Cost drivers used in ABC system
There was always a look out to move ahead from the more conventional methods of indirect costs and overhead allocation to a method that would provide more rational allocation based on incidence of costs that are attributable to a function or activity. Hence, Activity based costing emerged from that necessity. Under this technique overheads are allocating to specific items that are incurring that cost because of using it. The general presumption used in conventional methods of costing include allocating direct cost to specific activities and indirect costs are allocated to the product. In ABC method there is a departure from this system of allocation. Each type of work is treated as a cost driver and the entire costs related to that cost driver are accumulated there. This is then allocated to specific cost centres depending on how much of the usage of those cost drivers were done by the them. This ushers in a more transparent and logical allocation of overhead costs and a true picture of the cost structure to the management aiding them in better planning (Andiola, et al., 2018).
The cost drivers used in ABC system are simply a basis of allocating costs. Their frequency determines the quantum of costs to be allocated. There are two main attributes related to cost drivers that are considered in allocating costs. These are sub-divided into drivers called Duration driver and Transaction driver (Appelbaum, et al., 2018). Duration driver records the time spent on each driver and Transaction driver gives information on the number of transactions that occur. The frequency and quantum of both the drivers are directly proportional to the costs incurred on them.
Below are enlisted some of the advantages that Activity based costing possesses:
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- It becomes more logical to assign costs to a product or service in a more efficient and reliable manner using ABC. Here it becomes necessary to understand that the costs are driven by activities and not products. This becomes particularly helpful when the entity is a conglomerate and has diversified operations, services and products.
- For entities that operate in service industries such as healthcare, hotels and resorts, entertainment industry, financial services, etc. have a better analysis of overhead expenses the conventional methods of allocation in this sector fails to provide the correct picture of the cost position(Bumgarner & Vasarhelyi, 2018).
- When it comes to decision making on the to control or manage costs, ABC is of immense help. The known drivers can be managed in a controlled manner and the avenues to plug on or target areas can be easily identified and acted upon.
- When one knows what are the nature of each type of cost driver, it is easier to decide if it can be associated with a product or service associated with the given the nature of such costs to the type of product or service.
- A division or unit of a business which uses the driver can be tracked. Thus, the method provides a tracking mechanism for identifying who is the ultimate user. Since the cost centers get identified, the allocation becomes easier and more transparent(Fukukawa & Mock, 2011).
- ABC ensures identification of areas that have spare capacity. This done as the methodologies used result in pooling of cost to various activities. This in turn has a positive impact on resource utilization which ultimately boosts the profitability of the enterprise. . Redundant activities can be highlighted and their performance can be tracked. The management can take a call on those sections whether to abandon them or carry out some sort of restructuring to revamp them. Losses could be controlled by doing so.
ABC has a few downsides attached to it just like any other methods. Some of them are enumerated as under:
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- ABC are not that beneficial for smaller companies as they for the larger ones. Initial implementation of resources requires ample amount of investment, manpower and commitment from the senior management which may not be always economically feasible for them to undergo(Garon, 2018).
- ABC is useful for companies that follow a pricing strategy of cost plus. For companies whose are compelled to follow the market price approach due to conditions prevailing in their industry will gain nothing out of ABC implementation.
- Doubts may arise in the initial phase of the use of ABC as there are possibilities that the results obtained from them would vary with the results the entity might already be having out of the use of conventional methods. The management may find it hard to base their decision on the result obtained from ABC and these results are likely to create some sort of confusion in evaluation of manager’s performances in relation to the division they oversee.
- There are complexities involved in ABC is ascertaining the cost drivers and the cost pools involved. The decision making on their identification will involve substantial amount of time as well as technical knowledge to correctly ascertain it. The entities might not have their staff equipped to do it. This might create a logjam in the implementation in the initial phase itself. Any negligence on this front could render the whole exercise futile.
- ABC requires complete implementation across all spectrums of the organization for it to show good results. This might become logistically to put on ground as there strain the resources of the organization and effect normal operations(Heminway, 2017).
