Activity-Based Costing: A Strategic Approach to Cost Management - Term Paper Example

Activity-Based Costing: A Strategic Approach to Cost Management CONTENT PART 1.0 INTRODUCTION 3 2.0 ORIGINS AND THEORETICAL FOUNDATION OF ABC 4-6 3.0 ABC OVERVIEW 3.1 Hype Cycle 6-7 3.2 FACTORS ASSOCIATED WITH SUCCESSFUL ABC IMNPLEMENTATION 7 4.0 DIFFUSION OF ABC 8 5.0 ACTIVITY BASED COSTING OVER THE LAST DECADE 9-10 6.0 CONCLUSION 10 PART 2 1.0 CASE STUDY OF COMAPANY AX LTD 11 APPENDICIES 13-20 BIBLIOGRAPHY 21-24 PART 1 1.0 INTRODUCTION During the late 1980s and throughout the decade of the 1990s, a comprehensive debate took place in the academic literature concerning the relevance and effectiveness of Activity-Based Costing (ABC) as a managerial accounting platform. Proponents of ABC contended that it corrected a flaw in the traditional accounting model of overhead cost allocation and led to a higher return on investment (ROI) for firms that implemented this new cost management system (Cooper & Kaplan, 1988; Turney, 1991; Kaplan & Norton, 1992). Critics, on the other hand, argued that their was no empirical evidence to indicate that ABC eliminated unnecessary overhead costs and improved the profitability of companies post-implementation (Shim & Stagliano, 1997; Foster & Swenson, 1997; Chenhall & Langfield-Smith, 1998). During the last century, accurately accounting for overhead costs posed a major challenge for management accountants. Conventional allocation methods tended to distort product costs and Activity-Based Costing emerged as a realistic alternative to address this problem. This paper provides a brief overview of the origins of ABC and explores the theoretical foundation of ABC as a management and cost control system. The paper then discusses the major strengths and limitations of the ABC model and provides a practical example of how ABC has been fully integrated into the strategic management systems of a successful manufacturing company in Qatar. 2.0 THE ORIGINS AND THEORETICAL FOUNDATION OF ABC Activity-based Costing has gone through three distinct phases in its development. Each phase has its origins in one of the following theoretical constructs; the Japanese management movement, the total quality management and continuous improvement framework and Six Sigma modelling. The application of these theoretical models to the development of ABC is discussed below. Activity-Based Costing began to draw the attention of European and American companies in the early 1980s. Firms in the manufacturing and technology sectors in Japan were gaining global pre-eminence with respect to their product quality and significant profit margins while competitors in the West struggled to contain costs and to develop innovative manufacturing processes. Turney (2005), notes that companies such as Toyota and Sony were heralded as global leaders and as a result, their internal organizational processes were analyzed in minute detail and replicated by their competitors in the West. It soon became apparent that the traditional accounting methodology of allocating overhead costs uniformly across the various components of a firm’s product manufacturing processes provided a subsidy to some higher cost activities thereby under-representing their true cost to the firm. Japanese companies had developed a model where all costs associated with a particular product line could be allocated to that activity centre. It became immediately apparent that some products had high marginal costs associated with production while other products had lower marginal costs of production thereby maximizing the firm’s profits. Engineering and manufacturing processes were then adjusted based on this analysis and products that were not contributing to the firm’s profits in proportion to the cost associated with their production, were re-evaluated or eliminated. William Ouchi’s 1982 book, Theory Z, became an international best seller as corporate executives attempted to learn the intricacies of Japanese management. Ouchi was able to establish a nexus between employee morale and increases in productivity. As productivity gains were realized, company costs were reduced and the return on investment (ROI) increased. Okano and Suzuki (2007) describe the impact that Japanese management had on the field of accounting. They note the emphasis on the implementation of cost control strategies linked to what they describe as value engineering. McMann and Nanni (1995), surveyed the literature on Japanese management accounting and discovered that four themes were dominant throughout each study; emphasis on cost control, focus on quality improvement, time management and internal