Introduction
Fixed/variable cost thinking has no place in today’s cost accounting world; those are words of Hervey (2010, p.1) an all time accounting specialist. This observation is as result of many limitations that accountants and managers have experienced in the past years in their efforts to differentiate between fixed and variable costs.
Some costs cannot be classified as either fixed or variable costs and yet they have to be allocated somewhere in the process of allocating costs to different cost centers. Traditional costing is also expensive compared to other methods (Alabbadi & Areiqat, 2010, p.239).
The inadequacies in this traditional cost approach have led to development of other methods that can allocate costs appropriately to their respective cost centers. One of these methods is activity-based costing (ABC) that allocates costs to different centers based on the activities that have resulted to these costs. This paper will use Farm Standard Council case to look at the differences between traditional cost allocation and activity-based cost allocation.
Activity-Based Costing
In the case of Farm Standard Council, activity based costing is used rather under traditional cost accounting in identifying different cost centers in the cost pool and also in the cost allocation. ABC approach is based on activity and not volume (Bengu, 2010, p.213).
Cost centers include equipment, general farm, maintenance and shop among others. Cost centers are classified into support center, services center, production center, marketing and profit centers. Costs are allocated to different production activities such as production, harvesting, processing and storage.
These costs are then divided by the quantities of crops produced at the end of the season in order to calculate the amount of profit produced per hectare of land. If the Farm Council used another approach such as traditional cost accounting, it would not be easy for the management to allocate costs to different cost centers and hence calculating profitability of each crop would be a challenge.
It would not have been easy for the management to allocate some costs that are neither fixed nor variable. Costs such as maintenance and shop could not be fairly allocated as either variable or fixed thus giving misleading information about profitability of each crop. This view is supported by Rezaie, Ostadi, and Torabi (2008), who claim that ABC is more reliable than traditional approach (p.1047).
As Harvey (2010) posits, costs are no longer driven by volume but by the demands of customers (p.2). However, not all the costs are driven by customers since some like maintenance are fixed. Thus, this case study provides a good example of how activity-based accounting can be employed in agricultural enterprises when allocating their costs.
Alternative Solution
The alternative solution is a more general cost accounting approach that may apply in many situations since the suggested solution (activity-based costing) was tailored to specifically fit the situation of Mary and John farms. The alternative approach provides a design that summarizes all the cost centers into three categories viz. support, production and profit centers (Farm Financial Standard Council, n.d, p.14).
The advantage of the alternative solution is that it is simpler compared with the suggested solution. Accountants and managers can group similar costs in one centre to avoid complexity in their allocation. In the suggested solution, all the costs have to be accounted separately which involves a lot of work.
Conclusion
ABC approach is much better than traditional cost approach since all costs can be fairly allocated to their respective cost centers. Suggested solution applies this approach in allocating cost in different activities. However, I would prefer alternative solution since it is more reliable and at the same time simple to use.
References
Alabbadi, H., & Areiqat, A. (2010). The Systematic Relationship between the Activity Based Management (ABM) and the Activity Based Costing (ABC). Interdisciplinary Journal of Contemporary Research in Business, 2(2), 239-264.
Bengu, H. (2010). The role of activity based budgeting on target costing practices. Suleyman Demirel University Journal of Faculty of Economics & Administrative Sciences, 15(1), 213-233.
Farm Financial Standard Council, (n.d). Managerial Accounting Case Studies. Case Study, No. 1, 1-14.
Harvey, R. K. (2010).Throw Out Fixed and Variable Cost Thinking— Bring In Activity-Based Costing to Business Decisions. White Paper, I, 1-6.
Rezaie, K., Ostadi, B., & Torabi, S. A. (2008). Activity–based costing in flexible manufacturing systems with a case study in a forging industry. International Journal of Production Research, 46 (4), 1047-1069.