Activity Based Costing - Literature review Example

Activity Based Costing (ABC) Activity Based Costing (ABC) The current business environment is characterized by complexity, dynamism, and cutthroat competition. Production entities need to take caution of the impacts of rapid changes in business environments in order to develop proper strategies for survival and flourishing. Activity Based Costing System (ABC) is one of the pioneering costing methods that has been designed to eliminate the weaknesses of traditional costing approaches. The primary objective of this paper is to focus on the historical development of ABC, steps for ABC implementation, and critical guidelines for using ABC in determining costs. The paper will also evaluate the effectiveness of ABC system based on its weaknesses and strengths. Key words: Activity-based costing, costs, organization, business entity Introduction Activity-based costing focuses on costing and monitoring activities through tracing resource consumption and charging costs to final outputs. According to Hedhili (2013), ABC identifies organizational activities and assigns the cost of each activity to products and services depending on the amount that each consumes. ABC aims at providing accurate information about costing to managers in order to enable them allocate activity costs to products and services based on cost drivers. The Consortium for Advanced Management-International studied and formalized the principles of ABC between 1970 and 1980 to ensure that costs are assigned to activities based on their use of resources (Velmurugan, 2010). ABC system needs interested organizations to adhere to the critical steps of the system for effective implementation. Regardless of a few limitations that characterize ABC system, most production entities have implemented the system to enhance efficiency. Historical Development of ABC Activity-based costing was developed in the US manufacturing sector during the 1970s and 1980s (Velmurugan, 2010). Prior to introduction of ABC system, traditional cost accountants arbitrarily added a huge percentage of analysis into indirect costs. Activities that were identified by conventional accountants included actions that both people and machines performed. These techniques became increasingly inaccurate as the proportions of indirect or overhead costs rose; there was a recognition that all products do not equally contribute towards indirect costs (Cannavacciuolo, Iandoli, Ponsiglione & Zollo, 2012). One product could take extra time through one expensive machine than other products; however, the extra costs of utilizing the machine were not recognized since the direct labor and raw materials were equal. This phenomenon led to some products subsidizing others particularly when multiple products shared common costs. A need for a better system that could reduce this weakness came into the managers’ attention. ABC system, therefore, was designed. Steps to ABC Implementation Need identification and assessment These involve determining the viability of ABC within the interested organization (Lelkes & Deis, 2013). The company interested in adopting ABC performs thorough investigation to find out the extent to which the company will benefit from the system. Training of employees All employees should be trained on the basic requirements of ABC system. The strategic management should also be enlightened about its use through workshops, conferences and seminars. ABC system is characterized by complexity in using it (Kalicanin & Knezevic, 2013); therefore, it is essential to train employees on how to use it if the organization has to reap from its benefits. Definition of the scope of the project The company interested in installing ABC should assess the objectives of ABC implementation and determine whether they are in line with the strategic plan of the company (Lelkes & Deis, 2013). The objectives of successful implementation of ABC need to rhyme with the mission and vision of the organization. Identification of activities and drivers This involves finding out what elements of the organization drive particular activities. Activities are the main elements that lead to costs. Thus, identifying various cost drivers is critical in identifying the costs of production activities (Lelkes & Deis, 2013). Creation of a cost and operational workflow diagram Lelkes and Deis (2013) argue that the workflow diagrams are critical as they show how products and serves are related to resources and activities. Collect data Data collection is usually done on specific areas where the workflow diagram shows operational relationships. The organization should fully understand the sections that will be affected by the ABC system (Kalicanin & Knezevic, 2013). Implementation Implementation is usually achieved through building software models, validating, and reconciling (Kapic, 2014). This is the stage where the organization starts using the ABC system. The company should have installed all the necessary software, trained personnel and collected data concerning how each section will be affected. Monitoring and evaluation After implementation, the organization puts in place mechanisms for monitoring the effectiveness of ABC (Kapic, 2014). Monitoring seeks to identify areas of weakness that arises during the period of use to enable the management develop counteractive measures for avoiding further adversities associated with such problems. The method is also evaluated regularly to find out whether it is contributing to efficiency in real terms. Guidelines for Using ABC in Cost Determination The first step in applying ABC system is identifying the major activities of the organization (Kapic, 2014). Activities in the organization are responsible for causing costs; examples of these activities include ordering goods and raw materials, raw materials handling, machine operations, assembly, scheduling production activities, and dispatching. Secondly, the organization should identify its cost drivers. Cost drivers constitute factors that determine the size of the costs of the activity or cause the incurrence of costs (Kalicanin & Knezevic, 2013). Cost drivers related to volume are commonly used for costs that change with the levels of production in the short-run. The table below shows examples of costs and their respective cost drivers. Activity Possible Cost Driver Cost of car fuel Distance travelled Handling of raw materials Number of production runs Mailing costs Number of mails delivered Production scheduling Number of production runs The third step involves collecting the costs of each activity into cost pools. Cost pools are used to describe production areas to which the management initially assigns overheard costs (Kalicanin & Knezevic, 2013). Fourth, the organization charges support overhead costs to units produced based on their usage of the activity. The number of activity’s cost that a product generates is used to measure the amount of an activity that the product consumes (Phan, Baird & Blair, 2014). ABC system allocates service costs to the production department according to the usage of the services provided. Reasons for Widespread Acceptance of ABC System Activity-based costing identifies all the activities of an organization, and charges the cost