and external communication. The second major phase in the development of ABC relates to the total quality management and continuous improvement studies pioneered by Joseph Juran (1967), Kaoru Ishikawa (1985) and W. Edwards Deming (1986). They introduced the concept of statistical controls to improve quality and lower costs in the Japanese automobile manufacturing industry. Performance metrics were then established based upon quantitative statistical modelling. In the field of managerial accounting, quality improvement has been directly linked to the accounting system’s ability to identify quality costs. In a 1998 article in the International Journal of Quality and Reliability Management, Tsai establishes a direct connection between quality costs and Activity-based Costing. His COQ-ABC framework identifies opportunities for quality improvement by utilizing the firm’s accounting system in designing improvement programs that emphasize controlling quality costs. Ittner (1999) demonstrates how effective ABC is at identifying and precisely measuring costs that directly result in quality improvements (investments) and recommending changes to production processes where outcomes do not meet the quality expectations of customers. The third theoretical foundation for ABC is the corporate development of Six Sigma systems. Six Sigma is a comprehensive management system utilized by firms to control for variability in both product and process outcomes. Six Sigma utilizes data and statistical applications to measure a firm’s performance, to ascertain performance deficiencies, to eliminate product variability, to minimize costs and to maximize profits (Pande et al., 2000). Many of these goals form the foundation for Activity-based Costing. Six Sigma was adopted by Motorola back in 1981. Since that time, many global companies have now implemented this management system. Some of the more notable ones include GE, Merck, HSBC and Ford. 3.0 SUCCESS OR FAILURE? THE DEBATE CONTINUES Traditional accounting methodology tends to assign unit costs on the basis of production hours. ABC, on the other hand, utilizes a more effective allocation model by identifying manufacturing activities that are directly correlated with the overhead cost structure being analyzed. It then assigns the cost of those activities only to the products that are actually demanding the activities. Inaccuracies in the application of traditional cost accounting principles, was the primary reason ABC emerged during the mid-1980s. ABC allows firms to control for distortions inherent in traditional cost accounting systems. Companies are then able to adjust strategy, processes, and operations to improve their competitive position within the market. As noted in the introduction, ABC has come under considerable criticism over the past two decades. The discussion that follows is representative of the debates that have emerged in the academic literature regarding ABC’s applicability. 3.1 Hype Cycle A graphic representation of the development, application and implementation of a technology incorporating ABC was developed by Turney in his article, “Activity-Based Costing – An Emerging Foundation for Performance Management” (2010). The author utilizes the Gartner Hype Cycle to explain the differences in human attitudes toward the technology as knowledge increases and risk decreases over its development and deployment. Knowledge about the technology is limited in early phases of the cycle. This lack of knowledge constrains an organization’s ability to undertake an appropriate analysis of risk in the decision making process. As knowledge increases over time, managers are able to make more informed decisions regarding technology investments. Details of the six phases of the ABC hype cycle are provided in Appendix 1. Turney is clearly an ardent supporter of ABC. He contends that once a firm gets beyond the initial learning curve associated with the implementation of a new accounting system, the company is much better positioned to make strategic decisions concerning the firm’s overall financial management, profit maximization and the development of performance management metrics. 