Activity-Based Costing and the Service Industry Banks in the UK - Essay Example

ACTIVITY BASED COSTING AND THE SERVICE INDUSTRY The Main Features and Problems Faced by Service organisations In pursuing this Technique. The Case of (Banks in the UK) Word Count Statistics. Excluding this table Pages 10 Words 2122 Character no Spaces 11533 Character with Spaces 13620 Paragraph 56 Lines 283 A partial paper submitted for the fulfillment of the requirement of the course in Finance. November, 2007 1.1Introduction: A considerable deal of literature on Activity Based Costing (ABC) typically focuses on manufacturing applications with financial institutions and health care organisations being an exception in the service sector. This is not good news. With the rapid growth of the service industry, it is estimated that, this sector will subsequently employs more than half of the workforce. More than 74% of the United States work force for example is employed on this sector (Li H. & Smith L.2001). With a dramatic fall in labour cost, the cost of processing information, overheads has become far more important in the present age of advanced manufacturing technology (AMT) with direct labour representing 5%. Thus, it therefore now appears difficult to justify the use of direct labour or direct material as the basis for absorbing overheads. ABC was developed to overcome some of the major problems of the traditional cost accounting. The 80s witnessed an influx of research in to this concept. Activity based costing involves the identification of the factors which cause the costs of an organisations major activities (Lewis; J.R., 1993). In this regard overhead are charged on the basis of their usage of factor causing the overhead. In the UK and the US, information and manufacturing technology are widely used in both manufacturing and the service sector, with both sectors experiencing different degree of the usage (Palmer, A.2000). The four main characteristics inherent to services provide an answer to the main problem of ABC in the service industry. According Patricia, H. et al (1998), services cannot be touched or viewed, the consumption and production of services cannot be separated, unused capacity cannot be stored or use for future use and finally, services involve people, and people are all different. There is a strong possibility that the same enquiry would be answered slightly differently by different people. 1.2 Activity based costing and the service industry in the UK (Banking Sector). By the end of the 1980s, ABC became the focal point within the realms of academic researchers, consultants and managers as a means of overcoming the disadvantages of traditional cost allocation methods. Cost accounting was limited to it s usage of one volume sensitive driver (Cooper & Kaplan 1991). By 1990 initial followers of ABC in the manufacturing sector were able to reduce cost, identify opportunities for improvement and determine a more profitable product mix (Cooper & Kaplan 1991). Thus, the concept gradually gain grounds and became popular in the manufacturing sector. In the service sector, the adoption of ABC has been relatively slow, and the concept was rarely used apart from the health and banking sector. A recent study however, by Schultz & Rostocki (2004) concluded that, the rate of adoption of ABC in service and manufacturing industry was now similar. An essential part of managing and ensuring the long term competitiveness of banking institutions in the United Kingdom will be to configure, manage the service deliveries and their chain of distribution processes. The financial sector in the UK, like in any other country is characterised with the following characteristic Banking institutions and other financial houses are price takers. This is so because the prevailing market price has to be accepted. Large number of institutions offering the same services with none of these institutions being able to influence price. However, their actions are not negligible. As a move by institution A will trigger a whole chain of event, in the form of competitive service pricing, service design, and strategic decision. From the services being offered, it is difficult to identify consumers preferences, as all what is being offered for example, Lloyds TSB for consumer banking, is being offered by Barclays, HSBC and almost all the other chain of commercial banks. That is, the various services turn to be homogeneous. With free entry and exit common in such a market structure, the financial sector in general and banking institutions in particular turn to be very sensitive to information. Thus, the government through the central bank ensures fare play and gets the sector rid of adventurers and crocks. From the above features, one will see that, the market structure exhibited in the financial sector (Banking Institutions) is one of a perfect competition. According to the classical economist, "competition was the means by which information was gradually revealed to all participants, thereby altering expectations and behaviour, and driving the long-run market price toward average cost (natural value)" (Machovec,M.F.1995:2). Competition is a form of an indirect conflict which is not directed at the opponent but consists of a parallel effort, attempting to surpass an opponent by offering opportunities for exchange which are preferred by other buyers or sellers (Rosenbaum; F.E. 2000). Therefore, the shouldn't be a second thought about adaptation and implementation of ABC if banks, must, do proper pricing, get the right profit per product and allocate their resources to most efficient use. ABC involves a paradigm shift in management, a move from a functional view of an organisation to a cross-functional one. Banks which have adopted the concept have been able to do proper: Pricing structures Channel strategy Branch network strategy Capital allocation strategy and process Process efficiency, insourcing and outsourcing Product portfolio strategy Customer and customer segment attractiveness 1.3 Issue and Problems in Pursuing ABC in the service Sector Activity based management, is at the centre of cost management of modern organisation. Originally developed to satisfy some of the weaknesses of the traditional systems of accounting and make cost analysis more meaningful in managerial strategic decisions making (Young, S.M et al. 2006). The concept has limitations and problems from, labour, resources and commitment required to ABC as a change concept. The purpose of management is to create value drivers so as to improve operational efficiencies and consequently increase return on investment (ROE). A likely feature or problem to be faced by banks in implementing ABC will be identification of the institutions major activities, and the factors that determine the size of the cost of an activity. That is cost drivers. For example, the check clearing service