- ABC is computation extensive in nature. This means that there are a host of calculation to be done for cost pools and drivers which require a certain degree of arithmetical accuracy as well. Any deviation might lead to producing incorrect results.
For the study we have shortlisted two journals. The first one is written by three authors namely Warlop Luk, Eddy Cardinal and Filip Roodhooft. The article is titled “The Value of Activity Based Costing in Competitive Pricing Decision”. The other article in this discussion is written and presented by Hasan Ozyapici and Veyis Naci Tanis. The article goes by the title “The measurement and management of unused capacity in a time driven Activity Based Costing System”. Both the articles touch upon various aspects of ABC system and carry certain sets of similarities and differences in perception and opinion.
The journals give a sneak peak into the impact that ABC has on the business models worldwide both good and bad. One of the article considers the pricing prevalent in the manufacturing sector which it terms to be highly elastic to demand. The article compares ABC system along with other methodologies which are also in practice (Kachelmeier, et al., 2018). Both the articles enumerate more of positive sides of the method stating how the method facilitates decision making by the management and saving of time and resources by eliminating redundant or nonproductive issues. A more transparent and vibrant analysis is portrayed which ensures a more effective decision making (Covaleski, et al., 2003).
Advantages of ABC system
In the current business scenario, it has become increasing difficult to analyze only based on financial information as there are a host of data available on from other sources such as market review reports, customer feedbacks, etc. The significance of this method seems to be more critical in aspects where relevant information to compare data is lacking or not available. Due to large number of players involved in any given business segment at any point in time becomes challenging to set product or service pricing as fixing of prices uses conventional methods might give flawed results which will severely hamper the sale potential of a product or service as the cost derived from those means may not give the true picture and push the prices either too low or high and impact the sales and profitability (Knechel & Salterio, 2016). A study was conducted in the year 1999 that revealed that market factors that influence pricing gave enterprises better choices in pricing. The data was based on the data obtained from the markets and the benchmarks set by the entities. However, it would be pertinent to note that there were very few players in the market to complete. Later, when the number of market players increased the test was conducted again using similar parameters (Hansen, et al., 2003). The tests results for the both the occasions were then compared and it turned out that the results were drastically different. It was seen that in the first case, the hypothesis obtained suggested that the prices and return on the product were at its peak when the feedback received from the market was positive. It was exactly the opposite when the feedback was negative. The second hypothesis stated that the as the number of players in the market increase and there was a greater quantum of data available in the market, ABC system of costing became more irrelevant. Thus, it can be said that the methods seemed inappropriate in such circumstances. Some of this could be attributed to the reason of bias in the opinion of the feedback. To form a constant and a more conclusive pinion, a decision was taken to conduct one more tests. The involved a total of 131 participants and the whole population of those was divided into two groups. Care was taken in the selection of those participants (Lessambo, 2018). They were either chartered accountants or cost and management accounts. In the process, the participants were asked to participate in the allocation of costs as per the ABC and traditional costing system. Certain information related to the costs were provided to them. They were also provided details of the cost drivers in that case which were necessary for ABC allocation. The drivers were ordering, delivery and software handling. There were certain specific costs also that were allocated on directly. The outcomes were analyzed for ten different scenarios involving different time frames so that a direct relationship can be established with the costing and its corresponding effect on price. Herein the method revolved around finding out an average of the initial five results and evaluate it correspondingly with its interface with the view of the market and accounting view. The method did not yield the desired quality of result and hence dubbed as unreliable. This meant that the hypothesis in the second test can no longer be considered correct. The hypothesis suggested that its most likely that either all the competitor’s operators in a single market or the information on which the evaluation is done is unreliable or insufficient (Mock, et al., 2018). It concluded that instead of the market forces, had the focus remained on the cost drivers involved, the pricing would have been more logical and appropriate and that pricing will remain a competitive one and will yield profits to the company as well.
