Activity Based Costing in Practice - Case Study Example

Activity Based Costing in Practice Table of Contents Introduction 3 Activity Based Costing Method (ABC) 3 Traditional Costing Method 3 Difference between ABC and Traditional Costing Method 4 Stages in ABC System 4 Limitations of ABC 5 Research Gap 5 Conclusion 6 Reference List 8 Introduction In today’s continually changing and competitive business environment, companies are required to be cautious of the consequences of the transformation in business environment. Advancements in the communications and manufacturing technologies have considerably changed the means companies conduct their operations. Adoption of superior manufacturing technologies for example, computerised manufacturing and robotics have led to the considerable modification in the structure of manufacturing cost. It has led practitioners and academics to argue on subject that the traditional methods of costing are not sufficient enough within the latest manufacturing environment. This has led to the transformation from traditional cost model which is volume-based to new means of costing like ‘Activity Based Costing’ (ABC) method (Cooper and Kaplan, 1992). The paper will focus on the different methods of costing. Different stages of ABC system will also be taken into consideration as well as it limitations will be discussed which may have an effect on the ABC system. Based on the previous research, limitations of them will be identified by focusing on the research gaps which will be recognised in identifying the factors which may affect the successful implementation of ABC. Activity Based Costing Method (ABC) ABC is known as a costing method that recognises activities in a company and allots cost of every activity with the resources to entire services and products according to the genuine consumption by each. This method can be utilised for the targeted cutback of the overhead costs. The basic advantage of employing ABC system in a company is to more accurately find out that how the overhead is utilised. By implementing the ABC system, the manager can get the enhanced information about customer profitability, activity costs, margins, distribution costs, and production facility costs. These details will only be accessible if the ABC system is designed to give the exact data required for every decision (Baird, Harrison and Reeve, 2007). Traditional Costing Method Tradition costing allocates manufacturing overhead which are based on cost driver’s volume for example the quantity of direct staff hours required to generate an item. As manufacturing and production becomes more complicated the overhead costs of manufacturing usually increase whereas the production machine hours or the direct staff hours decrease. Therefore, the machine or direct staff hours are improbably the main cause of manufacturing overhead. To conquer the deficiency of the traditional costing, ABC system has been developed (Banerjee, 2006). Difference between ABC and Traditional Costing Method Activity based costing methodology is more accurate but a complex process while the tradition costing technique accrues values arbitrarily but is a simple process. In the traditional costing, the utilised resources and the cost objects are needed to assess the cost while in ABC method cost depends on the activities utilised by cost objects. ABC should be used when the overheads are high as little changes in every product cost could make big difference in general. Traditional costing methodology should be used when overheads are low as compared to direct costs. ABC method is more effective for internal use whereas the traditional costing is more valuable for external use (Cooper and Kaplan, 1991). Traditional costing technique uses a sole overhead pool as well as incapable to compute the accurate cost while the ABC system includes specific labour or products parts and it computes the actual cost. ABC method is preferred over the tradition costing methodology because it assists the company to recognise the requirements of eliminating or keeping particular activities in order to offer value to products (Shield and McEwen, 1996). Stages in ABC System To design ABC system, four stages are required which are discussed below: Identifying activities: Activities such as the processing orders which consume the resources as well as allot cost to them is identified at the initial stage. The activities selected should base on the cost-benefit criterion. Factors which need to be taken into consideration are the activity centre’s total cost and the capability of a particular cost driver to give a reasonable determinant of cost of activity. Allocating costs to the activity cost pools: The cost which will be incurred in the resources consumed for the entire period are allocated to every activity. Reliability of the cost details will be decreased if illogical allocations are employed to allocate a significant amount of costs to the activities. Determining cost driver: The most excellent cost driver is that which is causally connected to cost being allocated. The cost driver should also offer good justification of costs of every activity pool and should be effortlessly measurable. They are linked either to marketing process or production volume or to the complication of production. Assigning activities cost to the products: The activity costs are assigned by multiplying the rates of cost driver by the total amount of cost driver’s units in every product (Cooper and Kaplan, 1992). Limitations of ABC Expensive Implementation: Setting up ABC system is regarded as expensive as well as