of each activity to all products and services (Kalicanin & Knezevic, 2013). The main source of information for Activity-based costing constitutes Enterprise Resource Planning System, which is always accurate. Therefore, ABC system guarantees accuracy in its reports because it uses automatic information from the Enterprise Resource Planning system. Kapic (2014) contends that ERP enhances the accuracy of the system since it gathers exact data such as number of orders, raw materials used and production capacity of a production entity on a daily basis. This then enables companies to determine the products that have higher returns and those that produce low returns. Organizations then decide to produce the profitable products in large quantities and minimize the production of less profitable products. The ABC system considers product complexity when charging costs(Cannavacciuolo, Iandoli, Ponsiglione & Zollo, 2012). The costs that the system charges to the products relate to the circumstances under which the production was performed. Short-run and complex products attract higher levels of unit costs than the long-run and simple products. ABC system is based on the fact that complex and short-run products require extra labor hours and more expensive machinery to produce than simple products. This aspect has a considerable impact on relative product profitability if costing was done using conventional costing approaches. ABC system is critical in identifying wasteful products to ensure that resources are put into productive use. Lelkes and Deis (2013) suggest that activity-based costing system enables managers to prevent costs incurred on non-value adding activities. The objective of this is to provide greater visibility into business processes and operational cost drivers. This is beneficial to the company as it enhances efficiency, effectiveness and profitability as firms concentrate only on profitable activities and products. Improving information visibility also enables cost managers to adopt quality-related initiatives through identification and elimination of activities leading to poor quality and their cost drivers (Hedhili, 2013). ABC encourages a realistic approach to the stock policies of business entities. The system discourages the buildup of finished goods. The over recoveries that encourage buildup of stocks in other costing approaches so not arise in ABC system since the system treats greater proportion of production costs as variable rather than fixed (Velmurugan, 2010). ABC system reflects the happenings in production environments and identifies only those elements that are subject to managerial control. ABC, thus, includes aspects of stock control through encouraging costs that the management can best achieve through proper regulation of those activities that cause costs. ABC system helps companies to forecast demand for their products and predict sales using the capacity of the company (Phan, Baird & Blair, 2014). The capacity of an organization constitutes the ability of workers, equipments, and machines to produce goods of a particular quantity and quality. Organizations achieve the forecasting objective by comparing the products that employees and machines produce in a specified period to those that consumers purchase during the same period. The company discovers that demand for its products is higher than its capacity if it sells all the products that it produces. Companies are able to identify that the level of demand is below its capacity if consumption is less than production. Production entities then determine the amount of output to produce using the comparisons. Shortcomings of ABC System Implementing an activity-based system is expensive and time-consuming (Phan, Baird & Blair, 2014). Implementing ABC system requires a detailed analysis of cost pools and drivers than other approaches of costing. This increases the cost of administering this system of cost accounting. The process of identifying cost pools and drivers is not a straightforward task; the system requires a lot of time to rationalize the number of cost pools in order to reduce the cost and complexity of ABC system. Kapic (2014) regards this rationalization process as a compromise of the ABC system. The need to hire the services of a consultant with specialized knowledge and experience in setting up ABC system contributes to the increased costs. Additionally, the software for ABC costing system implementation may increase the costs of operation, reducing the level of profitability. Acquiring the ERP that is used together with the ABC system is also expensive and it may be unaffordable to some firms (Kapic, 2014). ABC system exposes organisations to possible misinterpretation of data (Kalicanin & Knezevic, 2013). ABC costing system reports are characterised by several pieces of complex information that may make the reports confusing. Poor interpretation of data may lead to making wrong decisions, which can risk business performance. Additionally, ABC system is does not inform companies about the customers who are highly profitable; this may force businesses to use Balanced Score Cards that, which leads to increased costs of operation and administration of organizations (Kalicanin & Knezevic, 2013). Conclusion Effective implementation of the Activity-based costing requires intensive input in terms of time and finances. ABC implementation stresses on the necessity of careful selection of the areas of implementation and proper management of the overall project. The proliferation of ABC system during the 1990s was caused by managers’ feelings that there was need to phase out traditional costing approaches. The initiators of ABC system developed guidelines for implementation and calculation of costs using the ABC system. Activity-based costing system emphasizes the need to focus and to cut down the cost of operational complexity. Given that ABC is not regulatory requirement for companies’ reporting, managers are required to perform extensive cost-benefit analysis and review its objectives before they engage in its implementation. References Cannavacciuolo, L., Iandoli, L., Ponsiglione, C., & Zollo, G. (2012). An analytical framework based on AHP and activity-based costing to assess the value of competencies in production processes. International Journal of Production Research, 50(17), 4877-4888. Hedhili, N. (2013). Location of the Time Driven Activity Based Costing method with regard to the method of activity based costing. (English). Revue Des Sciences De Gestion, 48(263/264), 12. Kalicanin, D., & Knezevic, V. (2013). Activity-Based Costing as an Information Basis For An Efficient Strategic Management Process. Ekonomski Anali / Economic Annals, 58(197), 95-119. Kapic, J. (2014). Activity Based Costing - ABC. Business Consultant / Poslovni Konsultant, 6(32), 9-16 Lelkes, A. T., & Deis, D. R. (2013). Journal Of Theoretical Accounting Research, 9(1), 57-84. Phan, T., Baird, K., & Blair, B. (2014). The use and success of activity-based management practices at different organisational life cycle stages. International Journal Of Production Research, 52(3), 787-803. Velmurugan, M. S. (2010). The Success And Failure of Activity-Based Costing Systems. Journal of Performance Management 23(2) (2010), 3-33. Read More