Activity Based Costing and Economic Value Added Measure - Essay Example

?Activity Based Costing & Economic Value Added Measure and their impact on Process Improvement & Business Profitability Introduction The concept of Activity based costing hinges on allocation or apportionment of cost lay emphasize on allocation or apportionment of the direct costs as far as practicable to the concerned activities without leaving a room for estimation. The consumption based approach in this process lends interplay of the scientific approach to the process strictly on the basis of cause-and-effect relationship to the processes, rather than ’ guestimation’ (guess and estimation) in the process of allocation and apportionment, with the underlining principle of ‘traceability’. Though ‘True Cost’ in any situation is fraught with so many uncertainties, by and large the efforts made in its ascertainment paved way for efficient and alternative management practices with improved results. An introspective analysis might reveal that no Value Added Measure circumventing this basic philosophy can make a headway in process improvement or business profitability, for the simple reason that all the value added measures hinges primarily on productivity, which could be addressed properly only through revisit of the approaches to the ‘value’, which predominantly depends on reasonably accurate calculation of the cost of production. Economic Value Added Measures Economic value addition (EVA) is generally discussed with reference to the financial performance, and acts as a complementary tool in the measurement of the performance in a broader perspective, keeping in line with the expectations of the stakeholders, where the finer details of the cost is not perceived as important as in the case of management practices of ABC. It has been stated, “in addition to traditional accounting measures of business performance, a new model of measuring business performance has been developed, its name being - economic value added (EVA)...it is a simple analysis which directs towards the factors of value;” (Ilic, 2010, p. 94). The concept of EVA is mainly related to capital investments and based on the difference between net profit and the cost of capital and the ways and means to tilt the scale in favor of an enterprise. Therefore, for efficiency in the operations, EVA needs to be integrated with ABC in the long run, because the later is related to the factors not directly related to ‘cost’ but scores of other factors such as alternative investments, competition, government policies and international events, which nevertheless influences cost. Cost Management Cost management is the basic underlying factor for the success of a business. Hilton, Maher & Selto (2008, p. 5) states, “Cost management is important to organizations because it is more than measuring and reporting costs that have occurred. Cost management is focused on the future impacts of current or proposed decisions. Cost management is a philosophy, an attitude, and a set of techniques to create more value at lower cost”. Computation of direct (or variable cost) of material or labor is relatively simpler. But, in the modern business enterprises and in the society, the increase in the proportion of other costs over the period of time which hitherto have been considered as fixed and uncontrollable assumed significance, since the controllability of such costs could not be overlooked in a competitive environment. Vazakidis, Karagiannis & Tsialta (2010, p. 382) state, “The use of this method [ABC] with the cooperation of new technologies and new methods of management, can resolve all the deficiencies of Public Sector, so as citizens and companies will be better served”. Fundamentals of Activity Based Costing Hilton, Maher & Stelto (2008, p 148) state that “Studies of company practices indicate that a large number of companies, as well as some organizations in the public sector, are using ABC. Some companies have tried ABC and dropped it. Reasons for this include its implementation cost. In the case of Hewlett-Packard division that one of the authors studied, management obtained a great deal of information from ABC, restructured activities as a result, and no longer had the problems that ABC had uncovered. ABC had served its purpose and was no longer needed.” Categorization of the indirect costs is the greatest challenge which could vitiate the cost estimation process. It is very important to identify each cost with reference a particular activity or apportion the common cost to the related activities on a scientific basis. Hilton, Maher & Stelto (2008, p. 147) state, “Categorize indirect costs, which are not easily traced to the product, into cost pools. Cost pools are groups of individual cost items; costs with similar cost drivers or allocation bases are grouped together. Ideally, we