Use of Activity-based Costing and Economic Value Analysis for the Justification - Assignment Example

 1.0. INTRODUCTION Activity-based costing (ABC) is an alternative approach to traditional accounting procedures (Chenhall, 2003). This approach is in effect set to overcome the limitations that have been encountered in the application of traditional accounting. On the other hand, economic value analysis (EVA) which is a trademark of Stern Stewart Company (Roztocki & Needy, 1999) has been used in analysing shareholders’ interests as it focus on how shareholders’ interests can be furthered. In this regard, it has been stated that a positive EVA implies an increase in shareholders’ interests but a negative EVA means a decrease in their share (Roztocki & Needy, 1999). As such, the use of ABC and EVA has been in various firms have been observed in the last two decades as both approaches provide an innovation that improves firms’ performance while protecting shareholder value. In lieu with this, Ioannou and Sullivan (1998) article Use of activity-based costing and economic value analysis for the justification of capital investments in automated material handling systems is an article that can be considered as an important article as it directly deals on understanding how activity-based costing and economic value analysis working together can be used in justifying decisions pertaining capital investments. Recognising the integral contribution of the article to accounting management, this paper, will be undertaking a critical analysis of the Ioannou and Sullivan (1998) article Use of activity-based costing and economic value analysis for the justification of capital investments in automated material handling systems. In the critical analysis that will be conducted, the study aims to apprehend the arguments that have been raised by the authors. Likewise, it will look into the validity of the methodology that they have employed to support their claims and finally to further comprehend the intertwined relation between ABC and EVA as clearly indicated in the article. The paper will be having the following structure. The first part is the introduction wherein a brief description of ABC and EVA will be presented. Furthermore, it informs the reader as to what the whole study will undertake and its aims. Likewise, the structure of the paper is presented. The second part of the paper will centre on the article, providing its synopsis. In the third part of the paper, discussion will focus on the analysis of the article. The fourth part will be the presentation of the recommendations. Finally, the last part will be the reflective summary. In the end, it is the hope of the researcher that this endeavour may add further understanding to the notion of activity-based costing and economics value analysis within the manufacturing industry in the context of justification for capital investments. 2.0. THE ARTICLE EXPOSITION The following discussion pertains to the elucidation of the article titled Use of activity-based costing and economic value analysis for the justification of capital investments in automated material handling systems. 2.1. THE TITLE Ioannou and Sullivan (1998) article is titled Use of activity-based costing and economic value analysis for the justification of capital investments in automated material handling systems. From the title one can already expect that focus of the paper is the application of the activity-based costing and economic value analysis for decision-making pertaining to capital investments of automated material handling system. The title is succinct in a way that it explicitly leads the reader as to what can be possibly expected from the entire material. It is clearly presents the topic of the article. 2.2. THE AUTHORS Both authors of the article are renowned in the field of management and engineering. George Ioannou is a professor of production and operations management with interest on the various fields such as Production Systems (Planning, Scheduling and Control), Business Process Modelling and Optimization Supply Chain Management (Inventory Management, Warehousing Design & Operations, and Strategy) Manufacturing Facilities (Cellular-Hybrid-Lines) Design and Material Handling Systems Information Technology Applications (MRP, MRP II, DRP, and ERP), Operations Management. He has written several scholarly articles and has co-authored books. Likewise, he has participated in numerous conferences around the globe. W. G. Sullivan, on the other hand, has authored and co-authored several books, has published numerous scholarly articles and is considered as an icon in the field of engineering economy. 2.3. THE ABSTRACT The abstract informs the reader of the development of a system that may be used as a justification for investing in the automation of material handling system. It tells that the system which, has been developed by the authors rely on the data gathered using activity-based costing. Likewise, mention of the software used in the research has been made and the reason for the choice of software is based on the premise that it can effectively capture the necessary data for the research. Moreover, economic value analysis is used as a tool for the comparison of various economic models. The abstract also informs the reader that a case study has been conducted in order to test the system that they have developed. 