The Managing Director of Bird Garden Products wanted to figure out why the financial reports were not showing improved profits for their toucan line despite the expanding volume of sales in both their toucan and parrot lines. He wanted the trace the reason for this so that proper measures can be undertaken. As Managing Director of the company, he would want their operations to focus on profitable products but he needed accurate financial reports as basis for any final decision that he would make.
While increased sales almost always accompany increased profits, the lack of such expected increase in the profits coming from the toucan line was rather unexpected and abnormal. Given the circumstances, the Managing Director considered the use of a different costing approach – one that hopefully would give him more accurate figures and would more clearly detail the specific costs charged to specific products of their company.
Among the prevailing realities in the operations of most companies are as follow: a) increased sales do not necessarily tantamount to increased profits; b) products can be either money-makers or money-losers; c) there are more money-losers to avoid than there are money-makers to go for; and, d) there is no way to
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These are the same realities that the Managing Director of Bird Garden Products was dealing with. Thus, a new system is needed to determine the true cost for each cost object (product, job, service or customer). Activity-Based Costing (ABC), then, comes as the alternative costing approach to implement. As compared to traditional absorption costing, Activity-Based Costing (ABC) would improve the quality of the financial reports submitted to management.
Activity-Based Costing is the more accurate cost management methodology. While the traditional absorption costing gives more attention to direct costs, Activity-Based Costing treats direct (direct materials and direct labor) and indirect (overhead) costs in the same way. While the traditional absorption costing simply allocates each expense category to the particular cost object, Activity-Based Costing traces each of them and accordingly charges them to the right activity or product (University of Pittsburg 2008).
2. Activity-Based Costing System is a costing system that is generally based on the idea that the total overhead and operating costs of a company are made up of traceable figures arising from a number of related processes and procedures that are all necessary to manufacture its products. Since manufacturing activities incur costs all the way, it is important to be as accurate as possible in identifying costs and recording them as production costs of specific products.
Given its nature, ABC therefore generates both near-accurate cost figures and comprehensive information about the make-up of the company’s product costs. (Cooper & Kaplan 1988: 98) The basic premise of Activity-Based Costing goes: Cost objects consume activities, activities consume resources, and this consumption of resources is what drives costs. Understanding this relationship is critical in successfully managing the company’s overhead costs (University of Pittsburg 2008).