could be considered as an activity and it cost drivers will be a function of the number of checks sent for clearing. Thus, a major problem will be for the management of the banking institutions, to analyse the organisation's activities, the extent of their occurrence, and show the relationship between activities, services and their costs (Young, S.M et al. 2006). A traditional problem of ABC likely to be addressed by banks with the adaptation and implementation of ABC here in the UK will be that of finding the right people and making them to become champions. ABC, being an Accounting tool is not a tool for accounting professionals only, for successful implementation and adoption of the ABC process requires getting people from all the functional departments in an organisation to man the process (Brownlee, L. et al. 2003). However, most banks will fail to see it as an organisational tool and not an accounting concept As with any change concept, ABC implementation and adoption in the service industry will not be an easy process. This will be complicated further with the intangible nature of services. Systems integration should not be neglected. Is the right system and system support resources in place (Human, financial and non financial resources). Will ABC system be maintained separately from financial reporting system Thus, resource availability should be a focal point in adopting ABC, for ABC is an expensive process. It requires top management support and commitment of resources (Young, S.M et al. 2006). Furthermore, the extent and nature of organisational change with ABC should be evaluated by drawing on the dichotomies of formal versus informal change, revolutionary versus evolutionary change, and regressive versus progressive change. Labour cost in banks turn to be very high, with one activity passing through many departments, thus raising the issue of adequately tracing the cost of an activity. ABC is not a total solution for all product costing problems. Adoption of an ABC accounting system will be more expensive to administer than a traditional system. " ABC system being impractically detailed and expensive is viewed as a major hurdle to ABC implementation with a problem of identification of homogenous cost pool in the service industry." King et al. 1994:148). Additional cost and the level of computer technology may explain why movement toward this more complex method of allocation has been relatively slow. A similar observation was reiterated by Canby (1995), while use of ABC can help eliminate the wasting of service resources, development of such a system within the service sector can be labour expensive and time consuming process. Positively, in competitive market structure, as market participants (Firms) makes short term abnormal profit. This abnormal profit will attract new entrants with supply increasing. This action will forced down prices, and consequently abnormal profit will be wiped out. Thus banks will be left with the issue of charging the right price for normal profit to be made. Thus, this price neglected by the traditional costing system will be provided by ABC. That is Price (P)=Average Revenue (AR) =Average Cost (AC) =Marginal Revenue (MR) =Marginal Cost (MC). That is, bank will be faced with the problem of finding the point where, P=AR=AC=MR=MC. At this level, Average cost is at its minimum. Economists refer to this point as the technical optimum point (Machovec, M.F. 1995). ABC will assist management of banks by providing them with good cost structures, from business account, to private account, which line of business or branch is expensive to run and change the cost per unit caculation. With this, banks can easily focus on core services; discontinue services with high cost or low profit margin, or redefining their value chain. Banks operate in a fierce competitive environment, and if resources must be allocated in a more efficient use, then ABC should be an answer. In this kind of market structure, banks must be able to address and assess service profitability realistically. With it good facilitation of what drive overhead cost, ABC should be an indispensable tool for management decision. 1.4Conclusion. Finally, Bank managers can use the new, more refined ABC cost data in strategic decision making, including controlling costs and developing more profitable business strategies. With it salient features on offering considerable benefits to some companies, decision of moving from the standard costing methods to ABC should not be taken lightly. The Association of Certified Chattered Accountants (ACCA) currently estimate the staff time involved in putting the system into operation at two persons years with cost at least $200000. Adopting such a system, has big implications for pricing, sales management, performance management and strategic decision making (Young, S.M et al. 2006). Thus, with the current market structure of financial institutions, with a high proportion of overheads, high degree of competition, and the important role and sensitive nature of information in this sector, ABC should be made indispensable. No wonder, banking institutions and the health care were the first to experience ABC in the service industry. References: Brownlee, L. et al. (2003). Global Electronics, Inc.: ABC Implementation and the Change Management Process. Issues in Accounting Education, Vol. 18. Canby IV, J. (1995). Applying activity-based costing to healthcare settings. Healthcare Financial Management, 49(2): 50-55. Cooper, R. & Kaplan R.S., (1991). "Profit Priorities from Activity Based Costing," Harvard Business Review. Vol.69, No.3 pp 130-135 Cullen J. Seal W. & Soin K. (2002). Activity based costing; banking industry; institutional theory; organizational change. Management Accounting Research. Volume 13, Issue 2, June 2002, Pages 249-271. King, M., Lapsley, I., Mitchell, F., & Myes, J. (1994). Costing needs and practices in a changing environment: The potential for ABC in the NHS. Financial Accountability & Management, 10(2): 143-160 Lewis; J.R (1993) Activity-Based Costing for Marketing and Manufacturing. Quorum Books. Li H. & Smith L (2001).Activity-Based Costing in the Service Sector: The Buckeye National Bank. Issues in Accounting Education, Vol. 16 Machovec, M.F. (1995). Perfect Competition and the Transformation of Economics. Routledge. Rosenbaum; F.E. (2000).What is a Market On the Methodology of a Contested Concept. Review of Social Economy, Vol. 58, Young, S.M et al. (2006). Management Accounting.5th Ed. Financial Times. Prentice Hall Patricia, H. et al. (1998). An Investigation into Four Characteristics of Services. Journal of Empirical Generalisations in Marketing Science 3. ... Palmer, Adrian (2000) The principles of services marketing. 3rd ed. McGraw-Hill Schultz M.S., & Rostocki N., (2004) Adoption and implementation of Activity-Based Costing: A Web Based Survey. Read More