Cost accounting systems were originally developed primarily to assign costs to products for financial reporting purposes. Managers today want more from their cost accounting systems. Managers’ decisions drive an organization’s costs. To manage costs, managers and employees must understand how those decisions affect the efficiency of work being accomplished. ABC is a management accounting technique that assigns costs to the specific activities performed in a manufacturing or service delivery process. By learning what activities the organization uses to produce goods and services, managers can trace the organization’s costs to products via activities performed.
Activity Based Costing (ABC) attempts to trace costs more accurately to products or other cost objects than traditional costing methods. The cost of various activities then becomes the building blocks used to compile costs of products or other cost objects. Activity related costs are collected and cost drivers are chosen for each pool. Direct and indirect costs are then assigned to products or services using these activity-based cost pools and cost drivers. The information derived from ABC can be used with activity-based management to improve operations and minimize activities that do not add value to the organization.
Most organizations that use ABC have two costing systems – the official costing system that is used for preparing external financial reports and activity based costing system that is used for internal decision making and for managing activities.
Traditional absorption costing is designed to produce data for external financial reports. In contrast, activity based costing is designed to be used for internal decision making.
As a consequence, activity based costing differs from traditional cost accounting in four ways.
Traditional cost accounting methods suffer from several defects that can result in distorted cost for decision making purposes. The advantage of a traditional costing system is its simplicity.
ABC Benefits:* Increase awareness of cause-and-effect relationships
But operational costs can play an important role in any budget because they can change rapidly at any time. If these are fully incorporated into a budget or planning model, results are more accurate and dynamically reactive to change.
In ABB, projection of any changes happening in demands placed on any product or service for the following year which stems from managers’ assumptions or market research efforts leads to the determination of the level of resources required for production to meet the demands. This way the organization prepares a performance budget based on the volume of products or services not based on an incremental change of the expended resources.
PERFORMANCE BASED BUDGETING SOLUTION
Budgeting is a system for producing and exchanging information pertaining to the finances of government. To change the way budgets are made, it is necessary to alter its informational content and structure. To implement performance budgeting or budgeting for results, it is necessary to insert information on results into the budget and to link that new information to expenditures. Although this may appear to be an easy task, it has proven to be quite demanding for governments striving to budget for results.
To understand the challenge facing PB, one must decompose it into its two main elements. We have identified three technical and three managerial elements that ensure successful and sustainable implementation of PB and embedded them into a master model, DIAMOND model, and wrote a best seller book on it.
The three technical elements are planning, costing and performance measurement to link cost information with performance information. In short, a government entity is required to
* Identify outcomes (long-term objectives), outputs (products and services as annual targets) and activities (day-to-day operations),
* Calculate the unit cost of each products and services using management accounting techniques such as activity based costing,
* Measure annual targets (outputs quantity) and long-term objectives (outcomes progress) to link the unit costs to the extent we have achieved our targets and objectives for budget implementation phase.
The three managerial elements involve change management, management flexibility and management accountability. To put it in a nut shell,
* We have to contemplate the requirements for a successful transition from a traditional budgeting to a performance budgeting system. Can it happen overnight? If not, how long do we have wait? Are there any necessary training for managers and employees operating in the new budgeting system? Any laws and regulations changes required? Any managerial freedom and flexibility required? Etc.
* The introduction of performance budgeting is often linked to broader efforts to improve expenditure control as well as public sector efficiency and performance. Thus, performance budgeting is generally combined with increased flexibility for managers in return for stronger accountability for the results, so as to enable them to decide how to best deliver public services. If not linked to broader reforms, there is a risk that managers will view performance budgeting as simply another layer of central control and will resist it. Provisions for sanctions – including dismissal of staff – in the case of non-performance need to be in place. And finally,
* Robust systems of accountability and control, including internal and external audit, are required before granting increased flexibility.
EXPERFORM enables an organization entity to go through the required elements of DIAMOND model.
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