match costs with allocation bases or cost drivers that have a cause-and-effect relationship with the cost”. Cost-driver bases could be number of clients, orders, units produced, machine hours and so on. The cost- driver rate for each cost-driver base forms the basis for computation of cost, and the apportionment of cost done on this basis establishes greater functional relationship of cost with the production or service activities as against batch level or product level apportionment of cost for example, adopted in the traditional costing system. Unused manufacturing capacity costs are excluded and also the unit level, batch level, product level and customer level activities, segregated in ABC, reflecting traceability of incidence of cost with reference to products or services in computing the cost of production. Hilton, Maher & Stelto (2008, p. 163) state that in the implementation of ABC, the organizations must follow four steps, viz. Step 1: Identify and classify activities related to products, Step 2: Estimate the Cost of activities identified in step 1, Step 3: Calculate a cost-driver rate for each activity and Step 4 Assign activity costs to products. Costs related to product level activities in this system are directly attributable to particular product, which otherwise might be indirectly related to a manufacturing unit which produces several products. Impact on Process Improvement The justification for ABC lies in the fact of its usefulness in realistic and logical methods in computation of cost. However, the ‘value’ from the customers’ point of view is not related to cost per se; it is also related to their expectation, satisfaction and perception, and involves other factors outside the purview of cost. Borysowich (2007) states “The transport of the product, within a business process, adds nothing to the product in the customer's view and is not necessary to support the business process.  The movement of work-in-progress is probably due to inefficient process design.  The goal in designing the process is to minimize the amount of movement required in the process”. Profitability in business Identifying inefficiencies in the processes for taking remedial measures to rectify the position and control of cost at all levels are the guiding principles in making the business profitable. All the production activities are directed to contribute to the value of the products or services. The value-add activities are inter alia concerned with the design of the products and the processes, packaging and advertisements with a view to satisfying the customer's expectations which might be guided by the changing tastes and fashions or other intangible factors. Therefore, integration of ABC & EVA under these circumstances is called for the objective of maximization of profits. Conclusion The scope of Activity Based Costing and EVA are not contradictory to each other, rather complementary to each other in achieving the corporate objectives and profitability. The integration of Activity-Based Costing (ABC) and Economic Value Added (EVA) has resulted into an integrated system of ABC & EVA. Hu (2010, p. 141) state that the integrated management mode of ABC & EVA has the advantages of ABC and EVA, and the introduction of EVA could improve the deficiency that ABC could not completely reflect the capital cost, and it is very important for the management of the enterprise. In this method, distribution of cost and capital in an enterprise would be taken into account for the growth and development of the business. References Borysowich, C. (2007) Observations from a Tech Architect: Enterprise Implementation Issues & Solutions, 21 November 2007, Toolbox.com, http://it.toolbox.com/blogs/enterprise-solutions/determining-the-valueadded-activities-of-a-process-20700 Hilton, R., Maher, M. & Selto, F. (2008) Cost Management: Strategies for Business Decisions, McGraw-Hill Higher Education, 4th Ed. HU, H. (2010) Primary Research of the Advantages and the Cost Control of the ABC & EVA Integrated System, International Business Research Vol. 3, No. 3; July 2010, pp. 141-143. DOAJ - Directory of Open Access Journals, http://www.doaj.org/doaj?func=searchArticles&q1=Activity+based+costing&f1=all&b1=and&q2=&f2=all Ilic, M. (2008) Economic value added as a modern performance indicator, Perspectives of Innovations, Economics & Business, Volume 6, Issue 3, 2010, pp. 94-97., DOAJ - Directory of Open Access Journals, http://www.doaj.org/doaj?func=searchArticles&q1=Economic+value+added&f1=all&b1=and&q2=&f2=all Vazakidis, A., Karagiannis, I. & Tsialta, A. (2010) Activity-Based Costing in the Public Sector, Journal of Social Sciences 6 (3): 376-382, 2010, ISSN 1549-3652, DOAJ - Directory of Open Access Journals, http://www.doaj.org/doaj?func=searchArticles&q1=Activity+based+costing&f1=all&b1=and&q2=&f2=all Read More