Roztocki (1999) states that in order to be successful in this new business environment companies have to be flexible and react quickly in manufacture. Furthermore, the author emphasises the need to have accurate and up-to date costing information to make decision-making effective and proper. Scarlett (2002) and Roztocki (1999) argue that traditional costing systems based on volume-allocation of overhead (direct labour hours or machine hours) no longer provide any accurate information for product calculation, due to the serious increase in overhead and the subsequent decline in direct labour. They even contribute to poor strategic decision making, owing to the tendency of traditional costing systems to distort product costs (Johnson and Kaplan, 1987). Hence, Freidank (1997) concludes that traditional methods of assigning overhead are deficient in terms of improving global competitiveness.
Activity Based Costing (ABC) has been designed to cope with the deficiencies of traditional costing systems. To achieve accuracy and transparency of product calculation, this accounting technique allows an organisation to determine the actual cost associated with each product and service (Coenenberg, 1992).
The main differences between traditional overhead absorption and activity based costing; the potential benefits from implementing an ABC system and the required information for its implementation are going to be analysed in this report.
1. Comparison of ABC and the client’s basis of overhead
absorption
.
1.1 Characteristics and function of the client’s current basis of
overhead absorption
The client’s current basis of overhead absorption and its functionality is based on the principle that overheads are allocated to products or services using only one volume-sensitive driver, typically direct labour (Cooper and Kaplan, 1988).
Idowo (2004) illustrates that with the approach of the traditional overhead absorption, organisations allocate overheads to objects namely: product, service and job using, a two stage procedure. In the first stage overheads are assigned to cost centres, while the second stage allocates the costs accumulated in the cost centre to products. Traditional cost systems concentrate on the product in the costing process. Assuming each product consumes resources; costs are traced to the product item. Therefore, traditional overhead absorption only measures attributes of the individual product item. Their share of overheads is absorbed on the basis of the product (Johnson and H. Thomas, 1993).
Idowu (2004) explains that at the end of the accounting period, organisations may either over - absorb or under - absorb overheads. This may raise problems because overheads represent solely a small proportion of total costs. Moreover, a drawback to this method is the old belief that all overheads relate primarily to production volume (Idowu, 2004). The author’s point of view is based on the works of Cooper and Kaplan. They say that the proportion of overheads to total costs have augmented, due to the increased multifaceted processes in companies.
They concluded that organisations could face serious profit-related consequences by using the traditional overhead absorption. This is because the cost object would continually be over - or under - cost (Idowu, 2004). Consequently, the traditional absorption of overheads effects a fair degree of cost accuracy and transparency.
Scarlett (2002) opines that calculating product costs using traditional volume-based absorption methods (labour hours) no longer produces meaningful results. This is because they do not attribute costs to products in a sensitive manner and at the same time fail to recognise the way in which overhead costs are actually incurred.
The client manufactures a wide range of furniture pieces that all vary in quality and price and in the production process. Irrespective of which product is being produced, both the production line and tools need to be changed frequently. For instance, the manufacture of a cupboard is a more complex operation than the manufacture of a table (Farrugia, 2004). The professional says that since a cupboard is made of more pieces than a table it uses more resources. This is not distinguished by traditional product costing. Scarlett (2002) points out that today’s manufacture takes place in short, irregular runs and a high part of product costs are determined at the design phase. As a consequence of this production environment, a rising percentage of overhead costs are incurred at product level (Scarlett, 2002).
By way of conclusion, Roztocki (1999) says that organisations using information generated from traditional overhead absorption will be troublesome for future decision making. Scarlett (2002) adds that this method does not decode information from the ledger into a format that serves managers. Subsequently, there are no answers to the question ‘what does it say about current or future processes and practices?’ (Andersen, 1999).
Since allocation systems do not reproduce the true cost and flow across the operations and processes of a business, this cost accounting technique for capturing cost is defective. As a result, operational management tends to ignore cost accounting information.
