Avtivity based Costing

During the 80’s, it be came apparent that the conventional techniques for recovering overheads were increasingly providing the management with cost information that was inaccurate and misleading. New techniques for overhead recovery was needed Innes,J. & Mitchell.F,(1991). In order to produce a more accurate costing system, Cooper and Kaplan in 1988 developed a more refined approach for assigning overhead to products and computing product costs and called this approach activity-based costing (ABC) (Colin Drury ,2001).

An article published by Mike Jeans & Michael Morrow (1989) summarizes that there are five main factors which led to the development of ABC. The factors are “management accounting practice has become distorted, direct labour has shrunk as a percentage of total cost for the majority of manufacturing companies, overhead costs are no longer a mere burden to be minimized, products have become more complex ,and the marketplace is more competitive”. It is because of all the reasons mentioned above, that companies needed a new costing system and hence the emergence of ABC.

What is activity based costing? Offtech Computing Pty Ltd, (2002) stated that Hicks (1999) has defined ABC as, ” a concept around which it can construct an economic model of its business that will provide the accurate and relevant cost information necessary to support sound business decisions of all types”. Activity-based costing is a costing model that identifies the cost pools, or activity centres, in an organization and assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or services.

(Narcyz Roztocki,1998) in his website and Jeans and Morrow (1989) both stated that cost objects consumes activities, which in return consumes resources and this consumption of resources is what drives cost.

Jeans and Morrow (1989) also discussed ABC approach and summarised it by saying that ABC is able to identify any factors or activities that has a direct cause-effect relationship with the resources consumed to produce a product. This means that ABC system traces rather than allocates each expense category to the particular cost object. In ABC, cost drivers are used to assign activity cost pools to products or services and this gives a better perspective of resource allocation and all cost involved in a particular product. ABC system design compromises of two stages according to Drury (2000) which are, to identify the major activities that take place in an organisation, assigning costs to cost pools / cost centres for each activity in the first stage, and determining the cost driver for each major activity and assigning the cost of activities to product according to the product’s demand for activities in the second stage.

In traditional system mentioned by Drury (2001) and Innes & Mitchell (1991), allocating overhead to production or a series of rates is based on departments. This means the companies’ total overhead is allocated to the products based on volume based measures such as labour hours and machine hours. Stuart (2001) stated that companies may tend to make an assumption that there is a relation between overhead cost and volume based measure and that these volume based cost drivers assume homogeneity on all products and if the products are heterogeneous than some products might be overcosted and others might be undercosted (cost subsidization).

Innes & Mitchell (1991) states that the basic formula used for traditional costing is (total product cost / production volume). They argued that most companies produce a range of different products and that each production consumes many resources and at different proportion of resources and traditional costing system do not take this into consideration in overhead allocation. In traditional costing overhead cost cannot be traced so easily and is allocated on assumptions. Drury (2001) further mentions that in ABC system, overheads are assigned to each major activity and many cost pools are established whereas traditional system overhead tends to be pooled by departments. There were many reports and researches undertaken in recent years, which show how ABC has benefited companies. We shall now see two of the three cases that have been highlighted by Professors Cooper and Kaplan in Mike Jeans and Michael Morrow (1989).

The first case study was on Siemens Electric Motor Works (EMW) a company that produced electric motors that adopts full absorption system. In the 1980’s EMW faced a problem when eastern competitors entered the market with an insurmountable cost advantage. EMW management reacted by doing an analysis on various departments and resulted in identifying a support cost. This cost was then removed and two new cost pools were assigned and were spread across five new departments. EMW’s revised product cost information enabled them to decide which orders were profitable and which orders should be accepted.

The second case study was on John Deere Component Works a group manufacturing a diverse range of agriculture products that operated on absorption system. In 1980’s the agricultural sector sustained a great depression. In order to secure sales bids with Deere’s they knew that they needed to lower prices and a detailed study was carried out. The team found out that the use of overhead resources could be explained by seven different types of support activities. These were recognised as the key overhead cost drivers and estimate percentage for each overhead account caused by the seven cost drivers and arrived to a suitable rate for each activity. This resulted in 41% of overhead shifted from labour and machine hour rates to activity bases and they were successful in bidding the next round.

It is very clear that the case study done by Cooper and Kaplan on these two organisations state that the implementation of ABC in these organisations has made product costing information more accurate which was very valuable to managers in identifying areas for process improvement and improve decision making.

