Activity Based Costing (ABC): An Overview

Traditional Costing Vs Activity Based Costing

Question:

Discuss about the Managerial overconfidence and accounting conservatism.

During last ten years the ABC (Activity Based Costing) approach gained high level of importance as a technique for management accounting that can improve costing accuracy for the services or products. It also assists the management to use the resources in systematic manners to achieve the targets and implement the strategies. However, while most of the organizations understood the fact that traditional costing system is are less relevant now, they must analyse the net benefits before implementation of  ABC as it requires considerable amount of time and investment. Further, it requires restructuring of the systems that may be costly and significant (Accounting for Overheads – Activity Based Costing (ABC), 2016).

It has been argued by various textbooks and literature on management accounting that the ABC system is better as compared to the traditional approach. Under the traditional approach the cost is allocated to the products on the basis of average rate of overhead. It takes into consideration all the indirect costs associated with production and thereafter allocate the costs using the cost driver like labour hours and machine hours (Estampe, et al. 2013). The traditional costing approach is easier as compared to ABC to determine the product costs as it depends on the allocation based on the average rate of overheads.  However, it is not accurate all the time as it does not consider non-manufacturing expenses. On the other hand, ABC approach is considered as more accurate as it takes into consideration the major factors while assigning the costs to the product (Ahmed and Duellman 2013). Though the process is time-consuming and complicated it considers the non-manufacturing expenses like managerial costs and administrative costs.

During the year 2005 a dedicated professional team “Better Management Team” conducted the empirical stud with their experience in the field of business management among the companies from all over the globe for determining the state of ABC adoption. The responses received from different industries like financial services, manufacturing, consulting, communication, public sectors, IT sectors and health care sectors. Major finding from the study was regarding the adoption and implementation of the ABC system by various industries (Byrne, Stowe and Torry 2018).  The companies who adopted and are actively using the ABC are represented as –

• Communication sector – 58%
• Financial service sector – 46%
• Public sector – 29%
• Manufacturing sector – 24%
• Other industries – 32% (Byrne, Stowe and Torry 2018).

The survey further revealed that the need of ABC implementation was driven by requirement of enhancing the customer profitability, to modernize the cost systems, improve the business processes, meet the needs of management, improve the cost control and improve profitability of the product (Fullerton, Kennedy and Widener 2013). In addition to the adopters of ABC various companies are there that consider the implementation of ABC as the future target and various companies that are not in consideration for ABC implementation. The reason of not considering ANC implementation is the difficulties like resistance to the alterations, uncertainty regarding the implementation cost, risk associated with implementation, absence of required technical support for implementation and uncertainty in receiving supports from the top level management (Govindan, Khodaverdi and Jafarian  2013).  The production cost for allocation under ABC involves the following steps –

Empirical Study on ABC Adoption

Step 1 – segregation of overheads into the cost drivers

Cost pool is the activity that consumes resources and the overhead costs are recognized and allocated as per the cost drivers. For every cost pool there shall be cost driver. Cost pool and activity often are used interchangeably. For instance, 1 activity can be quality control (Öker and Ad?güzel 2016).

Step 2 – Recognizing cost driver for each of the activity

Cost driver is the factor that drives or influences the cost level. For instance, it can be argued that the cost for quality control is influenced by number of inspection carried out instead of total produced units (Hoare 2018).

Step 3 – Calculation of OAR (overhear absorption rate) for each of the activity

The OAR is computed is computed like it is calculated under absorption costing OAR. However, Separate OAR is calculated for different activity through taking into consideration the activity cost and dividing it by the information of cost driver.

Step 4 – absorption of the activity costs

The activity costs shall be absorbed by the individual products. For instance, if it is known that how many inspections are required for the product then it can absorb corresponding quantity for control cost of quality (Monroy, Nasiri and Peláez 2014).

Step 5 – Computation of full production cost

After completing the step 1 to step 4, the activity costs shall be added to the cost of material and labour.

The above mentioned steps can be elaborated through the following example –

Suppose that ABC Plc manufactures two products, product A and product B. Product A is high-volume line product while product B is specialized low volume product. ABC Plc recognized 4 activities and important cost drivers on the basis of which the overheads are to be allocated (Parthiban, Zubar and Katakar 2013). The activities are –

• Purchasing material
• Machine set-up
• Product inspection
• Machine operation

Purchases are estimated as 100,000 pieces, materials requirement will be $ 200,000. Overheads include salaries of the employees for purchasing, storing and inspecting materials. For new product number of machine set up requirement will be 400 and overheads amounting to $ 400,000. Machines running cost will be $ 600,000 for 20,000 machine hours.

It can be observed from the above example that the allocation of overhead is made at higher level to Product B. this product absorbed more overhead per unit as the ABC system identifies the requirement for more number of set-ups and more inspection hours. It further reveals that specialized low volume products lead to higher cost as compared to the realization of the management.

