Development of an Activity-Based-Costing (ABC) System - Research Paper Example

 ACTIVITY-BASED COSTING A study into Development of an Activity-Based-Costing (ABC) System Introduction In today’s competitive business environment, a construction company’s cost accounting system should accomplish cost efficiency without a negative impact on the quality of products and services it provides and on the information being provided to the management as well. Though there are various costing methods, Activity-Based costing has recently emerged as an effective costing system that accomplishes basic three aims that are quality of service, accurate information to the management to maximize resources and assisting in continuous quality improvement. This piece of research paper focuses on developing an Activity-based costing system in relation to a construction business costing. This paper identifies basic costing principles of Activity-based costing and compares and contrasts it with traditional costing methods. Activity Based Costing Activity based costing is a widely used costing methods and is a particular type of costing, which in turn is subset Management accounting. As Management Account has an internal focus mainly to provide information to the management for decision making, activity-based costing also in turn has an internal focus of delivering more accurate cost information to the management and help them in decision making (Baker, 1998, p. 1). Activity-based costing is a costing method, that helps in decision making and allows organizations to clarify the actual costs linked with each product and service produced. Activity-based costing has been found to be an effective costing method that enables organizations to expand business performance through increased competence and cost-reduction (Bradtke, 2007, p. 6). Definition and Meaning Lewis (1995) quoted the definition of Activity-based costing from The Consortium for Advanced Manufacturing-International. According to that definition, Activity based costing is a method, that Measures the cost and performance of process-related activities and cost objects, Assigns cost activities based in their consumption of resources and assigns costs to the cost objects like products or customers based on their use of activities, and Recognizes the underlying relationship between cost drivers and related activities (p. 114). As Armstrong (2006) noted, Activity-based costing is a system which is based on the basic belief that activities cause costs and therefore a link should be created between activities and products by assigning costs of such activities to the related products (p. 363). According to Axelby (2003), Activity-based costing is a cost accounting system that uses both unit and non-unit based cost drivers in order to assign and attribute costs to the relevant cost objects that are traced from the respective activities (p. 78). Activity-based costing is thus a costing method of measuring, analyzing, controlling, recording and reporting on the costs and performance of activities. The Activity-based costing encourages continuous improvement rather than creating reports based on past operations and focuses on performance of activities rather than emphasizing on costs, costs units, cost departments and cost centers, and therefore Activity-based costing appeared as a promising decision support measure. Rationale of Activity-Based costing system The concept of Activity-based costing has been first developed by Robert Kaplan and Robin Cooper from the Harvard Business School. They found that cost departments in companies selling multiple products are taking important decisions about pricing, product ix and respective technology purely based on distorted cost information (Armstrong, 2006, p. 363). The traditional methods of costing of allocating factory and corporate overheads on direct labor, which was designed years ago when overhead expenses were significantly small, were main reasons for the above mentioned distorting. In today’s manufacturing environment, most companies are focusing on various product lines and marketing channels have recently proliferated. Today, direct labor represents relatively smaller proportion of corporate costs and expenses covering factory operation, marketing and distribution have exploded (Armstrong, 2006, p. 363). In traditional overhead absorption systems, a single measure of volume is used for each production or service. For example, machine hours, direct labor hour, direct material cost and direct material cost. As far as the nature of the activity at the cost centre and the nature of the absorbing cost are considered, the above mentioned bases for cost allocation are unjustifiable (Wood and Sangster, 2002, p. 491). In activity-based costing, cost drivers, that are activities that generate costs, are used as the basis for overhead absorption. Activity- based costing is more useful and rather complicated system of costing, because, the use of absorption costing needs biased selection of absorption criteria and cost volume assumptions. Activity based costing, therefore, would not be able to predict accurate profits figures when the manufacturing volume varies. It is the main reason for some experts to argue that activity-based costing system is not adequate for accurate decision making process. Comparing and Contrasting of Activity based costing with Absorption costing It is generally argued that traditional overhead absorption under-allocates overheads to lower volume products and over-allocates overheads to higher volume products. According to this argument, it is clear that Absorption costing creates potentially misleading information at both sides. But, ABC focuses attention to matters of