2.4. THE SYNOPSIS The authors introduced the need for coming up with a system that can be used in material handling activities. In a study conducted, this activity is said to have “consumed a large proportion of the overall production costs, and impact visibly on product cycle times” (Thompson et al 1996 as cited in Ioannou & Sullivan 1998, p. 2109),thus, making the problem an urgent concern. Furthermore, they claim that this concern is significant especially in industries wherein there is an intensive work-in-process handling like automotive, textile, consumer technology, and defence. They have also noted that there are already suggestions to address the concern pertaining to material handling activities of organisations and in fact, the suggested solution is to invest in automation. However, the authors have noted that the decision for investing in automation becomes difficult in the face of various solutions that have been offered. Recognising the current condition, the authors have proposed an answer that will enable decision makers to come up with quantifiable justification for investing in the automation of material handling systems (MHS). In this regard, two important elements are necessary in the system that the authors propose – activity-based costing and economic value analysis. According to Ioannou and Sullivan (1998), the ABC is not hounded by the problem of ‘intraceability’ of actual costs which is one of the major limitations of the traditional approaches in accounting (p. 2110). This concern has been overcome by ABC via the development of a more precise form of reporting for non-direct costs and provides a cost and effect rationale on how fundamental objectives create costs and results into outputs. Moreover, the authors have raised the notion that the wealth of information that ABC produces can be combined with the appropriate economic model in order to create justification for investments. The authors have also noted that there are numerous articles discussing the importance of technological innovation in the organisation. In their discussion, they have mentioned that the idea of combining ABC and technological innovation is already being proposed by some authors. Moreover, they have cited several authors whose works have already espoused the use of ABC as a way of justifying investments in different kinds of organisations (e.g. Smith & Leksan, 1991; Chen, 1996; Datar et al, 1991). In this sense, what the author are proposing is not something new in the field of accounting management but, is something that is already gaining ground among the scholars and practitioners of the field. After elucidating these factors, the authors have cited the purpose of their paper which is to “tackle the problems of: (i) quantifying accurate costs and benefits of material handling, and (ii) justifying capital investments in modern MHS for discrete parts manufacturing facilities” ( Ioannou & Sullivan, 1998, p. 2112). Likewise, they have named the DaCapo software as the software that they have used for process modelling and management. The rationale behind the choice of software rests on the supposition that it has a unique orientation towards process improvement studies and that it requires minimal hardware support. With this clarified, they have identified the material handling activities and costs. These are direct labour costs, activity costs, moving activity costs and drivers, loading and unloading activity costs and drivers, set-up activity costs and drivers, work-in-process storing activity costs and drivers, material handling system monitoring and control activity costs and drivers. They have also mentioned non-activity or opportunity costs of material handling. Under this group, they have identified production backlogging costs and drivers, inventory holding costs and drivers, waiting and idle time costs and drivers. Having identified the necessary activities and the costs that are en tailed in these activities, the authors further stipulated that information regarding organisational structure and the process analysis that is integral in ABC be appropriated. In this part, the authors have recognised the complexity of the data and processing of the data but, they claimed that if ABC is already implemented in the organisation, the complexity becomes manageable (Ioannou & Sullivan, 1998, pp. 2111-2120). Moving on, the authors discussed economic value analysis as the model that justifies capital investments. This selection is based on the supposition that maximising EVA directly implies optimisation of after tax profitability. This provides a quantifiable data since EVA “measures the difference between the profit earned on invested capital and the cost of that capital" (Ioannou & Sullivan, 1998, p. 2120). In both ABC and EVA, the authors have used the DaCapo software. Having presented this, they have shown the system that they have created for the justification of capital investment in MHS. SOURCE: Ioannou and Sullivan 1998 These theoretical underpinnings have been applied by the authors to a case study. In the case study that they have conducted, they have come up to the conclusion that investments in the automation of material handling systems require huge capital investments. In light of this, justification of the investment must not only rely on qualitative observations but on quantifiable data in order to attain solid grounds for the investment and concrete justification for the decision of investing. This whole idea is significant as it provides the arena wherein all costs can be traced through ABC and returned investments can be known using EVA. As such, through the new system that the authors are proposing, justification of capital investments for the automation of material handling systems rests on data derived from the operations and processes of the firm. 2.5. FURTHER THOUGHTS ON THE ARTICLE The authors’ system is basically built on the supposition that the combination of the necessary information that is gathered using ABC and the knowledge of the after tax profitability via EVA provide a quantifiable justification for capital investments in the automation of material handling systems. This article identifies what facets of ABC and EVA which are deemed useful for the creation of a much needed system that will trace costs which prior to ABC are considered untraceable. This is a significant innovation as it gives decision makers sufficient and necessary information that will not only justify the investment but also encourage further innovations and developments in the organisation. This is maintained based on the notion that decisions to invest are arrived at not through influential groups but through known data. It is also shown in this article that information as an asset and as knowledge shared in the organisation becomes not just a tool for understanding the market and the firms position in the market but, that it is one of the most concrete means with which growth, expansion and investments that the company will be undertaking many be based and justified. Furthermore, it highlights the new functions of accounting involving risk management and strategy formulation that will sustain the company’s competitive advantage while using all the information that the company has gathered in the course of its operations. In this regard, it can be impugned that the article’s contribution to accounting management includes: (1) the significant use of data gathered through ABC becomes a substantial element in company’s decision making. (2) EVA is an effective tool that can be used in order to know the status of shareholders’ value. (3) The combination of ABC and EVA is a strong foundation for the creation of a system necessary in addressing questions of investments especially in the midst of the of limited company resource. 