Activity Based Costing and the Theory of Constraints – Assignment

Activity Based Costing and the Theory of Constraints – Assignment Words: 2357

Business Management and Accounting I understand that the School does not tolerate plagiarism. Plagiarism is the knowing or reckless presentation of another person’s thoughts, writings, inventions, as one’s own. It includes the incorporation of another person’s work from published or unpublished sources, without indicating that the material is derived from those sources.

It includes the use of material obtained from the internet. (Senate Regulations 6. 46) By completing the above details, I confirm that I adhere to the School’s Policy on plagiarism. Activity Based Costing and the Theory of Constraints are, respectively, Overhead Absorption Costing and Marginal Costing in a different guise Introduction In this assignment I will be investigating the assertion that Activity Based Costing and the Theory of Constraints are, respectively, Overhead Absorption Costing and Marginal Costing in a different guise.

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To analyse this statement I will compare ABC with Overhead Absorption Costing and Theory of Constraints with Marginal Costing. All of these methods are well know and generally used in organisations, however Activity Based Costing and Theory of Constraints are relatively new methods, as both were developed in around 1970s whereas the other two are more than seventy years old. This is why it will be interesting to see how those methods compare, whether older methods will be still relevant and can they really be replaced by more contemporary techniques if those methods are alternative to each other.

The results should show similarities and differences between each method used in cost and management accounting, primarily whether each method is an alternative to each other, assuming it is used depending on required outcome, suitability to given information or size of the organisation. Activity Based Costing vs. Overhead Absorption Costing Overhead Absorption costing is a two stage process of allocating organisation’s overhead costs to particular cost objects. In allocation process, all variable and fixed overhead costs are charged to cost units produced. It was developed during 1920s, when most organisations were labour intensive.

Although this method is probably the oldest method developed in cost allocation, still this day is most widely used by most organisations. Absorption Costing is recognised by Ireland Revenue, as stock is not undervalued, moreover all companies must use this method in preparing financial accounts. Absorption process has two stages: allocation and apportionment of costs into departments called cost centres where they are reapportioned and finally absorbed to specific cost object which is the cost for specific unit. “Received wisdom has it that absorption costing should not be used for decision making, i. e. on-volume related costs should not be allocated to the product unit level. ” (Absorption costing for decision making by Mike Lucas, Management Accounting; London: Oct 1997) This is because some of the cost incurred by the company will be self-determining of the number of units produced. Major flaw to overhead absorption costing is that its absorption bases (cost drivers) are mainly volume related, such as machine hours or labour hours and in present times indirect overheads become larger proportion of total costs. Therefore allocating these overheads using this cost drives causes under or over absorption.

The consequence of this is variance between budgeted costs and actual cost. That is why this method is not appropriate for cost control. This is the main difference from ABC method, where there are more of costs centres know as the activity cost centre and they have their own allocation base, not necessarily volume-related. Activity Based Costing is a rather new method, applied to allocate overhead costs to particular product or service. ABC works on the bases of absorption costing but more detailed therefore more useful in decision making. It was developed in USA in the manufacturing sector throughout 1970’s and 1980′.

It came about, as overheads incurred in organisations became more activity-related rather than volume-related. , which is a result of more advanced technology used in manufacturing sector and increased global competitiveness, therefore traditional costing systems mainly including overhead absorption costing, became to some extent obsolete. The method is based on traditional absorption costing, therefore uses the same two stage process of allocation ‘Activity based costing assigns cost to activities based on the consumption of resources.

These costs are then assigned to products or services on the basis of their use of these activities’ (ABC v TOC: Same cloth as absorption v marginal, different style and cut? – Tony Tollington; Apr 1998). Activities can include such as production planning, maintenance, ordering, material handling, production set-up and other related activities. Activities include aggregation of many different tasks and are described by verbs associated with objects. Management and Cost Accounting; Colin Drury, 6th edition, pg72) ABC acknowledges those activities and their use of organisation resources, the amount of activities costs moreover may vary with the production level, also that some products may share larger proportion of those activities used in the production process. One of the main distinctions of ABC from overhead absorption costing is that overheads are accumulated to each separate activity, rather than the department, so called cost centres. In ABC this represents activity cost centre.

