Activity Based Costing in Construction Industry - Assignment Example

 ACTIVITY BASED COSTING Activity based costing (ABC) originated from the works of Robin Cooper and Robert Kaplan in the early 1980s as a replacement for traditional cost methods (Cooper & Kaplan, 1999). Traditional cost methods focus solely on the allocation of overhead cost to products or services for financial accounting. Traditional costing in a production and manufacturing environment typically allocates indirect costs based on volume, labor hours, or machine hours (Tseng & Lai, 2007). These cost methods capture the same cost per unit and do not take into consideration changes in batch size, set-up times, and economies of scale. Therefore, traditional costing methods in modern production and manufacturing environment do not paint an accurate picture of the actual product costs because the business processes have become more complex over time and are less labor intensive than in the past. Traditional costing in the services industry usually allocates indirect costs based on service volumes or the number of services provided. These cost methods do not take into consideration the dynamic services that are available in the current environment. The service industry has advanced greatly, and the costs associated with those services have grown with it. The traditional allocation of general, administrative, and other costs for services provides little information about the operating activities that generate these overhead costs (Tseng & Lai, 2007). Traditional cost measures distort product and service costs and have a tendency to undercost complex processes and overcost uncomplicated processes (Tseng & Lai, 2007). In contrast, ABC is designed to overcome the problems with traditional costing by going beyond just allocating costs to products and services. ABC improves the cost information available to management by identifying the cost drivers (Tseng & Lai, 2007). The cost drivers are the factors that influence the cost of activities or the work performed within an organisation (Tseng & Lai, 2007). Identification of the cost drivers allows the organisation to gain a better understanding of the cost behavior of activities and determine the root causes of the overhead costs (Tseng & Lai, 2007). ABC is defined by Barron’s Dictionary of Accounting Terms (Siegel & Shim, 2000) as “a costing system that identifies the various activities performed in a firm and uses multiple cost drivers to assign overhead costs to products” (p. 15). The principal function of an activity is to convert the organisation’s resources into outputs. An ABC organisation can achieve the same outputs at a lower cost and with fewer demands on resources because it offers insight on the existence, creation and deployment of resources and capacity (Lea, 2007). An ABC model based on the definition in Siegel & Shim, 2000 has two main views. The first is the cost assignment view, which is the vertical part of the model shown in Figure 1. It reflects the need that organisations have to assign costs to activities and cost objects to analyse critical decisions. These decisions have to do with issues such as: (1) Pricing, (2) Product Mix, (3) Sourcing, (4) Product Design, (5) Setting priorities for improvement efforts. The second part of the ABC model is the process view, which is the horizontal part of the model shown in Figure 1. The process view reflects the need that organisations have for a new category of information, information about what causes work, and how well that work is done. Organisations use this type of information to help improve performance and to increase the value received by customers. Figure 1. Cost Assignments and Process View for Activity-based Costing and Management. Time-driven ABC was introduced in 2004 to add flexibility and greater cost accuracy to the ABC process. Time-driven ABC assigns resource costs directly to cost objects using a capacity cost rate. The capacity cost rate can be calculated as the total cost of resources supplied to a process or activity divided by the actual capacity time for work performed for the activity (Kaplan & Norton, 2008). The new model allows the time estimate to vary on the basis of the specific demands allowing it to “capture far more variation and complexity than a conventional ABC model, without creating an exploding demand for data estimates, storage or processing capabilities” (Kaplan & Anderson, 2007b, p. 8). ABC can provide a number of benefits to organisations. The basic role of ABC is to support strategic initiatives so that management can streamline business activities, identify fundamental problems, eliminate waste, design cost out of activities, improve efficiencies long term, and link corporate strategy to operational decision making (Maiga & Jacobs, 2006). The most significant benefits are more accurate product costing due to the activity allocation of indirect costs as well as identification of non-value-added costs that lead to improvements in cost control, activity costs, and cost reduction (Lea, 2007; Tseng & Lai, 2007). An additional benefit is the ability to balance the operational and capacity requirements of the firm (Lea, 2007). The most common reasons companies implement ABC are to have better cost information for customer profitability analysis, pricing, and budgeting (Raab & Mayer, 2007). Some firms adopt ABC simply to upgrade their cost systems or improve business processes (Tseng & Lai, 2007). ABC also can supply management with more useful information for operational and strategic decision making (Kaplan & Anderson, 2007b). Cooper and Kaplan (1999) stated that ABC can offer insight for operational decisions that can increase efficiency, lower costs, and enhance asset utilisation, leading to an increase in capacity or lower spending, so fewer resources are needed to generate revenue. These changes can be measured by a reduction in costs, higher revenues, or cost avoidance (Kaplan & Anderson, 2007b). ABC also can provide information for strategic decisions to shift demand toward more profitable uses for product design, product development, and supply relationships (Chen & Wang, 2007; Cooper & Kaplan, 1999). The shift in demand will reduce the resources allocated to unprofitable activities. The main reason for the success of ABC systems in the companies that adopted and implemented them is the widespread support for ABC within the company, adequate training, and managers who understand and know ABC information. Additionally, research has found that ABC is adopted if 1) there is a current significant risk of cost distortions within the firm, 2) the firm is large, 3) the firm has continuous manufacturing processes as opposed to job shops, and 4) there is product diversity (Krumwiede 1998). Furthermore, if there is a significant top management support of ABC, then ABC will most likely become integrated within the firm (Krumwiede 1998). In construction industry, which traditionally utilised resource based costing (RBC), in which resources are traced directly to products and services, ABC constitutes an excellent alternative. ABC uses two-stage costing tracing resources to processes, then assigning processes to products and services. ABC assigns costs to the processes involved in those work packages before assigning costs to final cost objects. Moreover, in construction industry, ABC has gained considerable attention as a tool for evaluating supply chain performance. Construction companies also use ABC to evaluate how the performance of other supply chain members drive their logistics costs and affect overall profitability. Costs may vary based on factors such as cycle time, on-time delivery, and order accuracy. Moreover, if construction company opts in for using time-driven ABC approach over the conventional one, construction managers obtain accurate cost and profitability information to set priorities for process improvements, rationalise their project variety and mix, and manage customer relationships in ways that benefit both parties (Kaplan & Anderson, 2007b). Additional benefits of time-driven ABC for construction industry are (a) reduced demand for resources to collect activity information, (b) automation of the activity information collection process using existing enterprise resource planning (ERP) systems, and (c) enhanced ability to estimate when resources can be redeployed or eliminated due to continuous improvement or rationalisation (Kaplan & Anderson, 2007b). Finally, the benefits of ABC can provide construction companies with a number of opportunities to strengthen their strategic management processes and decision making. Along with significant benefits ABC approach delivers to organisations, particularly construction companies, ABC has some important limitations, which lie primarily in implementation and adoption failures. For instance, Krumwiede (1998) found a strong IT system in companies can prevent ABC adoption or the continuation of implementing it. The reason is that construction companies with strong IT perceive that they already have enough information for decision making; thus, ABC is not worth the cost to implement it. Additionally, Krumwiede (1998) found that weak top management support and insufficient training in ABC hinders implementation. Insufficient training causes employees to not understand and respect the benefits of an ABC system. Finally, some companies do not have enough patience to wait for the full benefits of implementation and that small firm size and job shops hinder ABC implementation (Krumwiede, 1998b). According to Maelah & Ibrahim (2007), found that the first barrier for construction companies to overcome is the justification for the information technology investment because of difficulty assessing the costs, the benefits, and the impact on the bottom line. Peacock and Tanniru (2005) investigated the relationship between IT investment and product profitability using an ABC justification basis by allocating the burden of the investment to the activities that receive the most benefit. IT investments can be justified using an ABC approach when the IT investment is focused and the complexity of the measurement process is low (Peacock & Tanniru, 2005). Justification for an ABC IT investment is the first step in getting management commitment for an ABC implementation project. If the costs of the systems can be justified and the ABC investment can be measured, then management is more likely to support the implementation process. Management commitment is an important factor that can determine the success of an ABC implementation project (Maelah & Ibrahim, 2007). Kaplan and Anderson (2007a) indicated that top management support is the most explanatory variable for the successful or unsuccessful implementation of ABC. The management team determines the objectives of the organisation and the allocation of resources within the company. Therefore, it is essential to have management support from the beginning of the ABC project. Along with these implementation issues, ABC poses some limitations within the system. One limitation of ABC is that the linear approach of activity-based costing provides poor estimates of actual expenditures when there is a nonlinear or discontinuous relation between the demand for and provision of resources (e.g. the resources are provided on a joint and indivisible basis). A second limitationis that an ABC system is expensive, complex, and difficult to modify/update (Kaplan and Anderson 2007a). A third limitation is that ABC systems also ignore unused capacity. A fourth limitation is that workers give subjective estimates of their time spent on various activities for Stage 1 cost assignments (Kaplan and Anderson, 2007a). In spite of these limitations, the main reason that some construction companies do not implement ABC is that they feel that the perceived benefits do not outweigh the implementation costs and that ABC will not enhance the control of costs. REFERENCES Cooper, R., & Kaplan, R. S. 1999. The design of cost management systems (2nd ed). Upper Saddle River, NJ: Prentice Hall. Chen, Z., & Wang, L. 2007. A generic activity-dictionary-based method for product costing in mass customization. Journal of Manufacturing Technology Management, 18(6), 678-700. Kaplan, R. S., & Norton, D. 2008. The execution premium: Linking strategy to operations for competitive advantage. Boston: Harvard Business School Press. Kaplan, R. S., & Anderson, S. 2007a. Time-driven activity-based costing: A simpler and more powerful path to higher profits. Boston: Harvard Business School Press. Kaplan, R. S., & Anderson, S. R. 2007b. The innovation of time-driven activity-based costing. Cost Management, 21(2), 5-15. Krumwiede, K. 1998. The Implementation Stages of Activity-Based Costing and the Impact of Contextual and Organisational Factors. Journal of Management Accounting Research 10: 239-277. Lea, B. 2007. Management accounting in ERP integrated MRP and TOC environments. Industrial Management and Data Systems, 107(8), 1188-1211. Maelah, R., & Ibrahim, D. N. 2007. Factors influencing activity based costing (ABC) adoption in manufacturing industry. Investment Management and Financial Innovations, 4(2), 113-148. Maiga, A. S., & Jacobs, F. A. 2006. Assessing the impact of benchmarking antecedents on quality improvements and its financial consequences. Behavioral Research in Accounting, 18, 97-123. Peacock, E., & Tanniru, M. (2005). Activity-based justification of IT investments. Information & Management, 42, 415-424. Siegel, J. G., & Shim, J. K. 2000. Barron’s business guides: Dictionary of accounting terms (3rd ed.). New York: Barron’s Educational Series. Tseng, L., & Lai, C. 2007. ABC joint products decision with multiple resource constraints. Journal of American Academy of Business, 11(1), 237-243. Read More