Activity Based Costing Abc example essay topic

INTRODUCTION Accurate and relevant cost information is critical to any organisation that hopes to maintain or improve its competitive position. For years, organizations operated under the assumption that their cost information actually reflected the costs of their products and services when, in reality, it did nothing of the kind. While hiding their shortcomings behind a cloak of precision, over-generalized cost systems were actually misleading decision makers, specially the managers, causing them to make decisions inconsistent with their organisations' needs and goals. It is the duty of managers of organisations, whether it is a small or large organisation, to make decisions about utilizing available resources, pricing products, and adding or dropping product lines. Information is the basis for these decisions. Generally the better the information the better the decision.

Historically, the accounting system has been the major source of such information, and the only source of profitability information. Yet, accounting has never been able to completely focus on the task of supporting managers in their full range of decisions. As accounting has to serve external groups, such as investors, bankers, and regulators, the accuracy and validity of information provided has been compromised for the sake of uniformity and simplicity. As these compromises are significant, the allocation of costs to products may misrepresent the true performance of the firm. Specifically, overhead costs have been allocated in such a simplistic manner that initiatives taken in plants to improve competitiveness have not been captured in the accounting reports. Thus, managers may be misled, develop inappropriate strategies, and make bad decisions.

However, a recent development, Activity-Based Costing (ABC), provides an opportunity for management to bring overhead allocations into line with the way a plant actually operates and to significantly improve the functioning of accounting as a decision support system for strategic moves in improving competitiveness. Activity based costing (ABC) is a relative new way to allocate costs to specific processes and services. This system assures that the costs are accurately distributed to the products or services that generated them. ABC illustrates costs more accurately; giving management insight to the cost associated with certain business activities. ABC extends the decision-making skills of management by expanding on traditional costing (job order costing / process order costing) techniques. However, since ABC's introduction in the 1980's, many organisations are not using ABC and this is despite gained managerial decision making capabilities.

'Even by the mid-1990's, ABC's use has not spread throughout the accounting industry and its use is not obvious' reported Selto and Jasinski (1996, p. 24). It can be evaluated from above paragraphs that the studying and understanding of Activity Based Costing method is critical to the accounting profession specially Management Accountantancy. This essay will discuss this importance, then the essay will go on to discuss Activity Based Costing in detail. What is the difference between the traditional costing methods and Activity Based Costing?

What is the process of ABC? What are the strengths of Activity Based Costing to organisations? Are there any limitations of Activity Based Costing? Despite gained managerial decision making capabilities, why are organisations reluctant to adopt this method of costing? This essay will address these questions. The Accounting Profession and Activity Based Costing There is no doubt that the profession of Management Accountant in the future looks good.

Management Accounting is going to be the wave of future for accounting. Due to new management techniques, accounting has become more vital to the company as a whole. Some of the new ways of management include total quality management (TQM), just-in-time (JIT) production and purchasing methods and importantly activity-based costing (ABC). These various types of management style pull accounting into the company process more easily. Accounting has become an actual part of the management process. Therefore, the need of Management Accounting has grown in proportion to the new management styles.

Accountants are now becoming a larger part of cross-functional teams and they are being used more in the decision making process. There is also no doubt that much have been written about the demise of traditional management accounting systems and the revolutionary attributes of Activity Based Costing. Management accounting has undergone a renaissance since the mid-1980's. While much of this has been attributed to the pioneering work of Professor Robert Kaplan and his colleagues, opinion varies on the nature of these developments.

What is not in dispute is that the business environment and its management information needs have changed dramatically during that period. New models such as ABC have been hailed as the answer to our changing needs, and this has given rise to other applications such's activity based management and shareholder-value analysis. Traditional management accounting systems aimed to offer neutral, objective and calculable financial information. These systems were expected to bring to light the facts of costing, to enable the pursuit of efficiency and help better regulate management labour relations. They were however criticised on the grounds that they do not provide the type of information required in today's highly competitive and global environment. They are accused of giving misleading signals about product costs and adopting a closed, historical and inward looking focus.

