Activity based costing - Essay Example

?Activity Based Costing is an example of a successful management accounting technique that has been widely adopted in different sectors in the UK. Discuss the main issues faced by managers in emerging economies who want to implement ABC Executive Summary With this new era of cost reduction and resource utilization, managers always have to come up with ways to maximize their bottom-line. One of the newest ways how companies can get increased cost-savings is by using a technique called Activity Based Costing (ABC). The main objective of this type of system is proper identification of all cost categories and using basing decisions on this information. Most organizations that use ABC systems have two costing systems – the official costing system that is used for preparing external financial reports and the Activity Based Costing system that is used for internal decision making and for managing activities. Table of Contents Executive Summary 1 Table of Contents 2 Introduction 3 Recent Studies in ABC 3 Role of ABC in Industries 4 Role in Manufacturing 5 Role in Financial Services 6 Role in Health Services 7 Role in Retail 8 Role in Government 9 Limitations of ABC 10 Conclusion 11 Bibliography 12 Introduction The main objective of Activity Based Costing is to understand the various types of overheads that are affecting the business. In comparison, normal accounting attempts to separate the different type of costs and the focus is on the cost of goods sold (or cost of services rendered in case of service companies). In this section, analysis of the various aspects of Activity Based Costing will be done, and how it is used effectively by managers in order to create the maximum value for the company. A number of examples will also be looked into when it did not prove to be very effective for the organizations. The basis of Activity Based Costing is simple, non-manufacturing as well as manufacturing costs may be assigned to products. Moreover, some manufacturing costs may be excluded from product costs. All overhead costs are attached to a product and activity is used as a measure of all the costs involved. The overhead rates or activity rates may be based on the level of activity at capacity rather than on the budgeted level of activity. To compensate for the deficiencies of the conventional information systems, ABC requires firms to collect costs in specially constructed “activity pools” rather than service departments or overhead cost centers. Each of the pools corresponds to a group of similar business processes or activities that are homogeneous in that all costs assigned to the pool are influenced or driven by a common factor (Rafiq & Garg 2002). Recent Studies in ABC A study in the year 2005 concluded that nearly half (55%) of respondents suggested within their entirety that their companies were at that time making use of the Activity Based Costing either in an active fashion or in a pilot with another 32% considering use. Only one in ten which amounted to around 11% did not contemplate using the ABC. The manufacturing industry had the highest representation with 24%, followed by financial services at 18%, public sector at 16%, and communications at 8%. Other industries accounted for less than 5% each. The same study found out that out of all the industries being considered, the communication industry is the most aggressive in adopting the ABC system (Timlin 1998). The primary reason for this being that the Activity Based Costing uses various activities to trace overhead directly to cost objects, such as products, processes, services, etc., avoiding the distortions of traditional costing systems. In order for the ABC system to be affective large investments will have to be made in IT to support this need for categorical information. Role of ABC in Industries Now taking a look at the different industries and trying to analyze how ABC system is used to achieve different goals according to the company. While company goals may vary greatly, the purpose here is to identify how Activity Based Costing is used in different sectors. The Diagram below shows the various types of strategies adopted by each sector: Role of Activity Based Costing in Different Industries1 Role in Manufacturing The main purpose of using the ABC system here is to reduce cost controlling. This is the primary method of achieving profitability, rather than using resources more efficiently and effectively. The cost cutting strategy is used to become more competitive with other firms based on price. Some experts say that this strategy is a very short-term strategy and companies will have to sacrifice on quality in the long run. Ford was one of the first companies to focus on Activity Based Costing. Their business model was such that they required large amount of information on the costs of continuing production (Lewis 1993). The fact is that, after the implementation of the assembly-line, more and more companies started following the same assembly method, and Ford needed to stay ahead of the competitors and hence it used the ABC system to identify and reduce the costs involved with the process. However, the main issue in manufacturing firms arises when the product is not capital intensive. In this case the identification and categorization of costs become difficult. In addition, many companies lack the financial backing to correctly implement the system. ABC requires complementary accounting systems that provide reasonably accurate costs organized by cost category and department (Liu & Pan 2007). The usefulness of ABC in developing countries probably depends on its incorporation into an ongoing information and management decision-making system. One-time data collection efforts are unlikely to result in information that will be useful over time. Furthermore, a major advantage of ABC is the trend data it provides on unit costs, but this requires an ongoing information