Furthermore in ABC each different each activity cost centre has its own, suitable allocation base, and than is directly absorbed to cost object, so they are not absorbed in mainstream departments, like in traditional costing systems. Another distinction of ABC is that service support costs are assigned to a separate support activity centre, where separate cost driver rates are established and than portioned directly to cost objects, whereas in traditional cost systems, support costs are assigned to production cost centres and than allocated to cost objects, therefore they are absorbed within production cost centre.

Overall ABC gives more detailed view of true resource consumption and links activities costs directly with manufacturing overheads and prime costs. Moreover ABC method helps organisations in cost control, as some activities cost may vary directly with production level; however they have different allocation bases. Where in traditional absorption costing these activities are not regarded as volume related, and are assigned with other fixed costs. This is where ABC is better method as it concentrates on identifying each factor that derives cost. The recognition to use ABC for planning and decision making was advocated by Kaplan and Cooper.

They state that the believed reason of ABC development is to improve the quality of planning and decision making; therefore a unit cost should not be the main focus. (Absorption costing for decision making by Mike Lucas, Management Accounting; London: Oct 1997) This is why both of the above methods are alternative to each other, because they both calculate unit cost, however with different purposes; traditional absorption costing used for financial reporting in cost accounting, because it is less time and cost consuming than ABC, which can be used for better planning, control and decision making in cost management.

Furthermore traditional absorption costing might give better results in companies where production process is labour or assets employed intensive, whereas in companies where their prime cost is outweighed by company’s overhead cost, such as service industry it will be more beneficial if ABC system is applied. Theory of Constraints vs. Marginal Costing Marginal costing is another alternative costing system known also as variable costing or direct costing. It is a costing method where only variable costs (direct costs) are charged to the cost of unit produced and included in the inventory valuation.

Fixed and non-manufacturing overheads are disregarded from calculation as they are considered to be period costs. (Management and Cost Accounting, Colin Drury; 6th edition, pg 229) Marginal costing is a simple process of taking company’s revenue and subtracting direct labour cost, direct materials costs and variable overheads. The given result is Contribution Margin which is subsequently utilized in paying company’s fixed and non-manufacturing overheads. Any leftover from sales revenue is considered as profit.

Marginal costing is a useful tool for decision making, as it reports profit levels at any given sales level. Therefore variable costing is straightforward method for managers to forecast costs and revenues at different activity level. With marginal costing, under or over absorption does not exist, as fixed cost are written off in Profit and Loss account, therefore it shows actual level of costs and profit at any given time, especially as calculations are directly linked with actual sales level rather than volume produced like in absorption costing. Consequently profits are never under or over-stated.

Marginal costing is ideal for monthly financial reports as it can be rapidly produced. Moreover through this method managers can set goals for sales level, as they can know exactly at what sales level the company would beak-even. However marginal costing ignores that some fixed cost will change according with the production level of specific product, maybe not in a short term. This can mislead of how much contribution should be charged to the variable costs, especially to specific product in multi product manufactures, since there are no allocation bases.

