Emergence of Activity Based Costing - Assignment Example

Business Finance Business Finance Emergence of Activity Based Costing Harvard business school published several case studies about costing practices by American Firms. In response, Cooper and Kaplan put forward the new costing technique that was initially called Transaction Costing but later became known as Activity based costing. Activity based costing was produced by the collaboration between two networks; the Harvard network led by Kaplan and Cooper and the network of Computer Aided Manufacturing (CAM). These networks together challenged the traditional costing methods as being superseded and inadequate. They claimed that traditional methods failed to enhance the efficiency and profitability of the American organizations as a result of which they were unable to compete in a dynamic business environment. They further argued that traditional methods are unable to provide accurate and reliable information to management (Dugdale and Jones 2002). ABC system was then put forward as a solution to overcome the problems encountered in the application of traditional methods. ABC attracted the attention from the corporate world, consultants and business institutions right from its emergence. It soon gained popularity and countered the critics by its dynamic and rapidly changing features. ABC system is said to be developed in two important phases. First was during the 1980’s when it was applied by manufacturing organizations to identify costs of the product. The second phase starts from 1990’s until today; it has been now applied widely by organizations to provide management the information about the costs through understanding of the activities. Hence, it emerged as a simple cost accounting technique and evolved into management approach, which is now regarded as an activity, based management. 2. Features of Activity Based Costing and Traditional Costing Systems Traditional costing method uses a single measure based on volume for allocating costs to products. It is often criticized for using a single benchmark that may not be appropriate for all types of costs relevant to the production. It could lead to miscalculation of costs relevant to the product. It allocates manufacturing overheads to products on the basis of the number of direct labor hours or direct machine hours involved in the production. It is stated that the assumption made by the traditional costing method is erroneous that all products create costs. It could be valid for direct costs. However, it may not be correct in the case of other activities of the business, which are not directly related to the production. In this way, traditional costing method does not allocate costs to activities. The total costs are allocated to all products manufactured by the business (Marx, 2009). Activity based costing is based on the assumption that costs are generated by activities. This method allocates costs to different business functions not just the production process. It implies that different activities of the business are considered as cost objects and the overheads incurred by the business are simply allocated not to the products and instead cost pools are created for each business activity and costs are allocated on the basis of resources consumed. It allows appropriate measure of cost of sales and also permits businesses to reduce costs associated with different activities. In this way, the activity based costing differentiates between primary and secondary activities. Management can evaluate fixed costs in a better way and take measures to control activities that are contributing to the total overheads (Kaplan & Anderson, 2013). 3. Implementation of Activity Based Costing The implementation of activity based costing requires organizational wide behavioral change. Its implementation requires support by the management and employees working at all levels of the organization. They need to be convinced that traditional costing method is not appropriate, and it generates distorted cost figures. The implementation of activity based costing could be justified on the basis of its complexity to provide operational information that would improve the overall efficiency of the business and its strategic decisions (Institute of Management Accountants, 2006). For this purpose, the implementation of the system would also require consideration of individual concerns and misunderstandings about the new system. Through effective communication, these issues can be addressed and in this the cost-benefit analysis of implementing the activity based costing system to employees. It has also been suggested that the effective implementation of activity based costing requires working in a backward manner by investigating business processes and identifying cost drivers for different activities performed by the business. A better approach would be to implement this costing system stage wise instead of doing it in one go. It will allow employees to understand different aspects of its implementation and respond in a better way. Overall, a careful approach is needed to ensure that all business functions and activities are aligned and generate the information that is required for effective implementation of activity based costing. The integration of activity based costing system with the organization’s information system is required. Furthermore, it could be stated that the implementation could be considered from two views that are cost assignment view and process view. Both approaches help in identifying cost objects and sequence of activities that add to the costs. Source: (Miller, 1996) 4. Evaluation of Activity Based Costing Managers utilize activity based costing by assigning the costs of significant activities to products which cause that cost to be incurred. In such a way, management obtains the information as to