Term Paper, 2004
13 Pages, Grade: 1,5
1. Comparison of ABC and the client’s basis of overhead absorption
1.1 Characteristics and function of the client’s current basis of overhead absorption
1.2 Characteristics and function of ABC
2. Analysis of the potential benefits of ABC
2.1 Determination of accurate product cost
2.2 Profitable Product-Mix
2.3 Process efficiency and improvement of the business plan
3. Implementation of ABC and the required information
The initial aim of this report is to layout the main differences of the client’s current basis of overhead absorption, compared to activity - based costing (ABC). By showing the divergence of both systems, it appears that information generated from traditional overhead absorption does not properly equip client’s management with suitable information for decision making. An additional aim of this paper focuses on the potential benefits of activity - based costing. It illustrates the chances of ABC as a decision making tool to provide management benefits regarding the accuracy of cost and the achievement of goals and strategies. Lastly, this report highlights all information required for the implementation of ABC into the client’s organisation. It also reveals the necessity to collect and process the information needed in the correct format at a reasonable cost.
Today, manufacturing firms are confronted with an increasing competition in the global marketplace. The demand to increase profitability and the need to control costs demand an optimisation of entrepreneurial ability in managing them. Cost management can provide the tools, techniques, and mechanisms needed by companies to help achieve goals and strategies (Andersen, 1999). The augmentation of automation and rationalisation in manufacture, as well as the steady increase of complexity in production and distribution, has led to a serious adjustment of the companies cost structure (Freidank, 1997).
Roztocki (1999) states that in order to be successful in this new business environment companies have to be flexible and react quickly in manufacture. Furthermore, the author emphasises the need to have accurate and up-to date costing information to make decision-making effective and proper. Scarlett (2002) and Roztocki (1999) argue that traditional costing systems based on volume-allocation of overhead (direct labour hours or machine hours) no longer provide any accurate information for product calculation, due to the serious increase in overhead and the subsequent decline in direct labour. They even contribute to poor strategic decision making, owing to the tendency of traditional costing systems to distort product costs (Johnson and Kaplan, 1987). Hence, Freidank (1997) concludes that traditional methods of assigning overhead are deficient in terms of improving global competitiveness.
Activity Based Costing (ABC) has been designed to cope with the deficiencies of traditional costing systems. To achieve accuracy and transparency of product calculation, this accounting technique allows an organisation to determine the actual cost associated with each product and service (Coenenberg, 1992).
The main differences between traditional overhead absorption and activity based costing; the potential benefits from implementing an ABC system and the required information for its implementation are going to be analysed in this report.
The client’s current basis of overhead absorption and its functionality is based on the principle that overheads are allocated to products or services using only one volume-sensitive driver, typically direct labour (Cooper and Kaplan, 1988).
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