interest that traditional overhead absorption is insufficiently sensitive to identify, due to that it over-allocates overheads to lower volume products and vice versa. ABC is therefore more useful and effective way for producing more useful information for decision making than traditional overhead absorption (Wood and Sangster, 2002, p. 492). In absorption costing method, the production overheads are spared over the units produced. Costs that are easily attributable to cost centers are allocated first, then non-specific costs are apportioned according the benefits received. Companies switched from using absorption costing to the activity-based costing due to that activity based costing is more accurate cost information for products. Activity Based Costing for Construction Business In very recent years, construction industry, as other manufacturing and service industries, has experienced tremendous changes due to advances in technologies, innovation, fierce competition among global players, automation etc. as a result, the amount of direct labor being used in the construction industry as well has been decreased drastically. It has also made a significant impact that overhead costs resulting from the depreciation of expensive machinery, equipments and expenses like utilities, repairs and maintenance have dramatically increased. As there is no direct correlation between direct labor and overhead, it has been found that using a pre-determined overhead rate is inappropriate. This is how, as detailed above, many companies have experienced cost distortions (Weygandt, Kieso and Kimmel, 2004, p. 144) In order to avoid this distortions in construction industry, many firms started using activity-based costing system. Eve though some companies have started using machine hours as a basis to allocate overhead and to avoid this distortion in automated manufacturing and construction environment, it has been found that machine hours cost basis also is insufficient to for a plant-wide cost allocation basis. Especially when the manufacturing process is complex, then only multiple allocation basis would be useful to provide more accurate product and cost calculations. Activity-based costing is thus an effective way of costing that uses multiple bases (Weygandt, Kieso and Kimmel, 2004, p. 144). Activity-based costing is an approach for allocating overhead costs. It allocates overhead costs to multiple activity cost pools and then it assigns the activity cost pools to products or services by means of cost drivers. When it comes to the construction industry, an activity can be an action, a transaction or even like building a wall, payment for cements bought for it etc that incur costs. A cost driver is, in relation to the construction industry, any type of activity that has more direct cause-effect relationship with the resources being consumed (Weygandt, Kieso and Kimmel, 2004, p. 144). There are basically two stages in using activity-based costing in the construction industry as well. In the first, overhead costs are allocated to activity cost polls such as ordering materials like cements, paints etc. But, in traditional costing methods, these costs are allocated to departments or jobs. Secondly, the overheads allocated to the activity cost pools are assigned to the final products, that are either buildings, roads, bridges etc. Role of Activity based costing in construction company Activity-based costing is found to have a significant role in process settings when there are multiple products being produced. When it comes to construction firm, normally it produces multiple products as buildings and various related sub-products and these are normally considered as separate and different products from the same firm. The main role of activity-based costing for a construction company is to assign overheads shared by many processes or construction departments to the individual processes. Activity based costing and service sectors Activity-based costing is more directly elated to manufacturing and construction industry and therefore it is not appropriate or not widely applied in service industries. Activity based costing has been introduced and developed as a tool to analyze costs and variations in relation to the manufacturing and construction or technology oriented businesses. But, recently, ABC system has been applied widely by service sector businesses like banks and small businesses like retail trade etc. The fundamental principle underlying activity based costing is similar for both manufacturing and service industries as in manufacturing and construction industries ABC focuses on the service constituent of the factory, machineries, plant and business as a whole (Kaplan and Cooper, 1998, p. 228). In analyzing the factory indirect expenses, it is clear that various expenses like ordering, scheduling, moving and designing activities are parts of services to a construction process that in turn enable construction or production to be taken place. Activity based costing, therefore, can work for service industries as is applicable to manufacturing and construction industries. Activity based costing has not yet been widely practiced by service industries like insurance and banking sectors. As Crandall (2008) emphasized, ABC was first applied and tested to determine the product costs in manufacturing and construction industries. It is because of that products are easily identifiable but service in contrast are more difficult to be classified and thus easy appropriation of costing cannot be expected (p. 139). When costing is concentrated at the unit level in a construction company, the number of units produced must be correlated with the amounts of overhead costs allocated to each units. Steps in developing Activity-Based costing in Construction Industry Following are the main steps involved in using Activity-based cost system in construction industry: 1- Identifying and classifying the activities related to the products of construction firms: A construction business also includes various activities like building design, construction, marketing etc. the activity based costing system in a construction business starts with identifying various activities that make use of resources and assigns costs to them (Venkataraman and Pinto, 2008, p. 90). The departments or people in responsibility of activity base costing are to identify the activities that the construction company performs to construct the final output. 