1.2 Characteristics and function of ABC
Activity-based costing is a decision making tool that allows, in comparison to the traditional overhead absorption, organisations to clarify the actual cost linked with each product and service produced. This is without regard to the organizational structure (Cooper and Kaplan, 1988). Andersen (1999) stresses the fact that ABC enables organisations to expand business performance through increased competence and reduction of costs. ABC identifies the key activities performed in all stages of delivering the product or service to the customer. It is these activities that consume the resource and these same activities that create the product. Recognising this relationship is the cornerstone of ABC. It allocates cost (or resources) to activities based on consumption of resources namely; resource cost assignment (Andersen, 1999).
ABC improves upon the traditional approach by using a two-stage allocation system and multiple cost drivers (Coenenberg, 1992). In the first stage, costs are assigned to cost pools within an activity centre, based on a cost driver. There is no equivalent step compared to the traditional overhead absorption method. In the second stage, costs are allocated from the cost pools, to a product based on the use of its activities. This stage is comparable to a traditional costing approach with the exception that the traditional approach uses solely volume related characteristics of the product. This is without consideration for non-volume related characteristics. Setup hours, numbers of setups, ordering hours and number of orders are examples of cost drivers not related to volume. This is the reason why the allocation of non-volume related costs using volume-based methods distorts the product cost (Cooper and Kaplan, 1988).
Figure 1: Relationship between costs, activities and products
(Roztocki, 1999)
2. Analysis of the potential benefits of ABC
According to Johnson and Thomas (1993), activity-based costing provides many positive aspects and benefits, especially in the manufacturing sector.
2.1 Determining the accurate product cost
The capability of providing more accurate product cost information is the keystone of ABC (Andersen, 1999). This is done by reproducing the true cost and flow across the operations and processes of a business and reducing arbitrary cost allocations. An approach to discover opportunities for cost improvement is possible. Hence, not only the relevance and quality of information is improving but also which activities and events are driving the costs. The knowledge of the factual cost of a product is for every manager the essential key factor to decrease costs and distinguish opportunities for improvement (Freidank, 1997).
2.2 Profitable Product-Mix
Johnson and Thomas (1993) point out that a sophisticated ABC system can provide good support to manage the mix of products. It clarifies how profits are generated at both product and customer level. In addition to this, those activities that truly add value to the customer are identified. Roztocki (1999) argues that in business reality nobody is sure where the money is being made and lost, especially when an increase in sales has no impact on the increase of profit. By identifying the most and the least profitable products, management can react and get rid of unprofitable products or transform them into profitable ones (Andersen, 1999).
2.3 Process Efficiency and improvement of the business plan
As the need increases for higher value-added uses of information, the focus of management moves beyond information available to more analytical applications, such as ABC with performance management capabilities (Andersen, 1999). ABC focuses on activities and equips managers with cost intelligence to drive improvements and to provide a better language for everybody to use in every day’s decision making. Hence, performance can be improved by managing activities instead of costs. ABC implementation will make the employees, across functions, understand the various costs involved. This sets free synergies within a company due to the various departments. These can now share common background knowledge and agree on what the underlying economies of the firm are.
By way of conclusion, Andersen (1999) states that as a norm 20% of the organisation’s customers contribute to 80% of the profit and similarly, 20% of the organisation’s products create 80% of costs. The power of ABC is that these activities can be studied, examined and analysed. Furthermore, such activities can provide more precise and competent decisions with regard to products and their related costs (Andersen, 1999).
3. Implementation of ABC and the required information
According to Roztocki (1999) the implementation of ABC involves, due to the lack of data, technical resources, financial resources, and adequate computerisation investment in time and money. The main obstacle is the lack of information and data which is required to establish a well designed ABC system in this organisation. Therefore, a vital goal is to collect and process the needed information in the correct format at a reasonable cost (Coenberg, 1997). All stages of an ABC process have to be analysed in order to find out the information required from the client’s management to design an ABC system.