3.0. THE CRITICAL ANALYSIS OF THE ARTICLE Although the system that Ioannou and Sullivan (1998) has stipulated addresses the concern pertinent to the justification concerning capital investments regarding automation of material handling system, there are certain observable gaps in the paper. These are; First, the title of the article is misleading. The article’s title is Use of activity-based costing and economic value analysis for the justification of capital investments in automated material handling systems but, as one goes through the article one gets the idea that ABC and EVA are stages of a system that have been developed by the authors in order to address the problem of justification of capital investments in the automation of material handling systems. The whole article is not about using ABC and EVA but it is using the system that they have developed where ABC and EVA are essential stages. In this regard, the title of the article does not fully correspond to its actual content. As such, the researcher believes that a more appropriate title for the article should manifest the system and not build on the popularity of ABC and EVA. A suggested title for the article is the incorporation of activity-based costing and economic value analysis in a system that justifies capital investment for automation of material handling system. Second, the abstract already alludes to the system that has been developed by the authors. It speaks of a first stage but it does not refer to other stages in the system. Likewise, it already mentions data derived from activity–based costing and it also refers to the use of economic value analysis. However, the abstract is silent whether ABC and EVA are stages in the system which according to figure 4 on page 2120 are necessary stages of the system that they have developed. Furthermore, the abstract already mentions the software that they have chosen to be used for the research. Nonetheless, it has not been named in the abstract. It is important that at the abstract the software has already been named since it is an essential detail that readers should be right away informed. It is deemed crucial since there are many available software for process and modelling management. The authors themselves are aware of this and they even mentioned this fact on page 2113. Omitting this information in the abstract is perplexing. Third, in the pre-processing stage of the system that the authors developed, they included the organisational chart. However, noticeable is the inverted position of the flow. At this stage there is the definition of activities, then identification and finally the creation of organisational chart. It would have been better if the first step in the pre- processing stage is the creation of an organisational chart because it is from there that functions are defined, lines of responsibilities are opened and delegated and the identification of the appropriate departments for a particular function is made. In other words, it is not the work that determines the organisational structure but it is the organisational structure that defines and identifies the functions and responsibilities of each section of the corporation (Gosselin, 1997). Moreover, the researcher is of opinion that the authors should have also incorporated the goals, mission and organisational culture of the firm so as to know whether the strategic analysis pertaining to capital investment that is to be undertaken is aligned. This is being proposed because the organisation is working at limited resources and that capital investments of the organisation should be geared towards attainment of interests that affects and influences the entire corporation as it aims to achieve its goals and create a competitive advantage (Avison, et al, 2004; Campbell, Kay & Avison, 2005; Chen, Romano & Nunamaker, 2006; Homburg, Krohmer & Workman, 2004). Fourth, the first stage of the system is application of activity-based costing. The process is complex, the gathering of data is tedious and the enormity of this stage is time-consuming. The authors themselves recognise that this stage is difficult (Ioannou & Sullivan, 1998, p 2119). This brings to the fore a limitation in the article – the authors do not provide justification for the use of ABC. Indeed, ABC is an innovative tool but there are also other tools like the theory of constraints. What they should have done is provide rationale for choosing ABC over other approaches. The same criticism goes also for the choice of using economic value analysis. They have provided insufficient rationale for the decision to incorporate it in the system. In fact there is no mention why EVA or even why not EVA. Again, there is a need for clarity in this aspect as there are other viable choices in the field and it was EVA that has been chosen to be part of the system which they have created. Fifth, the authors have included in their system the role of decision makers. In fact they have acknowledged that in the end the role of the decision makers are primordial and that the information provided by ABC serves only as a tool with which the decision may be based. However, in an organisation it has been accepted that leadership is integral in steering the firm towards the achievement of its goals (Avery, 2004; Becker, Huselid & Ulrich, 2001; Kaplan & Norton, 2005). As such, being an important stage in the system that they have developed they should have included even just a brief discussion of the kind of leadership that best suits the system that they have created. Sixth, the issue