system. Role in Financial Services Again one sees a very similar culture where the system is used to identify the different types of costs and used the system to reduce them for the benefit of the company. However, more financial companies are switching to focusing on product profitability i.e., maximizing the profit and minimizing the costs associated with the product. The important thing here again is to not compromise on the quality of the service offered. Many experts say that using the ABC system when it comes to financial and any such services is only a way of showing “fake” profitability i.e. since the correct cost centers cannot be identified, the costs are switched into administrative costs(which can or cannot be reduced in the future). Activity Based Costing has been known to be very affective in financial services. The largest reason being the well documented transactions that happen at these companies. In financial services a lot of emphasis is put on proper recording of all the transactions and this in creates a large amount of data that is easily traceable. The main distinguishing factor is the people’s (both internal and external) interest or more importantly the people’s interest in how and where their money is being used. Financial services companies have to make detailed accounts of all their expenditures and revenues. For example, at several banks, the management takes care that a detailed statement of all the costs be reviewed. They make sure that suitable authorization is taken before any action, so that all actions are traceable and the damage can be rectified. Lastly, these companies take a large amount of time to identify the various cost centers they have in the company. Although this is a pain staking process, it has to be done in order for the company to actually make money in the future. ABC naturally fits into this system and most of the information required is readily available to the user and hence it gives the company a strategic edge. Role in Health Services In the 1990s, a large number of Finnish hospitals began implementing new cost accounting systems, which were aimed at pricing the hospital outputs at full cost. They had to keep various variables in mind before reaching a conclusion as to whether it can be adopted or not. Factors such as role of the institutional environment, change in institution related rationales, role of efficiency related rhetoric and cost vs. benefits considerations, etc. Based on detailed observations and keeping in mind these variables it was found that all hospitals operate in different manner. The diagram below illustrates the observations collected from three different hospitals. Factor Hospital A Hospital B Hospital C Use of ABC/Cost accounting Full cost pricing in individual clinics Initially no use, intended for full cost pricing at the hospital district level. Profitability analysis and reporting. Increasing cost awareness. From this single observation, it can be seen that all hospitals are not the same and ABC may not be used for a similar purpose. The major difference why most experts believe that ABC may not be as successful as it is in the other companies is that in organizational environments there are no laboratories which would allow the actors responsible for constructing cost accounting systems to experiment with different solutions, and, based on those experiments, to make a rational choice among various alternatives. The major problem when it comes to implementation in developing countries is the fact that becomes increasingly difficult to document all the information coming and leaving the organization. This means that it is more difficult to identify and categorize the suitable cost centers. Role in Retail In retailing or retail management the dynamics are slightly more complex. Here the core function becomes minimizing the resources wasted on communication with the relevant external company to identify the cost center, etc. A major advancement of the ABC system here is the Time-Driven Activity Based Costing (TDABC). With TDABC, managers no longer need to interview and survey employees to allocate resource costs to activities before assigning costs to orders, products, and customers. Instead, managers exploit the data now available from the enterprise resource planning (ERP) systems in place in many companies. In addition to providing the normal benefits afforded by Activity Based Costing, TDABC offers new applications critical to any company seeking to control costs, make smart investment decisions, and better manage service levels within and outside the organization. Specifically, managers can now link strategic planning to operational budgeting, enhance the due diligence process during mergers and acquisitions, and support continuous improvement initiatives such as lean management (La Londe & Pohlen 1994). For a better understanding of the system, a live example is discussed. Sanac Logistics, a family-owned Belgian company that distributes and retails branded plant-care products to farmers, growers, public sector companies and landscapers, and large and small consumer shops. Through TDABC, Sanac quickly identified and improved inefficient processes and transformed unprofitable customer relationships. Its near-term profit improvements enabled Sanac to win a reputation as a well-run company in a highly competitive market. Role in Government Finally, discussion of the implications of the ABC system on the government is being sought out. This is an important section as one also identifies some other factors why it is difficult for developing countries to implement this system. Increased pressure on the city officials to look for more efficient ways of allocating and using resources has drove them to exactly identify the utilization of resources. The city of Paris is no exception to the rule. Each departmental head is given broad parameters to reduce its projections and consequently its costs by