Innes and Mitchell state that 'critics say that traditional methods do not accurately reveal the high costs of complexity caused by the proliferation of product lines, the globalisation of markets generally and the dramatic change in the cost profile of most organisations in the last thirty years or so' (1996, p. 6). The use of volume sensitive drivers to attach overhead costs to products may satisfy statutory and regulatory accounting requirements, but is not appropriate in today's competitive and dynamic business environment. This is perceived to have triggered the development of ABC in the mid-1980's. It purports to undo many of the flaws of traditional management accounting by providing an organisation with strategic and operational, financial and non-financial information.

It recognises business is a series of linked activities and processes that are undertaken to serve the customer and to deliver product attributes. Harrison & Sullivan (1996, p. 4) of University of United States (online) states that 'Activity Based Costing is clearly the most significant managerial accounting development within the last fifty years'. The basic concepts and mechanics of Activity Based Costing have been around for decades. However they were seldom used for a variety of reasons.

Hicks (1999, p. 8) of Gold ratt Institute (online) states that 'the concept of ABC has grown faster than any accounting concept in the recent history'. Simply, Activity-Based Costing is a valuable concept that can be used to correct the shortcoming of the over-generalized cost systems of the past. It is a means of creating a system that ultimately directs an organization's costs to the products and services that required those costs to be incurred. Activity Based Costing and The Traditional Costing Methods Over time there have been many definitions of Activity Based Costing. Kalpan has defined ABC simply as 'Activity Based Costing says that something has to be allocated' (1997, p. 9). Liggete (1997, p. 5) of Industrial Engineering (online) has defined ABC as, 'Certain activities are carried out in manufacturing of products.

Those activities consume a firm's resources, thereby creating costs. The products, in turn, consume activities. By determining the amount the amount of resources consumed by an activity and the amount of activity consumed in manufacturing a product it is possible to directly trace manufacturing costs to products'. ABC has been defined by Holman (1995, p. 2) of Computer Aided Manufacturing - International (CAM-I) (online) as, 'The collection of financial and operating performance information tracing significant activities of the firm to product cost'. Simply put Activity Based Costing is an accounting methodology that assigns costs to activities rather than products or services. This enables resource and overhead costs to be more accurately assigned to the products and the services that consume them.

For example: TRADITIONAL ABC Salaries $100 Clean door $40 Equipment $80 Paint door $75 Supplies $20 Inspect door $75 Overhead $45 Send door to assembly $55 TOTAL $245 TOTAL $245 ABC doesn't eliminate or change costs. It provides data about how costs are actually consumed. In the above example, if you wanted to reduce costs using traditional data you would have to decrease salaries, or decrease costs of supplies. You don't know enough to change the equipment or overhead costs. Using ABC data you can see that it costs the same to paint and inspect the door. Another example: Chart of Accounts View Activity-Based Costing View Salaries $621,400 Key / scan claims $32,000 Equipment $161,200 Analyze claims $121,000 Travel expenses $58,000 Suspend claims $32,500 Supplies $43,900 Suspend claims $32,500 Use and occupancy $30,000 Receive provider inquiries $101,500 Resolve member problems $83,400 Process batches $45,000 Determine eligibility $119,000 Make copies $145,000 Write correspondence $77,100 Attend training $158,000 Total $914500 Total $914500 How much financial insight is a manager likely to get from the chart of account report?

Although it provides the same total as the ABC report, the ABC report provides information that can be applied to cost management. The ledger information, although accurate, fails to report the business-process costs that run cross-functionally-that is, across an organization's departmental boundaries. It fails to show the true total cost of fulfilling a customer order that passes through many hands. This is quite understandable. After all, the general ledger is structured to collect transactions by departments-not to provide insights into work-related costs. As a result, the general ledger is effective for bookkeeping, but it's structurally deficient for assisting in decision making.

ABC is an extension of traditional product costing techniques. These techniques are called job order costing and process order costing. A job order costing system arranges costs for each unit as it goes through a production process. A process cost system collects costs in work in progress account. The numbers of units worked are recorded for the accounting period. These systems alone do not accurately illustrate costs incurred.

Instead, these two costing techniques generally lump costs into 3 main categories known as cost centers. These three categories are direct materials, direct labor and overhead. Cost drivers are then assigned to represent the relationship between the cost and the process it is allocated to. Activity Based Costing ABC provides a better map of the costs of manufacturing products or distributing services. ABC uses a multitude of activity centers, which are the equivalent to the previously mentioned traditional cost centers. Each of these activity centers has its own cost driver and driver rate.

