Managerial Finance essay
In actuality, the activity based costing is one of the widely-spread accounting methods. At the same time, in spite of its popularity, this method still evokes criticism from the part of opponents of this method, who believe the activity based costing to be unreliable accounting method. Nevertheless, the effectiveness of the application of the activity based costing in the accounting depends on the nature of business and organisations. At any rate, the empirical study shows that the activity based accounting may be successfully applied in some organisations, although it may fail in others. Therefore, the activity based costing is applicable but its efficiency differs depending on the particular organisation, the essence of its business, industry, business environment and other factors that may affect the efficiency of the activity based costing.
In its essence, the activity based costing (ABC) is the accounting method that involves the assessment of activities performed by a company and on the ground of such assessment indirect costs are assigned to products of the company. In such a way, companies conduct the assessment of their indirect costs on the ground of the analysis of costs of different activities which are directly or indirectly related to the production of certain products or services. As a result, the ABC involves the analysis of all activities within the organisation that ultimately affect the costs of the production of the organisation.
At the same time, it is worth mentioning the fact that the analysis of all costs implies the analysis of all activities, which is not always directly related to the production process or manufacturing of particular products. The ABC orients on activities of organisations and their costs rather than on the direct costs of certain products or costs of their production. In such a way, ABC method uses the indirect analysis of costs of products or, to put it more precisely, it involves the analysis of indirect costs of products and their production.
The major advantage of the ABC method is the recognition of the close relationships between costs, activities and products. In such a way, the revelation of indirect costs with the help of ABC can help to assess indirect costs related to specific products. The analysis of indirect costs is very important for organisations, especially in case of companies that have a complex organisational structure, such as multinational corporations (Mocciaro, Destri, Picone & Minà, 2012: 94). Large companies have the complex organisational structure that means that they have multiple costs which are not directly related to the production process or to specific products. As a result, companies have difficulties with the adequate assessment of their costs and, therefore, costs of specific products.
At this point, it is worth mentioning the fact that, if companies cannot define accurately the costs of the particular product, including indirect costs, they cannot set absolutely fair price. In other words, companies may set either too high price that would be unfair in relation to customers and put the companies into a disadvantageous position compared to rivals, who may sell the similar product at the lower price. Or, on the contrary, companies may set the price at the too low level. In such a case, sales of the product will not cover the costs of its production, including indirect costs, to the full extent. As a result, the company will suffer financial losses and deteriorate its marketing position in a long-run perspective.
However, critics of the ABC method of accounting (Sapp, Crawford & Rebishcke, 1990: 1223) argue that it is not always possible to assign certain costs to specific products. For instance, it may be difficult to trace the correlation between managerial costs and a particular product manufactured by the company. In fact, if a company cannot trace accurately the correlation between specific activities and their costs and relate them indirectly to the costs of specific products, the company may face difficulties with the adequate and accurate assessment of the costs of production and specific products (Drucker, 2009: 129). In such a situation, companies face the high risk of errors in the course of the accounting based on the use of the ABC method. As a result, many companies prefer other methods, including traditional ones, to calculate their costs and conduct their accounting, being uncertain in the reliability of the ABC method.
Therefore, being good in its intention to reveal the close correlation between costs, activities and products, the ABC method is still imperfect and the criticism of this method is, to a significant extent reasonable. In this respect, it is important to place emphasis on the fact that errors in accounting may be intentional and unintentional. In this regard, the ABC creates the risk of the emergence of intentional errors in accounting, when companies want to increase or decrease their costs pursuing their business goals, for instance, to attract investors. Moreover, top executives of companies may manipulate with accounting using the complexity of the ABC assessment of indirect costs of specific products. As a result, such top executives can create schemes with the help of which they can increase or decrease indirect costs to hide substantial financial losses of their company, for instance. In such a way, drawbacks of the ABC can create the ground for manipulations and intentional errors in accounting. At the same time, there is a risk of unintentional errors in accounting, when companies just fail to assess accurately indirect costs of products and correlate them to diverse activities conducted within the companies.
On the other hand, the criticism of the ABC method does not necessarily mean that this method cannot or should not be applied successfully. On the contrary, today, the ABC method has become particularly popular in the manufacturing sector, where it is easier to trace the direct relationship between costs, activities and specific products manufactured. In actuality, many companies operating in the manufacturing sector use the ABC successfully and conduct the accurate assessment of indirect costs of their products. The popularity of the ABC method in the manufacturing sector is the result of the specificity of the manufacturing sector and the ABC method. To put it more precisely, the manufacturing sectors involves activities which are all directed at the production process. As a result, the assessment of costs of those activities almost always lead to the revelation of indirect costs of specific products because there are no alternative activities that are not related somehow to the production process and to the manufacturing of the specific product.
At the same time, limitations of the ABC method prevent its wide use in the service sector and some other sectors, where it is difficult to trace the direct correlation between specific activities, their costs and services or products provided by the company for customers (Velmurugan, 2010: 12). The unwillingness of companies operating in the service sector to use the ABC method is also the result of the specificity of the sector and the ABC method. Unlike the manufacturing sector, the service sector cannot always provide accountants with the accurate information on various activities performed by companies which are directly or indirectly related to the costs of particular products. As a result, accountants face difficulties with the identification of all indirect costs and all activities related to the production of specific services or products. In such a way, companies operating in the service sector and some other sectors prefer refusing from the ABC and using traditional methods of accounting to ensure the high accuracy of accounting and prevent the risk of errors.
Thus, the activity based costing is an effective and popular method of accounting, which though cannot always be applied successfully. In actuality, the ABC method is very popular in the manufacturing sector but companies operating in the service sector, for instance, prefer using traditional methods instead of the ABC because they consider those methods more reliable. Such disparity in the use of the ABC in different sectors is the result of the specificity of the accounting method because the ABC method focuses on the analysis of indirect costs of products through analysis of costs of activities performed by the company which are directly or indirectly related to specific products. The more difficult it is to trace such correlation the less accurate the ABC method becomes. In the manufacturing sector it is easier to trace such correlation compared to the service sector, for instance. Hence, the ABC method is popular in this sector.
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