3.2 Factors associated with successful ABC implementation The following analysis of the academic literature reveals the factors associated with the successful implementation of Activity-Based Costing. Shields (1995), was one of the earlier studies that attempted to identify the factors associated with successful implementation of ABC. The research found that top management support, employee involvement throughout the process, the link to performance management and employee training, ownership by the accounting staff and adequate resources for implementation were significant variables in determining a successful outcome. A 1997 study by McGowan & Klammer corroborated the findings of Shields in determining that employee involvement and buy-in to the new accounting system were critical factors in predicting ABC’s success. Anderson & Young (1999) reached similar conclusions in finding that successful implementation of ABC was predicated upon the company’s reward policies, the quality and reliability of the existing information technology system and the resources allocated by the firm in implementing ABC including employee training. 4.0 DIFFUSION OF ABC Management accounting professionals began to realize that several organizations that had adopted and implemented ABC were experiencing significant difficulties during the implementation process. Moreover, it soon became apparent that several firms had decided to abandon ABC altogether and revert back to their traditional accounting systems. Innes and Mitchell (1991) conducted one of the first surveys in the UK that gathered data on the use of ABC by companies in Britain. They found that of the 187 UK companies that responded, only six percent had implemented the ABC system while fifty-two percent had not even considered implementing the new management accounting system. In a follow-up 1995 survey, Innes & Mitchell found that 21% of the respondents were currently using ABC, 29.6% were considering the product, 13.3% had assessed and rejected changing to the new system and 36.1% of the respondents had not considered implementing ABC. Gosselin’s (1997) research on Canadian manufacturing firms found that only 30% of the respondents had implemented ABC. Innes et al.(2000) replicated the survey in the UK and found that the ABC adoption rate had actually declined from 21% to 17%. The Kianni & Sangeladji (2003) survey of the Fortune 500 largest industrial corporations found that 11.8% of the respondents had a well established ABCM system while 40% had recently begun to implement the system. In two surveys of Ireland’s leading companies, Pierce (2004) and Pierce & Brown (2004) found that only 27.9% currently used ABC. A summary of the literature is provided in the table in Appendix 2. The considerable body of research described above indicates that early interest in ABC as the managerial accounting system of the future was initially quite high. However, as many firms began to experience difficulty in adapting to the new approach, the interest in ABC began to wane. 5.0 ACTIVITY BASED COSTING OVER THE PAST DECADE Kennedy & Affleck-Graves (2001) identified three factors that constrain the successful implementation of ABC: ABC is more conducive to manufacturing and technology firms and it may not be applicable to all companies ABC may not be responsible for creating additional profit in the firm. Other factors may in fact be responsible for a higher ROI Little empirical evidence exists that shows a correlation between implementation of the ABC system and increases in corporate profits or shareholder equity. Largely in response to the critics, a number of ABC variants were developed in the early 2000s. These new costing approaches were aimed at solving the fundamental problems identified with ABC’s implementation including the system’s capability to address full costing and idle capacity. Attribute-based costing and resource consumption accounting are two examples (Benjamin & Simons, 2003). The most recent and well known version, Time-driven ABC, was introduced by Kaplan and Anderson in 2004. These researchers discovered that even firms that had successfully implemented ABC found that the volume of data required and the time to collect and manage it imposed significant costs on the firm. The problem was particularly acute when new application software or other organisational systems were introduced. Time-driven ABC reduces this burden and its associated costs by focusing solely on two parameters; unit cost and time required to complete the activity. This new and revised system and the software used to manage it are easy to apply. In addition, the system is adaptable to changes in accounting and other organisational systems. Time-driven ABC not only provides accounting data, it also provides concise management reports for non-accountants. 