The Implementation of Activity Based Costing System - Literature review Example

? Management Accounting Table of Contents Table of Contents 2 Literature Review 3 References 7 Literature Review Overhead cost is the most complex among all the costs to manage. While determining the product costs, it is easy to trace the direct costs. But determination of the overhead costs is very difficult. Carr (1989) has stated that overhead costs are those costs which will be incurred by a company even if an activity is not being performed. Direct costs such as material and labour costs are incurred only when an activity is being performed. Chan and Pasquire (2002) have stated that the overhead costs are the administering costs of the project and includes site staff, site based services etc. Eksteen and Rosenberg (2002) have included other costs like communication, human resources, travelling, auditing, asset ownership etc. in the overhead costs. There is an important relationship existing between the direct and the indirect costs. Warsame (2006) stated that the direct and the indirect costs include the majority portion of the entire construction process. Some companies determine overhead costs as a percentage of the total direct costs. Carr (1988) stated that direct costs such as material, labour etc. are directly chargeable to the performed or implemented activity. Hegazi and Molsehi (1995) have estimated the overhead costs as a percentage of the total direct costs in 14 percent of their survey. Several researches have been made on the overhead costs and it has been divided into two parts. One is the work site overhead including the staff salary, the electricity charges, water supply charges, renting equipment and other is the administration cost (for example- office staff costs, insurance taxes, other fees etc.) (Shelton and Brugh, 2002; Carr, 1989; Assaf et al., 1999, 2001). Both these groups of overhead costs are required to be recovered by a company. There are two types of costing systems for determining the cost of a product. One is the traditional costing system and the other is the activity based costing system. Traditional costing system uses financial accounting information and activity based costing system uses management accounting information. While calculating the overhead costs, there lies confusion that whether it should be calculated based on the volume related factors or based on the transactions. In order to obtain an accurate product cost, allocation of the production indirect costs is very important. In the traditional costing system the allocation of production costs are done in two stages. In stage one costs like salaries, rents etc. are allocated to the respective departments (for example- maintenance, assembly etc.). The costs are allocated in this stage using some cause and effect reasoning like determining the number of employees while allocating the departmental costs. In stage two, the cost pools that have been calculated are allocated to the products. The costs which are traced directly are the direct costs like direct labour cost, direct material cost etc. The allocation of the costs in stage two are based totally on the volume related factors, for example- number of labour hours, number of units produced etc. Drury and Tayles (1994) have stated that many companies incur their overhead costs which are driven by the direct labour hour. Many researches reveal that the volume based overhead costs have been used extensively by a large number of companies (Yoshikawa et al., 1989; Management Accounting, 1989; Murphy and Braund, 1990; Nicholls, 1992). But the problem with this method is that the procedure of allocation of the production costs does not reveal the reality always. In recent manufacturing process, the combination of the costs in order to allocate the production cost is changing. Direct labour cost is decreasing and in comparison to that the overhead costs are increasing. Thus the problem arises as the volume based factors like the number of labour hour is no longer suitable for computing the overhead costs. If the overhead costs are calculated based on the output volume, then it can result in cross subsidization among different products. Higher volume products will be allocated with high overhead costs even if that is not required. This misinterpreted production cost can help the managers in overpricing the high volume products leading to unprofitable and low volume product lines in the future (Kaplan, 1988). However, researchers have found serious problems in computation of the overhead costs using the traditional costing system. Drucker (1963) argued that the overhead costs are caused by different transactions and has no relevance with the output volume of the products. Researchers like Miller and Vollman (1985) have also agreed to this fact that the primary factor related to the overhead costs are the transactions. One possible way to reduce the misinterpretation in the production costs using the traditional costing system is by the implementation of Activity Based Costing system (ABC). ABC system follows the technique of allocation of the overhead cost based on the activities that are driving these costs. The production of a product involves several activities. It is due to this reason that the use of ABC system for the calculation of the overhead costs is more appropriate. Since the performance of these activities during the process of production results in the consumption of the resources in this process, they are also known as the activity cost drivers (Cooper and Kaplan, 1992). Two frameworks have been made for analysing the behaviour of the indirect or the overhead costs. According to Miller and Vollman (1985) the overhead costs can be divided into