Therefore to make sure that the price is competitive on the market and that it covers all of the fixed costs, this can cause fluctuations in profit even if the sales level remains the same. (www. globusz. com/ebooks – Chapter 2- Marginal costing and Absorption Costing) Another disadvantage of this method is that it makes use of historical data, while decisions are related to future dealings. (www. basiccollegeaccounting. com –Marginal Costing: its features, advantages and disadvantages. Theory of Constraints was developed by Eli Goldratt during mid-1980s. At first it was known as Optimized Production Timetable (OPT). However through Goldratt’s continuous research, this concept evolved by 1987 to be known as TOC. This concept is based on two statements: •Every system must have at least one constraint (bottleneck), which “is anything that limits a system from achieving higher performance versus its goal” (Goldratt, 1998, pg. 53) •Constraint can also mean opportunity for improvement. TOC has two parts, one which is philosophy and consists of five working steps: •Identify the system’s constraint(s); •Decide how to exploit the systems constraint; •Subordinate everything else to the above decision; •Elevate the system’s constraints; •If in any of the previous steps a constraint is broken , go back to step one; (Theory of Constraints; A review of the Philosophy and its applications, author- Shams –ur Rahman, source – Emerald; pg. ) First stage also includes the drum-buffer-rope (DBR) scheduling methodology and the buffer management information system, which is normally referred to as TOC’s “logistic paradigm” which was evolved from the scheduling software called optimized production technology (OPT) Three are three measures to apply TOC ideas, which are the second stage of TOC and is called the thinking process (TP) •Throughput contribution and it works by deducting direct materials from sales. Investments (inventory) which is the sum of inventories, research and development cost and the costs of equipment and buildings •Other operational expenses which include all operating costs incurred to earn throughput contribution (Management and Cost Accounting, Colin Drury; 6th edition, pg. 337) There are not many similarities between TOC and Marginal Costing as TOC is mainly used in management accounting.

Its purpose is continuous improvement in all cost departments, “it provides a coherent management theory for running an organisation” (Theory of Constraints; A review of the Philosophy and its applications, author- Shams –ur Rahman, source – Emerald) However Goldratt uses one method in applying his theory that resembles very much Marginal costing, therefore it could be classified as alternative method in cost system. “Throughput is defined as the rate at which a business generates money through sales” (ABC v TOC: Same cloth as absorption v marginal, different style and cut? Tony Tollington; Apr 1998). The only difference from marginal costing is that throughput excludes direct labour and overheads as Goldratt considers those as not variable costs in the short run. Both throughput and MC have the benefit of no under or –over-absorption. Also both techniques of calculating variable unit cost cannot be used under SSAP9 standards in stock valuation purposes. Also both techniques are used to report profit at any given time. However throughput as a part of TOC concentrates on reducing costs, rather than just calculating variable costs and contribution margin.

Therefore it could be said that throughput is an alternative method to marginal costing however in a different guise. Taken as a whole, this essay has proved that Marginal Costing and Overhead Absorption Costing are alternative methods to TOC and ABC, however in a different guise. First two methods are used generally in cost accounting, where the main focus is on achieving cost unit, therefore they are used in external accounting. The main advantage of marginal costing and traditional absorption costing is that the results can be produced much faster and at lower cost than the other two techniques.

However they provide limited information as to what are the components costs of the unit cost, therefore they are inappropriate for planning, control and decision making. This is where TOC and ABC methods are more suitable, as Kaplan and Atkinson declared (1989) “is best exemplified by noting that over the last several decades, the costs that have risen fastest in most organisations have been those costs that their accounting system has considered fixed. Therefore these methods are tools necessary for running a successful business in such a competitive environment. Each organisation will benefit differently from each one of these methods. Most importantly TOC and ABC should not replace marginal costing and traditional absorption costing, but they should be used in conjunction as to make the best informed decisions. Overall any information is better than no information. References: Main reading: Management and Cost Accounting, Colin Drury; 6th edition, chp. 0 “ABC overhead analysis beats traditional approach”; Penne Ainsworth, source: The Practical Accountant 28. n7-July 1995 “Overhead projection” by Samuel Idowu; CIMA Insider, February 2004 Absorption costing for decision making by Mike Lucas, Management Accounting; London: Oct 1997 Theory of Constraints; A review of the Philosophy and its applications, author- Shams –ur Rahman, source – Emerald www. basiccollegeaccounting. om –Marginal Costing: its features, advantages and disadvantages. www. globusz. com/ebooks – Chapter 2- Marginal costing and Absorption Costing Marginal Costing by Adolph Matz ; research pg. 355 (Jun 1950) Introduction: Marginal Costing as a Management Accounting Tool, by Stephen Offenbacker; Management Accounting Quarterly. (Winter 2004) Absorption Costing -Money, Angela; Accountancy (Nov 1995) www. priciplesofaccounting. com – chapter 20: ProcessCosting and ABC

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