Value Added Activity-Based Costing
Activity-based costing is a departure from the traditional costing methods, which allocated costs to products or services using bases like machine hours or labor hours. The result of this was therefore to focus on high turnover, loyal and consistent customers who purchase from the company because they were assumed to be the ones bringing in more profits. In the traditional costing methods, the profitability of a product was associated with those customers who traded with the company always as well as whose business was significant (12Manage.com: 2008).
Activity-based costing on the other hand focuses and identifies those activities that cause costs and their related costs. These costs are then classified into cost centers or cost pools.
The costs in the cost pools are then assigned to cost drivers. Cost drivers are the activities that are undertaken in the provision of products and services of the company.
Activity-based costing facilitates the use of continuous improvement methods such as Kaizen costing where the staff of the company can identify and have the knowledge on the costs incurred in the production process. When the employees have understood the various costs, then, they are in a better position to identify those activities that add value to the production process as well as those that do not.
It is a form of ensuring production efficiency is enhanced throughout the production process.
The following diagram can illustrate the whole concept of continuous improvement and how it can be used to enhance process improvement.
One of the benefits of continuous process improvement is that the company will have the ability to produce quality goods and services at cheaper costs compared to rivals. Therefore, the company can improve its profitability.
Activity-based costing provides the company with accurate and up-to-date information on costs. This information can then be utilized by the management in the formulation of strategies to improve the overall profitability of the company.
Activity-based costing focuses on activities that cause costs leads to the determination of the profitability of the various products, distribution channels, and even individual customers. Thus, the company can be in a position to make informed decisions on whether to stop or continue with those products, customers, or channels.
Another benefit that accrues from the use of activity-based costing is that the company’s management can formulate strategies of improving the business profitability consequently enhancing shareholders’ wealth.
Economic Value Added method
Value creation and enhancement by the management of companies are becoming an important critical aspect of corporate performance measurement. This is because of the numerous factors that can affect negatively the financial performance of companies (Girotra, Arvind, Yadav and Surendra Jan-March 2001).
Economic value added is based on the premise that the shareholders must be rewarded adequately for the risks assumed and therefore the performance of the company should be equally rewarding as similar risk securities in the market. This method ensures that the company does not maintain surplus capital or have too much capital held up (Girotra et al., 2001)
The economic value added formula is as follows
EVA= NOPAT- WACC x capital employed
Where NOPAT- Net profit after taxes
WACC – Weighted average cost of capital
Economic value added is not a profitability measure but it helps the management in ensuring that the performance of the company is over and above the cost of capital to compensate the investors for the risks undertaken in investing in the company. This means that the management and staff can evaluate the investments decisions they make.
EVA can also be used in process improvement. The economic value added method enables the creation of cost and resources centers which consequently ensures that those processes that add value, as well as those that diminish value, are identified thereby enabling the management to make the necessary adjustments in the financial statements.
The economic value added method helps managers and the staff of companies ensure that they invest in assets that can generate returns that are above the cost of capital otherwise it is not worthwhile if it generates lower returns.
This method, therefore, forces the management of the company to make investment decisions like the owners of the company by investing in projects that only produce returns equal to or more than the cost of capital (Girotra et al., 2001).
Positive returns, therefore, ensure improved business profitability.
The economic value added method helps the company to set a benchmark rate of return for any investments to be undertaken. It recognizes that the lowest rate of return a project has to achieve before being accepted is that of the average return of the other investments in the market e.g. equity(Girotra et al., 2001). The benefit of this is that it guides the management of the company on which projects to invest in.
The overall profitability of the company can also be enhanced by the economic value added method if it is adopted in rewarding i.e. as a form of compensation to both the management and employees of the company.
The company can adopt a policy that gives extra rewards or incentives to employees that can produce returns that are over and above the firm’s required cost of capital. This in essence means that the employees are motivated and challenged to work extra to produce returns above the cost of capital. The same case applies to managers if the rewards are based on returns. They will be forced to improve on their performance.
Business profitability improvement can be facilitated by the flexibility of the economic value-added method. As seen earlier, EVA avoids the maintenance of surplus capital thereby ensuring that the company utilizes these excess resources in activities/investments that generate positive returns.
Integration of activity-based costing and economic value-added methods by companies can result in improved cost and capital management in terms of utilization and allocation through cost structure enhancement which leads to better process improvement and profitability (Roztocki, Needy)
Roztocki N, Needy L K . An Integrated Activity-Based Costing and Economic Value Added System as an Engineering Management Tool for Manufacturers. Web.
12 Manage Management Communities (2008) Activity Based Costing. Web.
Girotra, Arvind, Yadav, Surendra S (2001). Global Journal of Flexible Systems Management: Economic Value Added (EVA): A New Flexible Tool for Measuring Corporate Performance. Web.