Evaluating Traditional Costing Method and the ABC Method

2021-05-06 08:08:07
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I would like to bring to the attention of the Oz City Council the impact of the activity-based costing on the decision-making process having compared it to the previous traditional costing method. I understand this City was in a deplorable state before the current regime and the cause of the slow growth as well as dragging turnaround times was inappropriate costing methods and management policies. The city council is facing mixed reactions from different quotas due to the proposed implementation of activity-based scheme to determine the fee structures of various projects. The Financial Director having warned off running a budget deficit in the coming financial years it is only responsible for the City Council to implement policies that will mitigate the forecasted budget deficit. In accordance to the Financial Director, shifting from the allocation of equal cost to all the project was the best way to go around this problem. This would call for a change from the traditional costing method to more appropriate activity based scheme. Hence, it would notably cover the numerous reviews, for instance, plan reviews, site reviews and code reviews that come with the large projects which in this case are the only ones being affected by the change.

The stakeholders, who are opposing this raise of the fee to three times the current rate for the complex commercial, as well as industrial projects, are afraid of the scrutiny of the process. During the upcoming budget study session, it should be highlighted to all the stakeholders on the advantages that this activity based method has on the budget. Additionally, it should be put across to them the impact that this method has on the decision-making process. I find it appropriate to compare the two methods for clarity.

Traditional Costing Method

The traditional costing method is based on the mode of allocating the total projects overhead cost to the products that are being produced. The Traditional costing method is also referred to as the conventional method, and it allocates the indirect project costs to the products or services being produced based on their volumes. For instance, the total units produced the machine production hours as well as the total direct labour hours (Gregorio and Soares). This system of cost allocation uses only a single indirect cost in every department or even the entire project. Hence, the traditional costing system is entirely indirect cost driven. This is the system that the City Council had used to prepare the fee structure of the projects on the equal cost basis. Hence, the extra cost of the large projects, for instance, plan reviews, more working hours and clerical services were not reflected in the balanced costing approach. Additionally, this has the smaller projects being overcharged at the expense of the large projects since the total cost of all the projects is equally divided among the total number of projects (Sharma).

The major shortcoming of the traditional costing method is the fact that, most of the overhead cost for a single project is not correspondent with the single cost driver. Hence, this traditional cost accounting approach uses the volume-based driver, for instance, the direct machine hour or direct labour hour to allocate the overheads for all the projects.

Activity Based Costing Method

I would like to bring your attention to this method of cost accounting that the City Council wants to introduce as a way of curbing the forecast budget deficit. The activity-based costing approach traces the indirect cost of each project based on how each of the activities is using the available resources. The Activity-based costing method is instrumental in establishing accuracy especially in cases where the indirect costs are a considerable proportion of the total cost. Reflecting on its invention, the activity-based costing method was meant to replace the traditional costing methods which had been established approximately 1870-1920.Back in the days, the industry was heavily labour intensive, with no automation and the product varieties were limited, and so were the overhead costs. The activity-based costing was established due to the massive lack of relevance of the traditional costing methods since they were only structure oriented rather than processes oriented (Moorthy and Yacob). The following are some of the outstanding differences between the activity-based costing method and the traditional costing methods.

The traditional costing method considers that resources are consumed by cost objects while for activity-based costing method resources are consumed by activity objects.

The traditional costing methods often allocate the resources based on volume while the activity-based approach utilizes drivers at different levels.

The traditional costing methods are mostly structure -oriented while for the activity-based approach it is process-oriented.

The City Council would be right to implement the activity-based costing method since it appreciates the fact that cost cannot be managed. However, the activities can be managed, and the cost will automatically adjust itself accordingly.

Additionally, the activity-based approach will give the City Council a mindset that will avail more performance metrics on the employees productivity. They can systematically investigate the employees activities; they will readily identify any surplus capacity if any and also any misallocation of capacity or even total lack of capacity. This would result in a cost cut on the smaller projects and a reallocation of high value on the large projects hence yielding high productivity, unlike the tradition costing method.

Impact of the Activity-based Costing to the City Councils Decision

The Activity-based Costing method is meant to solve the problems that were caused by the previous regime that had upheld the traditional cost management systems. The traditional costing methods presented the City Council management with inappropriate cost accounting method which they used to make their decisions for setting the projects fees structure. Activity based costing tracks internal activities of the business, then allocates each of the activities is given a separate allocation. Unlike the traditional costing method, the activity-based costing considers several cost drivers, for instance, maintenance cost and inspection cost. Most of the stakeholders may be against the activity based costing due to cost centers. However, the cost center may not generate direct profits to the projects, but they are vital for a well-functioning City Council structure. Additionally, the activity-based costing ensures there is cost allocation for each activity of the projects whilst making sure that the fees charged correspond with the resources used (Lonsdale, Wilkins and Ling).

Recommendations

Most of the stakeholders at the Budget study session will be wondering whether the forecasted budget deficit will be a major concern. It should be noted that during a budget deficit the City Council will be spending more resources than they are acquiring hence there must be a way to mitigate the budget deficit. The City Council should adopt the activity based costing to raise the fee charged to the large projects. This will triple their current fees, and it will provide the City Council with sufficient revenue to fund its expenditure. The performance audit which was used to initiate a new cost allocation scheme was successful since it was able to identify the weakness of the previous scheme and hence it can be used as the blue print for the urgent reforms to mitigate the City Council from the forecasted budget deficit. In the short run, the adoption of the new cost allocation scheme will receive criticism from different quotas especially the developers in the large projects and the City Council leaders who are resistant to change. However, with adequate civic education on the importance of the change and the long-term benefits, they will adapt. Hence, the Citizen advisory board should conduct massive civic awareness.

Conclusion

In my conclusion, the new cost allocation scheme will lead to an efficient performance by the city council due to increased productivity. Despite the fact that the citizens are up against the implementation of this vital change in shifting the attention from output to outcome as well as activities, they will come to appreciate the change after they have realized the benefit, they are just afraid of committing to change due to the fear of the unknown. The Oz City Council will be in a position to mitigate the forecasted budget deficit due to the adoption of the new cost allocation scheme that replaces the traditional costing methods.

Works cited

Gregorio, Leandro Torres Di, and Carlos Alberto Pereira Soares. "Comparison Between The Mix-Based Costing And The Activity-Based Costing Methods In The Costing Of Construction Projects". Journal of Cost Analysis and Parametrics 6.2 (2013): 77-95. Web.

Lonsdale, Jeremy, P. A Wilkins, and Tom Ling. Performance Auditing. Cheltenham, UK: Edward Elgar, 2011. Print.

Moorthy, Krishna, and Peter Yacob. "Green Accounting: Cost Measures". Open Journal of Accounting 02.01 (2013): 4-7. Web.

Sharma, N. K. Advanced Cost Accounting. Jaipur, India: ABD Publishers, 2010. Print.

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