Production Costs Assessment and Activity Based Costing System

What is it Important for management to assess the production cost?

In manufacturing firms, it is critical for the management to assess the cost of producing each product as this knowledge is essential for the survival and success of the organization. Firstly, the assessment of the production cost for each unit has a huge impact on the profitability of the company (Fixson, 2004).  Profits can only be attained where the revenue earned in each product surpasses its production cost. Therefore, it is essential for the firm to assess the cost in order to determine the appropriate pricing mechanism. Second, the cost of producing each product has a significant impact on the firm’s budgeting. The budget process relies on accurate determination of costs, expenses and revenues, and is necessary for forecasting purposes (Fixson, 2004). When information on product costs are ignored, significant errors are likely to occur, leading to overspending and financial strains. Third, assessment of manufacturing costs allows the company to evaluate the range of resources required to produce one unit as well as how this information affects the long-term operations of the firm.

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If, for instance, the product is relying on repetitive costs and wastes, the company can then plan on how to integrate the concepts of lean production in order to create value and minimize wastes. Above all, product cost assessment enables the firm to apply the principles of effective product cost management (Fixson, 2004). This is particularly helpful when a business is developing or introducing a new product. It is important to note that no matter how great a product is, it cannot lead to success without profitability. It is the responsibility of the company to integrate a cost and value engineering approach at early stages of the development process through transparency on resources and costs in order to guarantee long term success.        

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 Activity Based Costing or Traditional Costing Method in Production Costs Evaluation?

In the field of accounting, production costs can be evaluated via different techniques including activity based costing and traditional costing method (Abernethy, Lillis, Brownell, & Carter, 2001). Both methods estimate costs and then assign those costs to units based on cost-driver rate. However, Activity based costing is more reliable and accurate in cases where a product uses different proportions of manufacturing overhead resources. As opposed to traditional costing which applies indirect costs to products based on presumed overhead rates, Activity Based Costing assigns costs to overhead activities and then proceeds by assigning those costs to individual products. Therefore an activity based costing system accounts for the relationship between overhead activities, costs, and manufactured products, thus assigning indirect costs to products less randomly than traditional acting techniques. This explains why Activity based costing is commonly used in manufacturing firms. To begin with, it enriches the reliability of data, which leads to nearly true costs and better classification of costs in the production process. Because it is based on activities (work units), such as designing products, setting up machines, operating machines, and distributing products, it is comprehensive in covering overhead costs.

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In conclusion, activity based costing improves the costing process in three major ways: it expands the amount of cost pools used on assembling overhead costs; it creates new bases for assigning costs; and it alters the nature of indirect costs and makes them more traceable to certain activities (Brimson, 1991). Activity based costing is more accurate and thus superior to traditional techniques of costing.

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