which activity causes the outflow of resources. In order to obtain full advantage of activity-based costing, performance improvements techniques such as analysis of cost driver, activity grouping, and activity evaluation should also be included in the process (Scarlett 2005). Despite the effectiveness and dynamicity of this technique, there is also the other side of the picture. Application of activity-based costing is based on a bottom-up approach which means there is less involvement of senior level management. It could result in conflicts between strategic and operational levels of the organization. Hence, it could only be applied when there are multiple products in a production line and when there are variations in production techniques. If used when circumstances are not favorable, the benefits of implementation may not outweigh the cost of embedding this technique. Surveys conducted shows that ABC costing is implemented by organizations to improve customer profitability, to control costs, to gain managerial information and to obtain the information required to produce budgets and evaluating pricing decisions. An empirical study conducted in 2005 shows that ABC technique is most widely used in Communication industry, financial sector and service sector with 58%, 46%, and 29% respectively. In today’s dynamic environment, it is the need of the organizations to have an effective and reliable costing technique. Management scientists recommend ABC costing for economic, normative and realistic reasons. The reason is that it represents best value, predicts financial events and helps in rational decision-making. 5. Emergence of Activity Based Management and its Usefulness Based on activity based costing, activity based management has been introduced a way to facilitate devise, implement, monitor and control long-term strategic decisions of the business. These decisions are related to resources that different business activities use and mix of products that it produces (Activity-based Management – An Overview, 2001). Activity based management therefore rejects the traditional costing method and management based on this method. It focuses on evaluating different activities carried out different business actions and undertakes measures to control costs related to these activities. It could be stated that decisions made using activity based management are more relevant as they are based on the information that is collected from various business segments and linking them for effective decision making. It could be stated that activity based management is an accounting tool that helps in better understanding of costs to devise ways of managing them effectively (Baker, 1998). Activity based management allows managers to consider different processes and activities and engage in continuous improvement to increase business efficiency and employee performance. The usefulness of activity based management is significant. The management technique provides relevant cost information and separates non-valued added activities in the cost pool. It, therefore, results in better understanding of cost drivers and their contribution to the business. It allows the business to devise tools for measuring and evaluating activity based performances. The management technique is not easy to implement and requires a lot of time and resources. Therefore, smaller companies often fail to follow. Furthermore, there are various challenges faced by companies that affects the usefulness of acitivity based management. These include difficulties in relating costs to specific activities as there could be an overlap in activities making the process of cost identification difficult and expensive. 6. Conclusion From the above discussion, it could be conclude that activity based costing system is a better alternative to the traditional costing method that ignores actual cost drivers adding to the cost of doing business. The activity based costing system allows businesses to evaluate each process and determine its contribution to the costs incurred by the business. Better allocation of costs to different processes within the organizations help in better management of costs. In this way, managers can adopt activity based management techniques to address inefficiency issues identified and then develop long-term strategies that could generate positive results for the business. Although activity based costing and activity based management are effective to improve strategic decision making by the company, they are difficult to implement. They require effective leadership and support at all levels to generate information that is more relevant and reliable. List of References Baker, J.J., 1998. Activity-based Costing and Activity-based Management for Health Care. Maryland: Jones & Bartlett Learning. CIMA Global, 2001. Activity-based Management – An Overview. [Online] Available at: http://www.cimaglobal.com/Documents/ImportedDocuments/ABM_techrpt_0401.pdf [Accessed 18 April 2015]. Dugdale, D. & Jones, 2002. The ABC bandwagon and the juggernaut of modernity. Accounting, Organizations and Society, pp.121 - 163. Institute of Management Accountants, 2006. Implementing Actvity Based Costing. [Online] Available at: http://www.imanet.org/docs/default-source/research/sma/implementing-activity-based-costing.pdf?sfvrsn=2 [Accessed 18 April 2015]. Kaplan, R. & Anderson, S.R., 2013. Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits. Massachuesetts: Harvard Business Press. Marx, C., 2009. Activity Based Costing (ABC) And Traditional Costing Systems. [Online] Available at: Activity Based Costing (ABC) And Traditional Costing Systems [Accessed 17 April 2015]. Miller, J.A., 1996. Implementing activity-based management in daily operations. New York: John Wiley & Sons. Scarlett, R., 2005. Management Accounting-Performance Evaluation. Amsterdam : Elsevier. Read More