6.0 CONCLUSION Despite the latest improvements to the ABC system, many companies remain unconvinced that the model is superior to traditional cost management applications and this scepticism will probably never change. In many ways, the failures with the implementation of Activity-based Costing systems were really not a function of the system itself. Part of the problem is that accounting professionals are very reluctant to accept change. After all, that is the way that our universities train accountants. Loyalty to the profession, uncompromised accuracy in reporting and steadfast adherence to the general accounting principals are part of the culture. Unfortunately, as many studies have shown, changing an organisation’s or a profession’s culture is no small task. Companies must also shoulder some of the responsibility for ABC’s limited success because many never provided adequate funding to implement the system and to train the accounting staff to manage the system. Moreover, in many cases the changes were viewed as an add-on to the existing work load of the accounting departments. In some instances, companies were actually running parallel accounting systems; the traditional and ABC. Perhaps Activity-based Costing is another example of a corporate philosophy developed in Asia that is non-transferable to western cultures. That is indeed unfortunate as the ABC system has many applications that can strengthen the way in which companies are managed. The next section provides a practical application of Activity-based Costing to a manufacturing company in Qatar. PART II 1.0 CASE STUDY OF COMPANY AX LTD (footnote here that gives the source using the pseudonym; ie: AX Ltd Annual Report and AX Ltd Consolidated Financial Statements) In Qatar, many companies have been slow to adopt ABC as a full-fledged costing system. This reluctance is primarily because firms who have traditionally used absorption costing, either do not want to change accounting systems, or are not convinced that ABC is a better approach. AX Ltd. (pseudonym) is a company that has, in fact, implemented ABC. AX Ltd, a manufacturer of heavy duty pipes for Natural Gas companies, produces and sells two types of pipes: Gas Safety Pipes (GSP) and MBC Pipes (MBC). Data on the company’s production are provided in Appendix 3. In addition, AX Ltd has identified the activities, costs, and activity consumption cost drivers as presented in Appendix 4. Activity cost data for each product are detailed in Appendix 5. Using the total cost for each activity and the total amount of activity cost driver we can then determine the activity cost rate from the table in Appendix 6: As we can see from the table, one set-up costs QR.294.12, one machine-hour costs QR.7.41, one inspection-hour costs QR.10.00, and one packing order costs QR.5.36. In order to calculate the per-unit cost of each product manufactured by AX Ltd we refer to the table in Appendix 7: The overhead cost per unit for each product has been deduced: GSP;19.82 and for MBC :80.39 Therefore the FULL Cost per unit is GSP MBC Prime Cost 21.00 35.00 Overhead cost 19.82 80.39 FULL COST PER UNIT 40.82 115.39 APPENDICIES APPENDIX 1 APPENDIX 2 Surveys on the diffusion of ABC (1995-2000) Country Population Response Rate Period Adoption Rate Innes & Mitchell (1995) United Kingdom Firms listed in TIME 1000 33.2% Early 1994 21% currently use ABC 29.6% are considering, 13.3% have assessed and rejected, and 36.1% have not considered Bjornenak (1997) Norway Manufacturing Organizations 57% 1994 40% wanted to implement, were current implementing, or had already implemented ABC Gosselin (1997) Canada Manufacturing strategic business units 39.5% October, 1994 to January, 1995 30.4% are implementing ABC Clarke et al. (1999) Ireland Manufacturing firms in the business and finance listing of Ireland 41% Not Mentioned 11.8% currently use ABC, 20.6% are considering, 12.7% have assessed and rejected, and 54.9% have not considered Innes et al. (2000) United Kingdom Firms listed in TIME 1000 22.8% 1999 17.5% currently use ABC, 20.3% are considering, 15.3% have assessed and rejected and 46.9% have not considered Surveys on the diffusion of ABC (2001-2005) Country Population Response Rate Period Adoption Rate Kianni & Sangeladji(2003) USA 500 Fortune largest industrial corporations 21.6% Fall, 1999 40% recently started implementing, 11.8% are having ABC well established Pierce (2004) and Pierce & Brown (2004) Ireland Top 500 companies and top 50 financial services companies from the 2001 Business and Finance listing of top Irish firms 23.2% March to May 2003 27.9% currently use ABC APPENDIX 3   GSP MBC Production Volume 10,000 5,000 Selling Price QR.78.00 QR.130.00 Unit prime cost QR.21.00 QR.35.00 APPENDIX 4 Activity Budgeted Cost Cost Driver Machine set-ups QR.100,000 Number of set-ups Machine running QR.400,000 Machine-hours Inspection QR.70,000 Inspection-hours Packing QR.30,000 Number of packing-orders Total QR.600,000   APPENDIX 5 Cost Driver GSP MBC Total Number of set-ups 80 260 340 Machine-hours 18,000 36,000 54,000 Inspection-hours 3,000 4,000 7,000 Number of packing-orders 2,100 3,500 5,600 APPENDIX 6 Cost Driver Cost (QR.) Activity Amount Activity Rate (QR.)   