Planning is one of the most important and fundamental parts of running a business (Topfer 2011). The basic goal of planning for any profit organization is to achieve maximum profit with limited resources. During the process choices must be made on how to allocate resources and model their costs (Graves 1999). Therefore cost information is used in various types of planning. For example when planning to start up a new business cost of capital is considered, in marketing plan cost of promotion activities is needed to keep it within budget, in financial planning cost of sales is used to project revenue, and etc.
Cost information is especially important in manufacturing companies as it will directly affect cost of goods sold and in turn overall profit margin. Thus, when formulating a production plan cost like material used, direct labor, manufacturing overhead (Goosen 2008), and other variable production costs must be identified and minimise. Besides that, cost information serves as a basis when estimating costs in future planning. For example when planning to add a new product in the product mix, we can calculate the estimated cost that will incur based on historical cost information.
Then it is used to determine the profit-making capacity and decide whether the plan should proceed. Control As an interrelated process with planning, the control process also uses cost information to access performance and keeps cost in check as planned (Cagwin and Bouwman 2000). Cost information in control process also serve as input for better plans in the future. In today’s competitive market, a business’s profit-making capacity is steered by its efficiency of controlling. This is especially true for a manufacturing company where costs are sensitive to the overall profit.
In order to maximise efficiency in the use of labor, materials, machines and plants, cost control is implemented. Basically cost control programs uses information derived from cost accounting to improve net margin for the company. These cost information includes input costs of each step of production and fixed costs such as machine depreciation (Investopedia n. d. ). Pricing In modern open markets, competition is very strong and the pricing are defined by the market competition and the product’s competitiveness (Garrison and Noreen 1999).
However, it is not feasible in the long run for a company to sacrifice its profit in order to compete with a lower price. Since profit should not be bargained, costs became the target function that can be influenced by a company to reduce price. (Pesonen 2001) Thus, when setting price for a product, the input cost of the product like product development, testing, and packaging have to be taken into account. Other than that, the life cycle of the product will also affect pricing as it usually costs more in promotion during new product offering stage.
Besides that the business context also influence pricing because to setup a brick and mortar shop to sell the product incurred more costs compared to an online offering (Tanner and Raymond 2010). ABC vs Functional Based Costing In the traditional cost system, a single unit-level basis is used to track indirect costs such as direct labor or machine hours used to manufacture the product (weygandt et al 2005). In this approach, the cost of overhead increases with increased volume of units produced.
Such costing system would create inadequate cost information in today’s global and technological environment as direct labor in manufacturing significant decreases while large amount of machinery usage increases (Rattanaphaphtham and Ussahawanitchakit 2010). This cost allocation would mislead managers in decision making on product price as the relationship between product and cost incurrence is not captured correctly (Qian and Ben-Arieh 2008). The main problem a traditional costing system faced is undercosting and overcosting.
As mentioned earlier, the system uses a single unit-level measure as an overall cost driver which tends to assign costs to products based on an arbitrary average basis. It does not meet the cause-and-effect criterion desired in cost allocation. Thus, products that require customization and more resources to build are not assigned its fair share of cost, resulting in undercosting. On the other hand products that are fairly easy to build and require fewer resources are assigned with higher costs which it should not bear, causing overcosting.
Using these inaccurate cost information in pricing decisions may cause unintended predatory pricing or over pricing. ABC has been accepted as more accurate in the costing and pricing of products than traditional cost accounting (Hilton et al. 2008). In ABC, cost is first allocated to all the activities performed to manufacture a product, and from there to the product based on how much each product uses the activities (Hilton et al 2008).
In this way managers can have a clear picture of what cause costs and modify the activities to reduce cost of product in an effective manner. Besides that, non-value added costs can be identified and minimise so that pricing can be lowered without sacrificing customer perceived value (Weygandt et al. 2005). For example, inventory storing and handling; transportation of raw materials or partly finished products; and redundancies in production-line configurations are few non value added costs that could be reduced.
In conclusion, activity based costing provides accurate, reliable and relevant cost information for managers to improve overall efficiency as unnecessary costs are identified and reduced. At the same time lower cost allows managers to make competitive price decisions effectively. However in companies that involve little indirect costs and accuracy of cost information is not crucial for the success of the company, using a traditional system might be much simpler and costs less than implementing a complex system that will not benefit the company significantly.