• It helps to minimize the cost through delivering meaningful information with regard to the available opportunities for cost reduction
• Activities under ABC can be segregated as non-value adding activities and value adding activities. It assists management to focus on the forces for value adding activities and discarding the non-value adding activities.
• ABC works only on activities and therefore the management is able to take quality decision as they know nature of all the activities.
• Some of the costs are known as the non-manufacturing cost, for instance, the advertisement cost. Though the advertisement cost is the non-manufacturing cost that is the major component of total cost for any product, these costs can easily be allocated as ABC clearly establishes the relationship among costs and associated causes of costs.
• Accurate cost allocated leads to accurate pricing policy.
• Accurate information of cost assists the management adopting of the approaches associated with productivity improvement like TQM (total quality management, BPR ( business process re-engineering)
• Expenditure statement can be prepared as per the activity and cost of each activity can be compared against each other for finding out the activities that shall be improved or eliminated for enhancing the performance.
• Buy or make decisions can be made through considering manufacturing cost of the product and can be sub-contracted with outside agency using the ABC analysis.
• If the available resources is not properly used even after the sub contracting management can itself decide to manufacture the product within firm
• When finished goods from one department are transferred to another department, the product cost to 2^nd department is known very easily which in turn fixes the transfer pricing (Ruiz-de-Arbulo-Lopez, Fortuny-Santos and Cuatrecasas-Arbós, 2013).

• The system produces the numbers like product margins and these numbers are odds as compared to the numbers produced by the traditional method. The managers are generally accustomed with the usages of the traditional approaches for running their operations and the traditional approach is generally used for evaluating the performances.
• ABC implementation is the major project and it needs substantial resources. Once the system is implemented it requires higher costs for maintaining the system. Further, it requires huge data collection, checking of the data and entering data to the system (Subramaniam and Watson 2016).
• The data from ABC system can be misinterpreted easily as the small mistake can change the entire data. Therefore, the system can be used with proper care while it is used for making any decisions. Further, the costs assigned to the products, various cost objectives and customers are only relevant and the managers are required to recognize the relevant costs associated with product.

Conclusion and recommendation

 It is concluded from the above discussion and analysis that the traditional costing approach allocated the overhead using the average costing method and uses the machine hours or labour hours to allocate the costs. On the contrary, ABC costing system is takes into consideration all the costs associated with the product and allocates the overheads based on the cost drivers. Due to the complexity, huge requirement of investment and time ABC approach received mixed kind of reaction with regard to its adoption. However, though the traditional approach is simple and easy to use, the ABC system is more accurate for allocation of the overheads. Choosing between 2 methods is not an easy job. However, this is an important aspect that shall not be neglected. Taking into consideration all these facts, the management is recommended to implement the ABC system as the alternative for the traditional method as it provides more accurate information.

References

Accounting for Overheads – Activity Based Costing (ABC). (2016). [ebook] Cenit Online, pp.5-6. Available at: https://studyonline.ie/wp-content/uploads/2016/08/ABC.pdf [Accessed 23 Feb. 2018].

Ahmed, A.S. and Duellman, S., 2013. Managerial overconfidence and accounting conservatism. Journal of Accounting Research, 51(1), pp.1-30.

Byrne, S., Stowe, E. and Torry, P., 2018. Activity Based Costing Implementation Success in Australia. [ebook] Australia: University of Southern Queensland, Australia, pp.4-9. Available at: https://eprints.usq.edu.au/3719/1/Byrne_Stower_Torry.pdf [Accessed 24 Feb. 2018].

Estampe, D., Lamouri, S., Paris, J.L. and Brahim-Djelloul, S., 2013. A framework for analysing supply chain performance evaluation models. International Journal of Production Economics, 142(2), pp.247-258.

Fullerton, R.R., Kennedy, F.A. and Widener, S.K., 2013. Management accounting and control practices in a lean manufacturing environment. Accounting, Organizations and Society, 38(1), pp.50-71.

Govindan, K., Khodaverdi, R. and Jafarian, A., 2013. A fuzzy multi criteria approach for measuring sustainability performance of a supplier based on triple bottom line approach. Journal of Cleaner Production, 47, pp.345-354.

Hoare, R. (2018). Absorption Costing V’s Marginal Costing. [ebook] Certified Public Accountants, pp.1-2. Available at: https://www.cpaireland.ie/docs/default-source/Students/F2-Mgmt-Accounting/absorption-costing-v-marginal-costing.pdf?sfvrsn=0 [Accessed 23 Feb. 2018].

Monroy, C.R., Nasiri, A. and Peláez, M.Á., 2014. Activity Based Costing, Time-Driven Activity Based Costing and Lean Accounting: Differences among three accounting systems’ approach to manufacturing. In Annals of Industrial Engineering 2012 (pp. 11-17). Springer, London.

Öker, F. and Ad?güzel, H., 2016. Time?driven activity?based costing: An implementation in a manufacturing company. Journal of Corporate Accounting & Finance, 27(3), pp.39-56.

Parthiban, P., Zubar, H.A. and Katakar, P., 2013. Vendor selection problem: a multi-criteria approach based on strategic decisions. International Journal of Production Research, 51(5), pp.1535-1548.

Ruiz-de-Arbulo-Lopez, P., Fortuny-Santos, J. and Cuatrecasas-Arbós, L., 2013. Lean manufacturing: costing the value stream. Industrial Management & Data Systems, 113(5), pp.647-668.

Salah, W. and Zaki, H., 2013. Product Costing in Lean Manufacturing Organization. Research Journal of Finance and Accounting, 4(6), pp.86-98.

Subramaniam, C. and Watson, M.W., 2016. Additional evidence on the sticky behavior of costs. In Advances in Management Accounting (pp. 275-305). Emerald Group Publishing Limited.

Order an Essay Now & Get These Features For Free:

Turnitin Report

Formatting

Title Page

Citation

Outline

Place an Order