that the authors intend to address is important as it deals with an issue that consumes a large segment of the company’s resources which is limited. As such, there is urgency in responding to this query. Moreover, considering the developments in management accounting, the use of new approaches in handling justification of capital investment in the automation of material handling system helps decision makers of organisations come up with decisions and strategies that will secure the firm’s competitive advantage (Ittner, Lanen & Lacker, 2002). Seventh, the authors used single case analysis. The authors did not provide a solid theoretical framework for the single case. They assumed that the reader would share the same appreciation for ABC and EVA. They failed to establish the theories that were supposed to buttress the system they had created. Likewise, a clear explication of the theoretical framework was necessary in order to confer validity to the decision of using a single case study (Yin, 1994). Moreover, they have tested the system using only one case. However, out from this research they have come to the conclusion that their study using ABC’s wealth of information can be used by any manufacturing organisations. This is based on the premise that ABC provides a wealth of information that organisations may used. Basically this is not an issue of the article. In fact it can be maintained that it is one of the assumptions that the authors implicitly made in the paper. There is in fact no justification for the use of ABC but there is acceptance of the fact that it can produce a wealth of information without question. This attribute is in effect one of the characteristics of ABC and is acknowledged by scholars and practitioners of the field (Lapide, nd; Pokerný, 2001; Kee & Schmidt, 1998; Cagwin & Bouwman, 2002). Finally, the eight criticism that is raised by the researcher against the article pertains to the conclusion. In the conclusion, notable is the significant role of ABC‘s capacity in providing wealth of information that is considered as necessary in making justification for capital investments. Although, this is an important point, it is inappropriate base on the supposition that ABC is only a stage in the system that they have developed. The conclusion should state the benefits and limitations of the whole system and not just a single stage or part of it. 3.1. COMPARISON OF THE ARTICLE WITH ANOTHER ARTICLE WITH A SIMILAR TOPIC The article of Roztocki and Needy (1998) uses activity-based costing and economic value analysis for the justification of capital investments in manufacturing companies. Perhaps, the immediate observable difference between the two is that the article of Ioannou and Sullivan (1998) directly deals with one particular concern in a manufacturing organisation while the Roztocki and Needy (1998) article does not zero-in on a particular investment issue but, tackles the concern from a more generalised perspective concerning capital investments in manufacturing companies. Furthermore, the Roztocki and Needy article has combined ABC and EVA in one step while the Ioannou & Sullivan article has come up with separate stages for ABC and EVA. The Roztocki and Needy article states that the combination of ABC and EVA will help managers realise that the capital investment of the organisation is a limited resource and that they have to be very careful in making decisions regarding capital use. This fact is not highlighted in the Ioannou and Sullivan article. This is an important development because it highlights the reality that information no matter how essential it is becomes inconsequential if it is not appreciated within the condition or context where it is supposed to be working. Moreover, unlike the Ioannou and Sullivan article, the Roztocki and Needy article recognises the reality that ABC and EVA should be combined with other theories and concepts in order to gain full benefit from the use of ABC and EVA. They have provided a more holistic perspective pertaining to the application of ABC and EVA in capital investments decisions. Furthermore, they have placed emphasis on the management with the notion that the combination of ABC and EVA affords the management a more holistic picture of profitability compared with just looking at the after tax profits that EVA alone provides. In fact in the end, they have acknowledged that “proposed integrated ABC-and-EVA system by itself will not make improvements in the business process, but rather will provide management with information that can direct improvement efforts. Management should be committed to make these necessary improvement steps” (Roztocki and Needy, 1998, p. 7). In this regard, the article of Roztocki and Needy will appeal more to leaders who are open to new conceptions and ideas. It demands a change of attitude from the management in terms of providing justifications for or against capital investments in particular and investments in general. Another point in this article is that it recognises that there are certain limitations in ABC alone or EVA alone. As such, they do advocate that it be combined with other measures in order to enhance the benefits that can be gained out from ABC and EVA. 4.0. RECOMMENDATIONS Considering the critical analysis that has been conducted the following are the recommendations of the researcher. 1. The title should be changed in order to show the real discussion which is the focus of the paper – the creation of a system incorporating ABC and EVA as necessary stages. The system created in turn can be used to justify capital investments for the automation of material handling system. As mentioned earlier, the suggested title of the article is the incorporation of activity-based costing and economic value analysis in a system that justifies capital investment for automation of material handling system. 2. The abstract should include all the important details that they have used for the research. Like the purpose of the research, the question of the research, the methodology used in the study and some of the significant findings of the study. 