four different types of transactions. They are logical transaction, balancing transaction, quality transactions and finally the change transactions. Logical transactions deal with the movement of the materials in the production process. Coordination between the demand and supply of the resources take place in the balancing transaction. Quality transactions ensure the fact that the goods are produced based on the requirements of the customers. Change transactions are used to check whether any alteration is required in the product or the production process design. Another framework has been proposed by Cooper and Kaplan (1991) and Cooper (1993) who have suggested that the overhead cost of a firm is driven by four different levels of activities. These are unit level activities, batch level activities, product sustaining activities and the facility sustaining activities. Unit level activities are those activities which support the production of one unit of the output. The overhead costs increase with the increase in the number of units produced. Batch level activities are the activities based on the production of one batch of output. These costs increase with the increase in the number of batches produced. This level of activity has no relation with the number of units produced in a particular batch. Product sustaining activities are those activities which enable the production of specific types of products. Finally the facility sustaining activities support the management of the facilities and their maintenance. Cooper (1990) and Drury and Tayles (1995) have stated that the facility level activities include non manufacturing overheads which remain fixed for a wide range and hence are irrelevant for product related decision making. However, the second framework has helped to classify the overhead costs based on the output and non output activities. This framework has also helped to determine the proportion of the overhead costs which are driven by the non output unit based activities. As the managers are given the responsibility of a particular department instead of the entire company, more focus should be given on the overhead cost structure of each department rather than the overhead cost of the company. According to the researchers Bailey (1991), Drury et al. (1993) and Drury and Tayles (2000) the product cost information could be prepared with the financial accounting system only. Researchers like Friedman and Lyne (1995) stated that many companies have decided not to use the ABC system for the calculation of the overhead costs because it is very difficult to depend only on the ABC system for assessing the product costs. Hopper et al. (1992) and Scapenset al. (1996) argued that the implementation of the ABC system provides flexibility in the product information. Many firms do not assign the manufacturing overheads to the cost centres and they just calculate a blanket rate of overhead for a particular factory or a group of factories (Drury, 2000). This was done to allocate the overhead costs to all the products without concentrating on the production departments in which these products are being manufactured. The blanket rate of overhead helps in allocating the overhead to each product produced in a factory having more than one production department, where the product consumes equal amount of resources from these departments. Drury et al. (1993) stated that in the United Kingdom 27 percent of the companies use blanket rate of overhead to allocate overhead to the products. Many other companies used two other methods in order to include the department costs within the product costs. 21 percent companies in UK include department costs while computing the production costs. It is very important to calculate the accurate product cost using the best possible cost system. It has been found from the prior research that the product cost is very important for taking many vital decisions (Yoshikawa et al., 1989; Kellett and Sweeting, 1991; Scapens et al., 1996 and Bright et al., 1992). It is very important for determining the product price also. However, other researchers disagreed to the fact that the product cost is an important determinant for calculating the product price. According to Gietzmann (1991) the product price is based on the market rather than that of the product costs. References Assaf, S.A., Bubshait, A.A., Atiyah, S. and Al-Shahri, M., 1999. Project overhead costs in Saudi Arabia. Cost Engineering, 41(4), pp. 33-8. Assaf, S.A., Bubshait, A.A., Atiyah, S. and Al-Shahri, M., 2001. The management of construction company overhead costs. International Journal of Project Management, 19, pp. 295-303. Bailey, J., 1991. 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Friedman, A.L. and Lyne, S.R., 1995. Activity based Techniques: The Real Life Consequences. London: The Chartered Institute of Management Accountants. Gietzmann, M., 1991. Implementing issues associated with the construction of an activity-based costing system in an engineering manufacturer. Management Accounting Research, 2(2), pp. 189-99. Hopper, T., Kirkham, L., Scapens, R.W. and Turley, S., 1992. Does financial accounting dominate management accounting? Management Accounting Research, 3(3), pp. 307-11. Kaplan, R. S., 1988. One cost system isn’t enough. Harvard Business Review, January-February, pp. 61-6. Kellett, B.M. and Sweeting, R.C., 1991. Accounting innovations and adaptations: A UK case. Management Accounting Research, 2(1), pp. 15-26. Management Accounting, 1989. Cost management in the 1990s. Management Accounting (UK), December, pp. 16-17. Miller, J. G. and Vollman, T. E., 1985. The hidden factory. Harvard Business Review, September-October, pp. 142-50. 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