unsound decision management following application of wrong information in decision-making processes (Groenewegen & Peter, 2008). The ABC method involves intense research and analysis of the various production entities thereby producing a result that reflects the exact cost that needs to be allocated to the entity.

Improvement of Business Processes

The ABC system is known for allocating costs, which are indirect to a product based on the product’s cost driver. The cost allocations to different products or production methods paint a picture of smooth running of business practices (Groenewegen & Peter, 2008). Areas that are in need of improvement are easily noted and the most appropriate improvement measures (Ronald, 2008). Areas that are in need of improvement are also easily noted and the improvement measures are implemented accordingly. It can also be used to identify activities that are non-value added hence the resources that might have been allocated to them might be used for different purposes. This, in turn, leads to effective business practices that work to ensure all its entities are given the correct amount of resources (Ison & Wall, 2007). The undertaking summarizes one of the major uses of ABC, which purposes to improve the general business process. Traditional measures offer an average approach to the various processes used in business practices. The aspect renders it hard to quantify the exact aspects of the production process. Therefore, it becomes more difficult to establish the areas in need of improvement (Ison & Wall, 2007). The result is stagnant business growth and the apparent lack of improved business processes.

Identification of Wasteful Products

The ABC method is known for cost accounting methods that are similar to the ways production work is done. This, in turn, allows you to understand where the overhead costs are allocated (O’Sullivan, Arthur, Sheffrin & Steven, 2003). The data can allow managers to identify the products and production processes, which are wasteful, hence deal with them accordingly. The products are also the sources of unnecessary costs. Uncovering the wasteful products is therefore a major boost in terms of production (O’Sullivan et al., 2003). Traditional cost control methods treat each production entity as an average. This may make it hard to identify the products, which are incurring unnecessary costs. The result of this as stated above is stagnancy and the apparent lack company growth (Rad, 2002). The facts further attest to the fact that traditional methods are obsolete in modern day standards.

Conclusion

            Companies may employ either traditional costing or the more modern ABC costing methods. The choice is entirely dependent on the companies’ production. The ABC approach is, however, a more efficient modern day approach to costing methods. Robert S Kaplan in his chapter in the Management Account Research publication (page 248-249) sites the various companies that are successful because of employing the ABC methods. It includes the well-known Hewlett-Packard Electronics Company and Sony Erickson. The success of these companies can be directly attributed to the employment of the ABC cost management method.

Bibliography

Rad, P.F. 2002. Project Estimating and Cost Management. Management Concepts.

O’Sullivan & Arthur & Sheffrin & Steven M. 2003. Economics: Principles in Action. Upper Saddle River, New Jersey 07458

Ison, S. & Wall, S 2007. Economics, 4th Edition, Harlow, England; New York: FT Prentice Hall.

Groenewegen & Peter 2008. “‘political economy'”, The New Palgrave Dictionary of Economics

Samuelson & Paul A.; William D. Nordhaus (2004). Economics. McGraw-Hill.

Blaug & Mark 2007. “The Social Sciences: Economics”, The New Encyclopædia Britannica,

Ronald, 2008. “Comparative advantage”, The New Palgrave Dictionary of Economics, 2nd Edition,

Kaplan 1994 “Development of New Practice and Theory” Management Accounting Research.

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