2- Estimating the cost activities identified in the step-1 In the primary stage, cost drivers associated with the work package are already identified. These elements are actually causing or driving an activity cost. For instance, labor force or human resources are major cost driver for many activities and processes in construction company. Various raw and finished products also will be used as cost drivers in the construction company. In the second stage, the costs of specific activities that causes costs are to be estimated. The cost accounting department thus requires to collect and maintain data regarding both human resources and physical resources (Hilton, Maher and Selto, 2005, p. 142). 3- Calculating cost-driver rate for each activity It is basically involved in calculating cost rate per unit of the cost driver. The activity cost data from the step above will be used to calculate a cost-driver rate and it will be used by the company to make it useful for assigning activity costs to goods and services. This cost-driver rate would also be used as a base that has some casual link to the cost factor. For instance, cost of running a construction machine is likely to be caused by the number of hours the machine is run (Hilton, Maher and Selto, 2005, p. 142). 4- Assigning activity costs to the products Finally, the cost driver rate which is prepared from step-3 is to be used to assign activity costs to the products or services. In the construction company example, the cost-driver rate is used to assign the activity costs to the building or anything which is constructed as the final output. For instance, a particular room-construction takes 25 machine hours and the cost-driver rate is $100 per hour, the room-construction will be assigned as $2,500 based on the machine hours. The cost driver rate is multiplied by the total number of cost driver units consumed in order to assign costs to a project (Hilton, Maher and Selto, 2005, p. 143). By completing the Activity-based cost preparation through these four steps, a company would be able to calculate the costs to provide existing goods and services. This cost-system can be used as an effective tool to identify and calculate the profitability of each project separately and to estimate the cost of future products (Hilton, Maher and Selto, 2005, p. 143). Limitations of Activity-based costing In many cases, Activity-based costing has been found to be less-worthwhile, that are listed below: 1- the costs in implementing such cost-system often outweigh the total benefits of it in some smaller organization. If the construction business is not operating in relatively larger scale, using activity-based costing may not be worthwhile. 2- In contexts of managerial decision making, the accuracy that is exaggerated of ABC system may be immaterial. 3- Activity based costing is obviously less beneficial for single-product or single-service organization. 4- Though many organizations use ABC is a method of costing, due to that it requires excluding administration, selling and distribution expenses, many organizations use absorption costing system along with activity-based costing as well (Wood and Sangster, 2002, p. 493). Conclusion This piece of research paper has highlighted basic cost-concepts of Activity-based costing and detailed various literatures regarding its definition, meaning and basic underlying principles. This paper has addressed the relevance of activity-based costing for a construction business, along with brief explanation of basic four steps involved in developing ABC cost system. References Armstrong, M (2006), A handbook of management techniques: a comprehensive guide to achieving managerial excellence and improved decision making, Illustrated third edition, Kogan Page Publishers Axelby, G, (2003), CIM Coursebook 02/03 Management Information for Marketing Decisions, Revised and illustrated edition, Elsevier Baker, J. J (1998), Activity-based costing and activity-based management for health care, Illustrated edition, Jones & Bartlett Learning Bradtke, D (2007), Activity-Based-Costing, GRIN Verlag Crandall, R. E (2008), New Methods of Competing in the Global Marketplace: Critical Success Factors from Service and Manufacturing, CRC Press Hilton, R. W, Maher, M. W and Selto, F.H (2005), Cost Management, Strategies for Business Decision, McGraw Hill Irwin Kaplan, R. S. and Cooper, R (1998), Cost & Effect: Using Integrated Cost Systems to Drive Profitability and Performance, Edition: illustrated, Harvard Business Press Lewis, R. J (1995), Activity-based models for cost management systems, Illustrated edition, Greenwood Publishing Group Venkataraman, R. R and Pinto, J.K (2008), Cost and value management in projects, John Wiley and Sons Weygandt, J. J, Kieso, D.E and Kimmel, P. E (2004), Managerial Accounting, Tools for Business Decision Making, Third Edition, John Wiley and Sons Wood, F and Sangster, A (2002), Frank Wood’s Business Accounting, Ninth Edition, Volume- 2, Prentice Hall, Pearson Education Read More