a certain percentage. This has led to some government employees having to make personal cost controls, and obviously an increase in the number of disgruntled employees. The budgeting process is probably the most important process for the government (Weiner 1995). Each department has to show a previous record of all the costs and expenses on the basis of those numbers, resources are allocated for the future. The fact is that at a government level, resource allocation is harshly debated before a final decision is made. Needless to say, the level of “red-tapism” does affect the flow of information and can hamper the process in essence. However, use of ABC is not very popular in the Government Sector, and literature is almost scarce in the local government application. In the case of the United States the Government the Defense and Department of Transportation have been the main users of ABC. Documentation done at such a macro-level is very difficult and those who do have proper controls invest heavily in infrastructure and technology to support this information need. In addition, many experts have identified that government organizations may be looking to sanction higher budgets in order to meet their own personal gains (Awashti 1994). If this is the case, then the adoption of ABC will mean more transparency and lesser chances of making personal wealth. Some politicians and government officials of developing countries have defended the non-usage of the system by saying that the country is at such a critical level that it should focus on getting the needed resources to the right people instead of wasting time on documentation and other related processes. They argue that to become a developed country, they should try and use the maximum resources in order to stimulate the economy and not be tied down by documentation. This debate is an on going process and is beyond the scope of this paper. Limitations of ABC Even with many benefits, Activity Based Costing may not always be used in companies. One of the biggest problems is the lack of adoption to more intellectual activities. Experts have found that the ABC system is best implemented in companies where tasks are routine and repetitive. Similarly, it may have is that in many companies, it is difficult to assign the costs into the relevant cost centers/pools. This means that many costs remain uncategorized and therefore can create ambiguity among the finances of the company. Another major source of concern is the legitimacy of the cost, i.e., some costs cannot be associated with running the business. Some experts say that although these costs are heavily involved in the working of the company, this system does not allow proper documentation and hence it adds to the confusion (Camm 2001). On the other hand some may argue that costs untraceable to activities should be "arbitrarily allocated" to products, it is important to realize that the only purpose of ABC is to provide information to management (Taney 1998). Lastly, categorization of overhead costs can also be misleading. An example will be of a Chief Executive’s salary, which cannot be assigned as an overhead. Conclusion From our discussion, it can be seen that the ABC system offers a wide range of benefits to any company or government. However, there are various factors, both internal and external those have to be checked before putting this system into place. The critical step for any organization looking to implement this system is to first identify the goals of implementing this system and in doing so have a long term vision. The implementation of a new cost system involves investment in time and money. A cost system based on ABC requires organizational changes, employee acceptance, investment in software and hardware, equipment for data collection, and so on. It has been suggested that the narrower the scope of the company, greater is the ease with which it can be implemented within an organization (Swain & Gladwin 1998). This Cost versus benefits of this system can be debated very heavily; however the general rule is that if implemented properly it has beneficial results. Therefore, a series of smaller steps should before gradually implementing a full ABC system where the estimated data is replaced by actual data. As a future step a software package based on this methodology can be developed that would trace overhead cost to products accurately, at low cost, and in short time. Bibliography Awashti, Vidya N (1994). Abc's of Activity Based Costing. Industrial Management, Vol. 36, July Camm, Frank (2001). Environmental Management in Proactive Commercial Firms: Lessons for Central Logistics Activities in the Department of Defense. Rand La Londe, Bernard J & Pohlen, Terrance L (1994). Implementing Activity]Based Costing (ABC) in Logistics. Journal of Business Logistics, Vol. 15 Lewis, Ronald (1993). Activity-Based Costing for Marketing and Manufacturing. Quorum Books Liu, L.Y.J. & Pan, F (2007). The implementation of Activity Based Costing in China: An innovation action research approach, The British Accounting Review, 39 Rafiq, Aamer & Garg, Ashish (2002). Activity Based Costing and Financial Institutions: Old Wine in New Bottles or Corporate Panacea? The Journal of Bank Cost & Management Accounting, Vol. 15 Swain, Monte R & Gladwin, Bruce (1998). Activity Based Costing and Simulation Modeling. The Journal of Bank Cost & Management Accounting, Vol. 11 Taney, Charles R (1998). Activity Based Costing: the Missing Ingredient. The Journal of Bank Cost & Management Accounting, Vol. 11 Timlin, Peter S (1998). The Abc’s of Activity Based Costing. The Journal of Bank Cost & Management Accounting, Vol. 11 Weiner, Jerry (1995). Activity Based Costing for Financial Institutions. The Journal of Bank Cost & Management Accounting, Vol. 8 Williams, Michael J & Simpson, Wayne K (1996). Activity Based: Costing, Management and Budgeting. The Government Accountants Journal, Vol. 45 Read More