The following steps are essential to create a sophisticated ABC system (Drury, 1997):
Step 1: Identify major activities that take place in the organisation
In order to identify activities, an activity analysis has to be carried out. Innes and Mitchell (1995) believe that a physical plan of the workplace and payroll listings should be provided as a useful starting point. This will make out how all work space is being used and ensure that all relevant personnel have been taken into account. Moreover, the complete business process has to be divided into a set of activities. Management should supply a flowchart of the processes in order to identify the main activities. Each box may represent activities and the arrows may denote the flow of the system (Innes and Mitchell, 1995). Accordingly, such needed activities stem from homogenous processes that have to be grouped together. An example of the client’s activities could be production supervision, material handling or the receipt of a customer inquiry.
Step 2: Assign costs to cost pools for each activity
Specific and accurate information from accounting has to be provided in order to identify the cost of resources consumed over a specified period. This can give further information as to whether they are directly attributable to specific activity centres, or not (Drury, 1997).
Step 3: Determine the cost driver for each major activity
Drury (1997) suggests that in order to find a suitable cost driver, all information has to be offered to guarantee that the possible cost driver provides a good explanation of costs in each activity cost pool. In addition, the author points out that when generating this information it should be ensured that cost drivers stand for a homogeneous measure of the output of every activity. In this step the straightforwardness of generating information on cost driver consumption by products is vital for further actions (Drury, 1997).
4. Conclusion
It seems that activity-based costing offers many strategic, operational and financial benefits to the client’s organisation. The comparison of ABC and the client’s current basis of overhead absorption reveal that ABC has the capability to produce more meaningful results with a higher level of accuracy. It contributes effectively to the client’s decision-making process due to its method to measure product costs based on the activities performed to produce it. As a result, the client’s organisation will be equipped with answers to the market needs. This will give rise to improvement of efficiency and reduction of costs without sacrificing the value to the customer. Lastly, the successful implementation of ABC into the client’s company depends on the supply of accurate and proper information such as an activity analysis of the client’s complete business.
.
5. References
ABC – The road to cost management. 2002. Issue No.2. Alwarpet, Chennai: TCM bulletin on activity based costing.
ANDERSEN, A. 1999. The mysteries of Activity Based Costing in Oracle Applications Release 10.7SC. Chicago: Arthur Andersen Business Consulting.
COOPER, R. and KAPLAN, R.S. 1988. Measure cost right: make the right decisions. Harvard Business Review, pp. 98 – 101.
COENENBERG, A. 1992. Kostenrechnung und Kostenanalyse. Lech: Moderne Industrie.
DRURY, C. 1997. Management Accounting for Business Decisions. London: International Business Press.
FARRUGIA, F. 2004. Product - Manager IKEA. Cardiff, 11 Nov. 2004.
FREIDANK, C-C. 1997. Kostenrechnung. 6th edn. Munich / Vienna: Schaeffer – Poeschel Verlag.
IDOWO, S. 2004. Overhead projections. CIMA Insider, pp. 22 – 23.
INNES, J. and MITCHELL, F. 1995. A survey of activity – based costing in the UK’s largest companies, Management Accounting Research, 6(2), 137 – 54.
JOHNSON and THOMAS, H. 1993. Activity – based accounting. Management Accounting, pp. 29 – 31.
JOHNSON and KAPLAN, R.S. 1989. Relevance lost: The rise and fall of management accounting. Boston: Harvard Business School Press.
ROZTOCKI, N. 1999. A procedure for smooth implementation of activity based costing in small companies. New Paltz: State University of New York.
SCARLETT, B. 2002. ABB fab. CIMA Insider, pp. 18 – 19.
6. Bibliography
VALUE BASED MANAGEMENT.NET. 2004. Activity Based Costing. [WWW] http://www.valuebasedmanagement.net/methods_abc.html (10 November 2004)