A B C=A/B Number of set-ups 100,000 340 294.12 Machine-hours 400,000 54,000 7.41 Inspection-hours 70,000 7,000 10.00 Number of packing-orders 30,000 5,600 5.36 APPENDIX 7 GSP (10,000 units) Activity Cost Driver Activity Rate Activity Amount Total Overhead Overhead per Unit   A B C=A x B D=C/10,000 Number of set-ups QR.  294.12 80 QR.  23,529.60 QR.  2.35 Machine-hours 7.41 18,000 133,380.00 13.34 Inspection-hours 10.00 3,000 30,000.00 3.00 Number of packing-orders 5.36 2,100 11,256.00 1.13 Total       19.82 MBC (5,000 units) Activity Cost Driver Activity Rate Activity Amount Total Overhead Overhead per Unit   A B C=A x B D=C/5,000 Number of set-ups QR.  294.12 260 QR.  76,471.20 QR. 15.29 Machine-hours 7.41 36,000 266,760.00 53.35 Inspection-hours 10.00 4,000 40,000.00 8.00 Number of packing-orders 5.36 3,500 18,760.00 3.75 Total       80.39 BIBLIOGRAPHY Books Deming, W. Edwards. Out of Crisis. Cambridge: MIT Press, 1986. Ishikawa, Kaoru. 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(2003) A Planning and Control Model based on RCA Principles Cost management 17.20-27 Bjornenak, T. 1997. Diffusion and accounting: The case of ABC in Norway. Management Accounting Research (March): 3-17. Chenhall, R. H. and K. Langfield-Smith. 1998. Adoption and benefits of management accounting practices: An Australian study. Management Accounting Research (March): 1-19. Cooper, R. and R.S. Kaplan. Measure Costs Right: Make the Right Decisions. Harvard Business Review, Sept/Oct. 1988, 96-105. Foster, G. and D.W. Swenson. Measuring the Success of Activity-based Cost Management and Its Determinants. Journal of Management Accounting, 9, 109-141. Gosselin, M. The Effect of Strategy and Organisational Structure on the adoption and implementation of Activity Based Costing. Accounting, Organizations and Society, 22(2), 1997, 105-122. Innes, J. & Mitchell, F. A survey of activity-based costing in the U.K.s largest companies. Management Accounting Research, June, 1995, 137-153. Ittner, Christopher D. (1999). Activity-based Costing Concepts for Quality Improvement. European Management Journal, 17(5), 492-500. Kaplan, R.S. The Four-Stage Model of Cost System Design, Management Accounting, February, 1990, 22-29. Kaplan, R.S. and D.P. Norton. The Balanced Scorecard-Measures that Drive Performance. Harvard Business Review, Jan/Feb, 1992, 71-79. Kaplan, R. S. 1998. Innovation action research: Creating new management theory and practice. Journal of Management Accounting Research (10): 89-118. Kaplan, R. S. and S. R. Anderson. 2004. Time-driven activity-based costing. Harvard Business Review (November): 131-138. Kennedy, T. and J. Affleck-Graves. 2001. The impact of activity-based costing techniques on firm performance. Journal of Management Accounting Research (13): 19-45. Kianni, R. & Sangeladji, M(2003). An Emphirical Study About the Use of ABC/ABM models by some of the Fortune 500 largest industrial corporationsin the USA. Journal American Academy of Business3 174-182 Innes, J. & Mitchell, F. 1991. ABCM: A Survey of CIMA Members," Management Accounting (UK)(October): 28-30. McGowan, A.S & Klammer, P.(1997).Staisfaction with activity –based cost management implematation.Journal of Management Accounting Research 9.217-237 McMann, Paul J. and Alfred J. Nanni, Jr. Means Versus Ends: A Review of the Literature on Japanese Management Accounting. Management and Accounting Research, 6(4), 1995, 313-346. Pierce & Brown (2004) An Emphirical Study of ABC systems in Ireland. The Irish Accounting Review 11,33-53 Pierce, B. (2004) Activity Based Costing .Accountancy in Ireland 36,28-31 Shields, M. D. 1995. An empirical analysis of firms implementation experiences with activity-based costing. Journal of Management Accounting Research (7): 148-166. Shim, E. and A.J. Stagliano. (1997). A Survey of U.S. Manufacturers on Implementation of ABC. Journal of Cost Management, March/April, 39-41. Tsai, Wen-Hsien. (1998). Quality Cost Measurement under Activity-based Costing. Journal of Quality and Reliability Management, 15(7), 719-752. Turney, P.B. How Activity-based Costing Helps Reduce Cost. Journal of Cost Management, Winter, 1991, 29-35. ARTICLES Activity-Based Costing -An Emerging Foundation for Performance Management(2010) by Peter B.B. Turney, PhD President and CEO Cost Technology, Inc. WEBSITES http://costechnology.com/performance-center/features/activity-based-costing-an-emerging-foundation-for-performance-management Read More