ABC identifies many different costs to products by adjusting the cost driver and driver rates to specific activity centers. This process avoids across the board allocations of cost. For example, a product, which takes up. 05% of space in the warehouse, would require. 05% cost absorbed by product sales revenue. If the depreciation unit requires 6% cost to replace equipment at a latter date, 6% is the driver rate for that particular product.

Unit, batch and product level costs can be determined with ABC. ABC Process The following steps can summarize the ABC process. The first step is to identify the activities that consume resources and allocate costs to those activities. For example, purchasing materials, record keeping, labor, materials, miles driven, machine hours and number of customers served are activities, which consume resources and needs costs to be assigned to them.

The second step is to distinguish the cost drivers that are related to each activity. For example, if machine hours an activity used in the process, then the number of hours used in production of one unit would be the particular cost driver rate. The last step is to allocate costs to products by multiplying the cost driver rate by the number of cost driver units consumed by the process. Strengths of ABC There are many inherent strengths in the ABC model. The ABC model allows costs to be allocated to many different activity centers. Few corporations can focus on undifferentiated product lines and be successful.

Having multiple product lines means the company has multiple cost drivers associated with each different product line. ABC is helpful in selecting which products are successful and which ones should be eliminated. Accurate cost information is key in determining the actual costs of frequent product changes. This cost is important because costs can be a good indicator of the justification or termination of varying product lines. Product lines have become more complex.

Product lines of past were much simpler. For example, the Model T Ford came in one style and one color, black. Today, Ford cars have many different colors and styles. These different styles all have different cost drivers and activity centers. ABC illuminates hidden costs when high volume sales are not present and product differentiation is. This is advantageous because unprofitable lines can be replaced with lines that are profitable.

Kelly has found that not many years ago, labor comprised 25 to 50 percent of a product's cost. However, since the 1960's, labor is increasingly less involved in the production process. Kelly goes on to say that 'labor cost today is infrequently the driving force behind costs it was during the development period of cost accounting in the 1930's. Instead, indirect costs have replaced labor as the dominant portion of costs for some products' (1997, p. 21). To use labor as the major basis for allocating as job costing or process costing accounting does, may lead to inaccurate decisions by management. Limitations of ABC Despite its nuances and subtleties, an ABC system is still essentially an historic cost system.

Smith (1994, p. 7) of Chuck's College suggests that 'in certain circumstances its usefulness is doubtful, especially if future cost consideration are greater importance'. Far from eliminating arbitrary cost allocations of overhead costs, an ABC system actually may increase the number of such allocations. Thus, one must determine decision rules of the pooling of common overheads into separate cost pools and common cost drivers into separate activities. Smith went on to say that 'once these items have been identified, there is the danger of trying to employ a single cost driver that may not be entirely representative to explain the cost behavior of the whole cost pool' (1994,267). The aim of ABC is to apply overhead costs on the basis of course and effects; that is, production overhead costs are closely traced to products. Kennedy (1996, p. 5) of University of Arkansas (online) states that 'as there are some costs such as factory rent for which driver cannot be identified, the allocation of such costs to products remains arbitrary even under ABC' (1996, p. 59).

Why the Low Adoption Rate? In 1995 the Australian Society of CPAs initiated a major survey on ABC amongst Australian manufacturers. 'This survey, which was conducted by the University of Technology, Sydney, involved 213 firms covering all aspects of Australian manufacturing firms's tates Cokins (2001, p. 10). This survey showed that 45 per cent of the surveyed firms had never considered adopting ABC although eighty eight per cent of those surveyed acknowledged awareness of Activity Based Costing. It also showed that twenty nine per cent were still in the process of considering adopting it, fourteen per cent had considered and rejected it and only twelve per cent of the firms surveyed had actually implemented it. The highest adoption rates of ABC were found amongst the food, beverage and tobacco industry with twenty five per cent of this group using this method.

