Executive Summary
This report shows that Cambden Company needs to adopt the activity based costing model (ABC) because it improves its efficiency and complements its product and service delivery process. Recommendations are given for the adoption of the model because the company operates a dynamic product line and it experiences stiff competition from other companies. The activity based costing model would therefore modernize the company’s costing systems and make them more efficient, accurate and reliable.
Introduction
Cambden Company is located in Clayton, Melbourne, but it mainly sells its products to retail shops in Victoria, Australia. The company sells cakes and pastry products. Since 1985, when the company was formed, tremendous changes have been witnessed in the business. Most of these changes are attributed to changes in production strategies and changes in the operating environment. Most of these changes have been initiated by the current managing director, who is the son of the company’s founder. For instance, the company has tremendously revolutionized its production systems from being human-reliant to machine-reliant. Currently, most of the company’s production system is reliant on machine input as opposed to human input, with most of the human input reduced to supervisory roles aimed at ensuring the machines are working properly. This change has ensured the company reaps maximum benefits arising from increased production levels. However, these gains have been reduced by increased competition from other manufacturers. The competition has significantly reduced the company’s market share and indeed, its profits. These changes have seen the company’s managing director worry about the future growth of the company. Concerns are centered on the sustainability of the company’s operations, in light of minimum sales experienced as a result of increased competition. The company now ponders on if to employ better marketing and advertising strategies to improve its sales, but the company’s new management accountant, Monnie Jones, observes that, if the company adopts better costing methods, it will be able to significantly reduce the company’s costs, thereby improving its profitability.
The main concern for the company’s new management accountant is the fact that the company relies on a product-based costing system which distorts the way costs should be allocated. In her view, the company should allocate the production costs, based on the company’s activities. As a result, Monnie Jones wants the company to pursue an activity based costing system because she believes the current product-based costing system distorts the cost allocation of high and low volume products, while the activity based costing system can do a better job at this. The fact that the company changed its production strategies to a machine-based costing system was of more concern to the newly appointed management accountant because the company is currently experiencing increased production costs, which need to be properly allocated to production factors.
This paper is based on a report that seeks to justify the use of activity based costing by highlighting the limitations of the current costing method. This paper therefore exposes the advantages that the company can enjoy by adopting the activity based costing system by showing how the new costing system will help the company overcome the current limitations it experiences from its current costing system. Finally, this paper highlights the missing centre costs and resource drivers for the company, including the missing costs for the list of activities for the factory in the year 2010.
The Current Costing System
Cambden has been known to use the traditional costing system. This system allocates costs to products on an average rate. The main difference between Cambden’s current costing method and the activity based costing method lies in their sophistication and accuracy1. Activity based costing is complex but more accurate when compared to Cambden’s current costing method. Cambden’s current costing system allocates its costs to its products, based on a predetermined overhead rate, and unlike most costing systems, Cambden’s current costing system treats its production overheads as a single pool. This costing system is known to be highly efficient if there is a low threshold of indirect costs as opposed to direct costs. However, this is normally not the case because after the company experienced a change in production levels, its costs tremendously increased. It is therefore unrealistic for the company to continue using the current costing method, though it is simplistic and therefore, easy to apply.
The strongest limitation of Cambden’s current costing system is that, it is very difficult to apply in a company that produces many products. Research shows that the system is more efficient for companies that produce only one line of products but it is less efficient if a company produces multiple product lines2. Cambden produces multiple products. Emblemsvåg explains that,
“Firms that have a lot of overhead expenses need a more reliable method to allocate the overhead costs to different products. If a business uses incorrect costing to allocate costs, it could price its products incorrectly. This might affect its competitive position”3.
Cambden’s costing system therefore has a direct impact on the competitiveness of the company, and it is equally crucial to note that the company is currently grappling with the challenges of increased competition. Cambden’s costing system therefore limits its chances of overcoming its competitive pressures.
Another limitation of Cambden’s costing system is its inability to cope with change. Manufacturing trends have tremendously changed over the years and Cambden’s costing system has failed to adapt in this regard. Here, we can see that the company’s costing system is outdated4. For instance, most manufacturing processes currently use information technology and organizations or companies that use direct labor (for example) are misguided because information technology has greatly reduced the reliance on human labor. In fact, these trends have greatly led to the increased adoption of activity based costing system because it is modern and it is a better way of allocating overheads.
The potential consequences of using the current costing system are numerous. For instance, the current costing system is likely to limit the company’s chances of overcoming its competition because the current costing system is inefficient and expensive, considering the company’s operating nature. It is therefore almost impossible to overcome the challenges that are experienced as a result of increased competition if the company does not adopt a newer and more efficient costing system. Lastly, as mentioned in earlier sections of this report, the efficiency of Cambden’s costing system is limited to the production of a single (or a few) product lines, whereby if it is subjected to the production of many products, it becomes highly inefficient5. It is therefore impossible to use Cambden’s current costing system if the company engages in the production of multiple product lines. This is a strong limitation to Cambden’s operations.
Appropriateness of Activity Based Costing
As mentioned in earlier sections of this report, the activity based costing system is complex but more accurate than Cambden’s traditional costing system. Its accuracy is attributed to its ability to break down Cambden’s indirect costs into respective activities where costs are allocated. The activity based costing model is precise in allocating costs for entire products and services, and it is also accurate in identifying products and services that are profitable, and those which are not. In the face of stiff competition, the ability of the activity based costing to identify products or services that are profitable (from those that are not) is a good tool to specialize on producing and marketing products which are profitable, and discontinue the production of slow moving products to reduce the costs of production for maximum profitability. Cambden needs this tool to wade through its competition. This tool is closely linked to management’s decision making role, whereby they are supposed to make strategic decisions regarding the future sustainability of the company in the wake of stiff competition.