Downsides of ABC system
The second study raises the issue of measurement of the optimum utilization to identify the spare capacity whose potential is yet to be in clocked. ABC answers this question. Identification of unused capacity becomes a challenge in circumstances where the entity’s production line operates in double shifts. This case can be termed a complex and a help of two less familiar concepts can be taken in this regard namely, compulsory unused capacity and real unused capacity (Mubako & O’Donnell, 2018). The names of these two concepts are self-explanatory in many ways. The primary objective of the research is focused towards is pushing up the efficiency level of the Activity based costing system and Time driven Activity based costing. There are clear definitions of the real unused capacity and compulsory unused capacity in relation to each shift of the process. An allied objective of the activity of research is to allocate surplus workforce to areas that are underutilized to maximize resource optimization. Since the dynamics of the functions of businesses have changed it would be rather prudent to say that conventional and orthodox methods of costing would fail to deliver in such scenarios since their applications have lost relevance. The competitive work environment in which business thrive today made it improbable for conventional methods to yield fruitful tangible benefits. The research underscores the limitations that ABC system faces in terms of identification of cost drivers which at times becomes a cumbersome exercise (Rimmer, 2017).
With time, the ABC method has evolved itself with a few versions that each have certain special attributes. The latest version bears the addition of time factor. In this version, it is necessary for the company to first clearly what resources it has at its disposal and then what optimum mix of those resources would results in achieving the targets set in terms of production achieved. The necessity for this advanced version came from creating a niche for the company among its competitors in a tight battle for achieving greater consumer base in cut throat market. The application of the Time-Based Activity costing revolves two main factors which are the cost incurred per unit of material or article and the quantity used for the production. The goal is to ascertain the time required and the resource needed for finishing a set of actions. The method aims to minimize the impact of other constraints of ABC to boost productivity (Segal, 2017). The costs are ascertained based on normal possible capacity rather than an unrealistic full capacity. For any given resource for productions say a machine there will always be some amount of downtime which could be attributed to several reasons such as breakdown, scheduled maintenance etc. Hence, total capacity is ignored for the purposes of computation and rather emphasis is laid down on effective capacity. More information about this could be gathered from asking question to the right people that’ is the staff equipped to do the job, seeing the work being performed, etc.
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- Bothe research articles aim to eliminate or at least minimize the inefficiencies associated with the conventional methods of costing. The studies lay their attention to identification of redundant or insignificant areas to remove them for becoming a bone of contention and thereby bringing down cost, time and resources to a reasonable level. This not reduces the cost burden of the entities but also provides relief to the workers and ensures that their efficiency is not hot due reasons beyond their control(Sirois, et al., 2018).
- Both the studies have laid enormous emphasis on the dual factors of time and inputs. These two factors have been held as critical factors in maintaining a transparent and reasonable cost structure and better pricing standards. Both them can boost production and reduce costs of the products.
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- Activity based costing aims at eliminating factors that lead to lower efficiency and less utilization of resources not only in terms of money but also in terms of efforts and time involved. Optimum price structures are achieved through appropriate allocation of costs by assigning it to appropriately chosen cost drivers. What TDABC does is it focuses on significantly reducing the time taken and makes the entire production cycle more smooth and easy going. The modern companies have begun favoring TDABC over the ABC system although both the system comes with their own share of advantages and disadvantages.
- The first study focuses more on the concepts related to the cost driver and issue ancillary to it. However, the second study is more inclined towards the time aspect of the process. There was certain weakness pointed out in the activity based costing system but those were undone by the introduction of the time-based version of activity based costing.
Though both the variants of activity based costing have their own share of drawbacks to some extent, but when the methods are compared to the more conventional methods were prevalent earlier, this seems more reasonable and appropriate from many aspects can be used over time with certain modification warranted by time.
Journals on ABC system
Overall it can be said that the two methodologies discussed above are more beneficial than not when compared to the previous tools being used. There are a few takeaways from the two research papers.
Following are the learnings from the first paper:
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- A player who enters certain industry for the first time needs to follow the rules of the trade set by the other existing players which are well established. This is kind of disadvantageous for the company. Also, the profits as per the accounting treatment are being shown at a level lower than the original one. This doesn’t have a good effect(Axelsen, et al., 2017).