Innes & Mitchell (1991) reported a case study on a multi national company in USA that has a base here in the UK that previously adopted full absorption system of overhead based on labour cost. In later years the labour cost proved only 5% of total product cost, which then influenced the UK plant to look at ABC costing system as the management knew that overhead cost based on labour cost was inaccurate. After using ABC system, it identified fourteen different cost drivers and also determined each cost pool for each driver. The ABC system used produced substantial information for plant management in exhibiting some substantial differences to absorption system and gave them a detailed data on how and where production overhead incurred.

Innes & Mitchell (1991a, p.29) says that ABC system “significantly improves efficiency through reducing material movements, eliminating non-value added activities in consumer servicing and identifying and resolving maintenance problem areas”. Drury (2001) said that ABC cost system may be used to view as a resource consumption model which could be used to make decisions on adjusting the spending on the supply of resource to match resource consumption. C & K Management Limited (2002) mentioned that ABC analysis could be used for forecasting cost, performance analysis, to set competitive price for products, developing budgets and target settings for a company.

Although there were many case studies undertaken about the benefits of ABC on organisations, there are however many critics about the relevance of it. An article published by Piper and Walley (1990, p.37) questioned the fundamental assumption on which ABC is based. They argued that “decisions cause cost is superior to the argument that activity causes cost as a decisions precede activity” and factors such as decisions or time, volume and other factors were not taken into consideration in the Jeans & Morrow (1989) case studies. These case studies also did not prove any benefits of ABC as they were many other changes taking place in those companies.

In another article by Piper and Walley (1991, pg.42), they criticised ABC’s approach, which treats “the relationship between activity and resource consumption as being linear, absolute and certain”. They argue that ABC only uses a small sample of historical information and extrapolates it into a long term situation and the Japanese uses labour based overhead absorption system which encourages operational staff to reduce labour element or as they mention “motivates employees to reduce unnecessary activity”. They further criticise that ABC actually does not provide any useful information because of current increasing application of marketing and competitive strategies, the linkage between price and cost is too complex to be captured by any means of costing system including ABC. They mentioned their concern over ABC system that it assumes that the change in the usage of resources will result later in a change in cashflow.

Bromwich and Bhimani in Piper and Walley (1991, pg.44) states that “there is no real evidence that…profitability can be increased if this new technique (refers to ABC) is used in firms” and further argued that ABC is not appropriate at strategic level and at operation level management.
Cobb, Innes & Mitchell (1992) conducted a survey on various companies to measures the problems of practice in implementing ABC in their organisations and reported their findings in 1992. This survey was conducted on thirty companies, which were considering implementing ABC in their organisation. In their findings they concluded a series of problems with ABC system and the implementation of it.

The first problem was the amount of work involved in installing the system. Many managers complained that ABC needed too much of detailed information which takes up too much of time to gather these details especially in identifying activities, selecting cost drivers and collecting the raw data needed for the cost drivers and relating it to specific products.

Other complains reported was that there were more important or urgent priorities to look into such as the survival of the company and changing manufacturing systems.

Lack of staffs and scare resources of computer was another limiting aspect. Most companies complained that there just was not enough time for accountants to concentrate on ABC. Selection of appropriate cost drivers was also mentioned as a problem foreseen in ABC.

Other reasons reported was the lack of support from the parent companies or top managements, staffs changes in firms, identifying activities, and also the problems of reaction from staffs to ABC information’s and the need to re-educate managers.

Some companies that were considering implements ABC complained that consultants fee are too expensive and some products tend to cost more and this was not favoured by staffs and in some cases activities tend to cross departmental boundaries.

Drudy (2000) mentioned that ABC systems in which cost units are calculated will suggest an inappropriate degree of variability by giving different average cost per unit of output depending on the selected output level. He also mentioned that only traditional costing system traces the cost of unit-level activities to products and this cannot be done by any other costing system.

C&KManagementLimited (2002) mentioned that ABC does not consider opportunity cost
As a conclusion, traditional product costing system distorts product costs whenever an organization produces a diverse range of low- volume and high volume products. ABC emphasises the need to obtain a better understanding of the behaviour of overhead costs, and to ascertain what causes overhead and how they relate to products. ABC system is a model of resource consumption and not spending. ABC also attempts to measure the total organisational resource required to produce a product and it also designed to identify priorities for managerial attention. ABC are used in companies for product costing, and cost management purposes. There are many case studies done on companies that have implemented ABC as a costing system, which resulted in improved decision-making at management level and the better understanding of their product cost. However ABC tends to be a problem in implementing in small companies because of its high cost and time consuming. Further more there are no evidences that ABC in the long run would be more profitable than companies that use traditional costing system.

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