time consuming. As the business activities are broken down into individual component and then it is measured and placed in new system so, it is a lengthy process. Making use of software also adds to additional expenses (Clarke, 2002). Misinterpretation of data: Reports which are produced by this system include information like product margins, which vary most often. Due to this, it may be feasible that some of the costs which is activity based may be not relevant in some decision making situations (Clarke, 2002). Complexity: The most well-known limitation of this system is that it is complex in nature which thwarts its extensive application (Clarke, 2002). Difficult installation: ABC system is extremely c, with the several-year setting up being the custom when a firm wants to install or set up it across entire facilities and product lines. For such complicated installation, difficulty arises to maintain a top level of budgetary support and management as the time passes with the completion of installation (Clarke, 2002). Research Gap The limitation of previous research was that the researchers focused only on the software and architectural design of the ABC system that led to the letdown of the ABC implementation. There exist gaps due to the difference in the opinion of researchers. Identifying the gaps in recognising factors which may have an effect on the success of ABC implementation, researchers shifted their main emphasis from technical aspects to other variables like contextual, organisational and behavioural, culture, and organisational structure (Anderson, 1995). First gap is that most of the research on ABC was carried out in the developed nations and very few have been conducted in the developing nations, especially in the Asian context. Therefore it is required to recognise whether Asian culture and their means of conducting business might have different effect on the degree of ABC acceptance and implementation. Second gap states that most of the ABC researchers adopted the organizational and behavioural variables to investigate the factors which are influencing the success of ABC. Till now, only one study examined the impact of the organisational structure on the success of activity based costing among the Canadian business entity (Cavana, Delahaye and Sekran, 2001). Third research gap focuses on the fact that the previous research does not identify the implementation stages of ABC completely. Only four stages have been identified among six stages. Those are: introduction, adoption, adjustment, acceptance, routinisation, and infusion. It has been known that the last two phases are regarded as the ‘mature stage’. It is also argued that at dissimilar stage, the leading factors which determine implementation of ABC are different. To examine the factors which are influencing the success of ABC more correctly, the present research will focus on a particular phase i.e. the mature stage of ABC implementation. The final gap is that most of the research on implementation of ABC was conducted by making use of quantitative methods, and very few studies used the qualitative method. Questionnaire survey comprising of data collection frequently encounters trouble of low responses and to defy this trouble, researchers are persuaded to use various methods to gather data (Cavana, Delahaye and Sekran, 2001). Conclusion The main objective of this paper is to lay emphasis on the issues which are affecting the flourishing implementation of ABC system in a company. Activity based costing methodology is more accurate but a complex process. ABC method is preferred over the tradition costing methodology because of its accurateness and also because it assists the company to recognise the requirements of eliminating or keeping particular activities. However, it also includes some limitations like expensive Implementation, misinterpretation of data, complex process, and is also complicated to install. Research gaps have been identified to focus on the factors which have an effect on the flourishing implementation of ABC system in a company. There exist some gaps due to the difference in the opinion of researchers. In order to make the implementation of ABC more effective, both technical as well as non-technical factors should be taken into consideration. The limitation of earlier research was that the researchers focus only on the software and architectural design of the ABC system that led to the letdown of the ABC implementation. Reference List Anderson, S.W., 1995. A framework for assessing cost management system changes: The case of activity based costing implementation at General Motors, 1986-1993. Journal of Management Accounting Research, 7(1), pp.1-51. Baird, K.M., Harrison, G.L. and Reeve, R.C., 2007. Success of activity management practices: The influence of organisational and cultural factors. Journal of Accounting and Finance, 47(1), pp.47-67. Banerjee, B., 2006. Cost Accounting: Theory and practice. New Delhi: PHI Learning Pvt. Ltd. Cavana, R.Y., Delahaye, B.L. and Sekran, U., 2001. Applied Business Research: Qualitative and Quantitative methods. Australia: John Wiley & Sons. Clarke, P.J., 2002. Accounting information for managers. Boston: Cengage Learning. Cooper, R. and Kaplan, R.S., 1991. Profit priorities from activity based-costing. Harvard Business Review, 69(3), pp.130-135. Cooper, R. and Kaplan, R.S., 1992. Activity-based systems: Measuring the cost of resource usage. Accounting Horizons, 6(3), p.1. Shield, M.D. and McEwen, M.A., 1996. Implementing activity-based costing systems successfully. Cost Management, 9(4), pp.15-22. Read More