Although the survey showed low adoption rates, it also showed that the firms, which actually had adopted ABC, achieved five goals. These goals were more accurate product costing, better cost management, better-cost control, better allocation of overheads and more accurate cost information. It can also be said that the accounting profession has largely overlooked ABC. 'Among other reasons cited for low adoptions were employee resistance and the organizational changes essential with the use of ABC's tates Ness & Cucuzza (1995, p. 8). Some trace the source of hindered adoption of ABC to technical as well as cultural issues. Brausch (1998, p. 3) of Harris Semiconductor (online) suggests that 'others feel that ABC would be more widespread in industry if it were marketed better by the accountants themselves'.

There is other several reasons for ABC low adoption rate. Complexity is an obstacle to implementing ABC. ABC requires detailed records of the costs associated with producing products and services as compared to traditional methods. This detailed record keeping requires more effort from the accountants and is more time consuming. The complexity of ABC can contribute to more errors. ABC can require more time to check and recheck to uncover errors.

ABC generally requires more effort on the part of the accountant verses traditional methods and reduces the adoption rate of ABC. Another reason for not using ABC is the increased economies of scale. Many corporations are standardizing their products to reduce the costs to manufacture them. For example, Coca-Cola distributes its products in many different countries. The product varies very little in respect to packaging and manufacturing.

Traditional methods of accounting can assign costs more easily, quickly and accurately for those products that have little or no product variation. An interesting fact is that although Coca-Cola products have little variation, it uses the ABC method of costing. Organisations and Activity Based Costing Businesses like Coca-Cola Company have been performing Activity Based Costing for many years. They are advanced and mature ABC users who are interested in two goals. The first one being to institutionalize the ABC company-wide into a permanent, repeatable, and reliable production reporting system. The second being to establish the ABC output data to serve as an enabler to their ongoing improvement programs.

These ongoing programs are six sigma, lean production, change management, cycle-time compression, core competency, business process reengineering, product rationalisation, target costing, and channel / customer profitability. Am rik S. Sohal of Department of Management, Monash University of Australia conducted a case study on an Australian manufacturing company in Melbourne, which has recently implemented Activity Based Costing. The company is referred to as Me lco, which is not its real name. Sohal (2000, p. 5) of Monash University of Australia (online) reports that: The benefits of the implementation of ABC were many and will be discussed below. Firstly, more accurate information on costs and pricing and hence competitive positioning of the company in the marketplace. Secondly, identification of appropriate benchmarks that can be used against imported competitive products.

Thirdly better information has enabled the company to outsource many products which were inefficiently manufactured in-house. Fourthly more appropriate capital investment decisions being made as a result of better weighting being determined on various aspects of this exercise. Fifthly many problem areas identified where costs were excessive. Sixth, performance measures have been developed which are used to identify improvement initiatives.

Lastly, validation of annual budgets for specific expenses. Even though twelve months man-time was necessary for implementation, the benefits clearly outweigh the costs. The overall benefit has been the much more accurate and relevant information, which can be effectively used by management. ABC provides a tool for management for commercial decision making. Conclusion ABC is a valuable tool in calculating the costs of producing varying product lines. These differing product lines require more extensive accounting practices than traditional costing methods provide.

The information obtained from ABC can help promote product lines that managers feel are profitable between those which should be eliminated. Labor is less frequently the major ingredient in the production process. ABC addresses this concern by examining and illustrating the overhead costs associated with particular activity centers. ABC describes these over head costs more accurately and is beneficial when increasingly more complex manufacturing processes are used. Adoption issues should be addressed to implement ABC method when costing decisions matter to managers.

Activity-based costing continues with the new wave of management techniques. This form of costing is much more detailed and difficult to master but the cost numbers are more accurate. ABC systems cannot be successful without the wholehearted support of management accountants. Since traditional cost accounting systems are the responsibility of management accountants, it is sometimes difficult for them to accept the fact that these systems may be inadequate, inaccurate, or misleading. Unless the accounting professionals are convinced that traditional methods no longer work accurately in this highly competitive era and that an ABC approach is the solution, the ABC system will be doomed to failure. Management accountants must work to keep the ABC approach moving towards its success through their enthusiasm, technical knowledge, conceptual understanding, creativity, innovation, ability to overcome real and perceived obstacles, and persistence.

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