- The markets are easily influenced by the pricing decisions set by the big players internally in their respective organizations. This could prove to be detrimental to the interest of small new players who might be able be able to bear the brunt of low pricing.
Following are the learnings from the second paper:
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- The method helps in achieving the group’s goal congruence objective of reducing costs incurred to thereby reducing pricing to boost demand and capture a larger market share.
- The TDABC system focuses on the practical capacity rather than the real capacity. This gives a more appropriate picture. However, there are challenges in determining the cost centers(Bailey, et al., 2017).
References
Andiola, L., Lambert, T. & Lynch, E., 2018. Sprandel, Inc.: Electronic Workpapers, Audit Documentation, and Closing Review Notes in the Audit of Accounts Receivable. Issues in Accounting Education, 33(2), pp. 43-55.
Appelbaum, D., Kogan, A. & Vasarhelyi, M., 2018. Analytical procedures in external auditing: A comprehensive literature survey and framework for external audit analytics.. Journal of Accounting Literature, 40(1), pp. 83-101.
Axelsen, M., Green, P. & Ridley, G., 2017. Explaining the information systems auditor role in the public sector financial audit. International Journal of Accounting Information Systems, 24(1), pp. 15-31.
Bailey, C., Collins, D. & Abbott, L., 2017. The Impact of Enterprise Risk Management on the Audit Process: Evidence from Audit Fees and Audit Delay. Auditing: A Journal of Practice & Theory, 37(3), pp. 25-46.
Bumgarner, N. & Vasarhelyi, M., 2018. Continuous auditing—a new view.. Continuous Auditing: Theory and Application, 20(1), pp. 7-51.
Covaleski, M., Evans, J., Luft, J. & Shields, M., 2003. Budegting Research Three Theoretical Prespectives and Criteria for selective Integration. Journal of Management Accounting Research, 15(3), pp. 3-49.
Fukukawa, H. & Mock, T., 2011. Audit risk assessments using belief versus probability. Auditing: A Journal of Practice & Theory, 30(1), pp. 75-99.
Garon, J., 2018. Ownership of University Intellectual Property. Cardozo Arts & Ent. LJ, 36(1), p. 635.
Hansen, S., Otley, D. & Stede, W., 2003. Parctice developments in budgeting : An overview and Prespective Research. Journal of Management Accounting Research, 15(1), pp. 95-116.
Heminway, J., 2017. Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and Organic Documents. SSRN, pp. 1-35.
Kachelmeier, S., Schmidt, J. & Valentine, K., 2018. The disclaimer effect of disclosing critical audit matters in the auditor’s report. SSRN, 2(1), pp. 1-39.
Kangarluie, S. & Aalizadeh, A., 2017. ‘The expectation gap in auditing. Accounting, 3(1), pp. 19-22.
Knechel, W. & Salterio, S., 2016. Auditing:Assurance and Risk. fourth ed. New York: Routledge.
Lessambo, F., 2018. Audit Risks: Identification and Procedures. Auditing, Assurance Services, and Forensics, 3(1), pp. 183-202.
Mock, T. J., Ragothaman, S. C. & Srivastava, R. P., 2018. Using Evidential Reasoning Technology to Enhance the Audit Quality Assurance Inspection Process. Journal of Emerging Technologies in Accounting, 15(1), pp. 29-43.
Mubako, G. & O’Donnell, E., 2018. Effect of fraud risk assessments on auditor skepticism: Unintended consequences on evidence evaluation. International Journal of Auditing, 22(1), pp. 55-64.
Rimmer, M., 2017. The Trans-Pacific Partnership: Intellectual property, public health, and access to essential medicines.. Intellectual Property Journal, 29(2), p. 277.
Segal, M., 2017. ISA 701: Key Audit Matters-An exploration of the rationale and possible unintended consequences in a South African. Journal of Economic and Financial Sciences, 10(2), pp. 376-391.
Sirois, L., Bédard, J. & Bera, P., 2018. The informational value of key audit matters in the auditor’s report: evidence from an Eye-tracking study.. Accounting Horizons., 32(2), pp. 141-162.
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