3. The paper should be more organised. The purpose of the research should be written before discussing the concern regarding technological innovation. Likewise, the problem should be stated in such a way that readers are not kept guessing as to what really is the problem of the study. They have provided the urgency of coming up with a system because of large consumption in the resources but they have not connected it with the literature pertinent to technological innovation. As such, the researcher is recommending that in the introduction the problem, the aims, the significance and the structure of the paper should be provided. Then it should be followed by the literature review for ABC, EVA and, ABC and EVA. Then the case study, followed by the conclusion, limitations and future direction of the paper or research. 4. They should also present a clear link among the different stages. This simply means that in the discussion an explanation of the connection among the stages should be made. It is not enough that they have identified some stages and are deemed essential to the framework. This is important but what is necessary is that the connection among all the stages comprising the system are logically link and their connections are justified. 5. The authors should develop a strong theoretical framework for the system that they have created. It is not safe to assume that everybody shares the same positive reception towards the concepts that the authors have incorporated in their system. Likewise, they should provide rationale or justification for choosing one theory over another. This gives the reader an idea as to why ABC is picked over theory of constraints or EVA over NVP. 6. The authors should also justify why they have picked DaCapo over other softwares available in the market. Again, the underlying basis for this recommendation is to provide the readers ample justification for the decisions regarding tools that have been used for the gathering of data and teh entire research. 7. Together with the application of the system in a single case, the authors could have conducted a survey among the experts using the Lickert chart in order to get viewpoints regarding the gravity of the problem that is being addressed by the article and the proposed solution to the problem as developed by the authors. 8. In the same way, the authors should incorporate in the discussion, even just a brief one, as to what kind of leadership or management style is appropriate for their system. This recommendation is based on the idea that information provided by ABC and EVA can change the manner with which the management appreciates the limited capital resource of the organisation and as such decision makers should be more careful in the use of the capital for investments. 9. Finally, the researcher recommends that the conclusion be modified in order to show the relevance of the system that they have developed in connection with the problem of the research and the purpose of the study. Again, the researcher does not discount the importance of ABC as a strategic costing approach; however, the whole research pertains to the scheme that can provide an adequate justification for the decision of capital investment for the automation of material handling system. 10. The authors have succeeded in coming up with a system that can be used for justification. In this sense, it can be claimed that they satisfied the purpose of the research. However, the authors seem to confuse the success of ABC and EVA with their system. Their system is not ABC and EVA but it incorporates the two measures as essential stages for the system they have created. 5.0. REFLECTIVE SUMMARY During the entire course of the research I felt that I was overwhelmed by ideas. I found myself weaving between theories and the real world as I try comprehending the important theories included in the article while at the same time musing over the gravity of the theories’ impact in the life of the organisation. Sometime, I felt that there is urgency for me to grasp the meanings and consequences of the theories as they do not remain as abstractions from reality but, that they explain that which is real and helps make sense of the intricate relations that we have observed in the course of the discussion. It is in this sense of awe and exigency that I approach the article. At first I tried reading several times to optimise the impact of the article. Then, I tried reading it by section, hoping that it will make the ideas of the article clearer but, I was mistaken. So, what I did was read it again. Then i started with the research in the library using several key terms like activity-based costing, economic values analysis, manufacturing industry, technological innovation and competitive advantage. There are numerous articles that can be found but I have tried placing exclusions in order limit my research. Again this part is not easy. What I did was limit the time frame of the articles that I would be considering. I chose a fifteen year span from1995 – 2010. I, also, looked only for articles that used activity-based costing and economic value analysis in the manufacturing industry within the context of capital investments. Although I really thought that the limitations or the criteria for inclusion was still too broad but, it helped me during the research phase for articles. During the entire duration of the research, I have given myself two weeks for the actual library research. Then another two weeks for going over the reading materials and taking down notes and another two weeks for the actual writing. The entire experience has clearly shown me that there are still many things that I have to learn for me to become effective in this craft. I also think that I have to become more careful and diligent in the performance of the profession since it theories and frameworks connects and influences the real world. REFERENCES: Avery, G.C. (2004) Understanding Leadership: Paradigms and Cases. London: Sage. Avison, D., Jones, J., Powell, P., & Wilson, D., 2004. Using and validating the strategic alignment model, Journal of Strategic Information Systems, vol. 13, pp 223–246. Becker, B., Huselid, M.A., & Ulrich, D., 2001. The HR Scorecard: Linking people, strategy and performance, Business Digest (March 2001), pp 1 – 7. Cagwin, D., & Bouwman, M.J., 2002. 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