The activity based costing can help Cambden’s management to make better decisions regarding the company’s cost and product development because it provides a deeper understanding of the two elements. Cambden’s management can therefore make better-informed choices regarding the best strategy to undertake in the wake of stiff competition. For instance, the company can make better decisions regarding if to outsource some of the company’s production processes, how to price the company’s products and similar strategic tasks that have a direct impact on the company’s bottom-line.
The activity based costing system is also a better representation of the company’s production processes because it provides a clearer understanding of the company’s activities. Cambden’s traditional costing system provides a mere snapshot of the company’s operations but it fails to highlight the small details of the company’s operations which are crucial for costing purposes. For instance, the activity based costing system provides a better understanding of the company’s overheads and it utilizes the company’s unit costs as opposed to the company’s total cost. The computation of total costs is an abstract way of computing the company’s total costs and therefore, it does not represent the true position of the company’s operations. However, most importantly, the activity-based costing system provides a more accurate assessment of the company’s overheads and it easily facilitates the benchmarking of company operations.
How Activity Based Costing Would Help In Overcoming Organizational Hurdles
As mentioned in part two of this report, Cambden’s traditional costing system greatly limits its sustainability, in the wake of increased competition. Secondly, the second part of the report highlighted the limitations of the traditional costing system in supporting the production of multiple product lines. The activity based costing model seeks to overcome these hurdles because it is modern and it has been easily used to allocate costs in companies which produce multiple products6. Its application to these companies is based on the accuracy it provides companies when computing for products that are either profitable or not. Companies which have struggled to establish which products perform well in the market (and which ones perform badly) have found the activity based costing system beneficial to their operations. The time and effort required to implement the activity based costing model is worth Cambden’s time because it produces multiple products. The traditional computation system is weak in this regard because it lacks the capacity to compute multiple products.
Activity based costing will also go a long way in ensuring Cambden stays above its competition because it increases the efficiency of the company’s operations. With an increase in efficiency, there will be a significant reduction in operating costs which will in turn result in increased competitiveness. This is a contribution that the activity based costing model will add to Cambden’s operations (it will also enable it to comprehensively overcome the limitations of its traditional costing model, with regards to the efficiency needed in the marketplace).
Cost Amounts
In excel spreadsheet.
Total Product Costs
In excel spreadsheet.
Cost Difference Explanation
The total cost of production for the traditional costing system and the activity based costing system vary because of the accuracy of the activity based costing system. The production overheads are precisely allocated (under the activity based costing system) and therefore, the results are more efficient and precise.
Implementation of Activity Based Costing
The implementation of activity based costing is not a simple task. In fact, the transition from traditional costing methods into activity based costing models is a complex issue. In this regard, Cambden needs to consider the technical expertise needed to implement the activity based costing model because the system is more complex than the traditional costing model. Here, a range of technical skills is needed to implement the model and it may entail the training of hiring of new personnel to implement the model. The management accountant therefore needs a well-trained financial team that knows how to implement the new costing model.
Another factor to consider in the implementation of activity based costing is the financial muscle of implementing the new model. Cambden needs to have enough financial resources because the implementation of the new model may require the hiring of new personnel, restructuring of business activities, compliance with new costing standards (among other factors) which are crucial in the implementation of the activity based costing model. These requirements demand an intense capital investment.
8.0 Conclusion
Activity based costing is known to improve the overall costing system of a company. This paper affirms this fact, and points out that Cambden Company is set to gain from improved efficiency and a stronger capacity to produce several lines of goods if it adopts activity based costing. This advantage is especially supported by the fact that Cambden Company bears an expansive operational framework that manufactures several product lines. The efficiency of the activity based costing model comes in handy because it enables the company to improve its competitive position. The activity based costing model would therefore modernize the company’s costing systems and make it more efficient, accurate and reliable.
References
Cokins, G. (2001) Activity-Based Cost Management: An Executive’s Guide. London, John Wiley and Sons.
Baker, J. (1998) Activity-Based Costing And Activity-Based Management For Health Care. New York, Jones & Bartlett Learning.
Drury, C. (2007) Management and Cost Accounting. London, Cengage Learning EMEA.
Emblemsvåg, J. (2003) Life-Cycle Costing: Using Activity-Based Costing And Monte Carlo Methods To Manage Future Costs And Risks. New York, John Wiley and Sons.
Weygandt, J. (2009) Managerial Accounting: Tools for Business Decision Making. London, John Wiley and Sons.
Footnotes
- Cokins, G. (2001) Activity-Based Cost Management: An Executive’s Guide. London, John Wiley and Sons.
- Cokins, G. (2001) Activity-Based Cost Management: An Executive’s Guide. London, John Wiley and Sons.
- Emblemsvåg, J. (2003) Life-Cycle Costing: Using Activity-Based Costing And Monte Carlo Methods To Manage Future Costs And Risks. New York, John Wiley and Sons, p. 2.
- Drury, C. (2007) Management and Cost Accounting. London, Cengage Learning EMEA.
- Weygandt, J. (2009) Managerial Accounting: Tools for Business Decision Making. London, John Wiley and Sons.
- Baker, J. (1998) Activity-Based Costing And Activity-Based Management For Health Care. New York, Jones & Bartlett Learning.