Criticism Of Traditional Costing System Accounting Essay
The traditional costing can be divided into absorption costing and marginal costing. The main differences between these two costing methods are the treatment of fixed cost. Normally, the absorption costing allocates the fixed cost to the units produced based on labour hour or machine hour whereas the marginal costing treated the fixed cost as periodical costs. That's means the fixed cost will not be allocated to the units produced. In reality, the absorption costing is more popular than marginal costing (Geri N & Ronen B., 2005).
Criticism of Traditional Costing System
The absorption costing also has few critical areas that probably affect the management's judgement. The administrative and marketing expenses are ignored in the traditional costing system so this will negatively affect the decision making. The traditional costing may not reflect the real cost of the product since the fixed production cost are allocated by on one or two cost drivers. The components of the fixed production overhead are not analysed in traditional costing so the management does not know the crucial areas in the fixed overhead (Tardivo .G & Montezemolo .G, 2009). For example, the management may not know the reason of sharply increase in fixed overhead because the costing system does not analyse the fixed overhead. Cooper .R (1990) appears to be in agreement with Tardivo .G & Montezemolo .G in that the traditional costing cannot reflect the real cost and even argue that the company management cannot recognize the profitable orders if the costing system cannot provide accurate product cost. According to Geri N & Ronen B. (2005), the allocation of overhead in absorption costing is subjective so the result may not reliable.
Definition of Activity Based Costing (ABC)
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Since the traditional costing system has many deficiencies and criticized by many practitioners and academics. The new costing system was introduced to overcome the problems that arise from the traditional costing system. This new system called Activity Based Costing (ABC) and it was mainly develop by Cooper and Kaplan. The ABC is defined:
An informative system that identities the activities performed, that determines related costs and that subsequently determines activity costs connected to products and services through various cost drivers. Cost drivers reflect the use of resources through product and service related activities (Tardivo .G & Montezemolo .G, 2009, p. 68)
In simple sentence, the ABC is a costing system that helps the organization to identify the activities subsequently uses the cost driver to assign the activity cost to products or services. The activities include set-up, machines, receiving, packing and engineering. The cost drivers can consist of number of production orders, number of deliveries, number of receipts and number of machine hours.
How ABC Overcome The Deficiencies of Traditional Costing
According to Geri N & Ronen B. (2005), the ABC can provide more precise and reliable data to management so it is suitable for decision making. Tardivo .G & Montezemolo .G (2009) appears to be in agreement with Geri N & Ronen B. in that ABC can provide more accurate data and even argue that the information from ABC can help cost reduction and process improvement (Tardivo .G & Montezemolo .G, 2009). This argument is supported by Drake .A et al (1999) and says that most of the company that adopts ABC has achieved the cost reduction and continuous improvement. Cooper .R (1990) also support Drake .A and say that the detail information from product cost is very important when the company in a highly competitive market.
The Criticism of ABC
Even though the ABC can bring many benefits to the company and it can overcome the deficiencies from traditional costing whereas it still criticized by some practitioners. According to Johnson & Kaplan's Relevance Lost (1991), support special study is one of the main functions for a new cost system so the historical and disaggregate data need to be collected and retained (p. 228). This is because the management does not know what type of data needed for special study (p. 228). However this will cause the company to spend a lot of time and expenses to collect date. According to Cross .L (2003), the cost of collecting information is the main reason to stop the printing company adopt ABC. This is supported by Roztocki .N et al (2004), the ABC is seldom adopted by small manufacturing firm because of the limited financial resources and lack of computerization. Geri N & Ronen B (2005) also argue that, another reason that causes the small company to abandon ABC is because ABC system excessively emphasizes the cost allocation and this cause the data over-precision eventually boosts the maintenance costs.
A survey that conducted by BetterManagement (2005) appears to be in agreement with the Roztocki .N, the result show that 71% of large enterprise implement ABC and only 42% of small businesses adopt ABC (BetterManagement, 2005).
Other criticism of ABC include the ABC cannot help the management to identify the bottleneck so the management cannot decide the most profitable product mix (Geri N & Ronen B., 2005). That's means the ABC cannot recognize the profitability of each product so the management cannot decide the optimal product mix. ABC assumes the activities and costs have positive correlation whereas this is unrealistic in short term (Geri N & Ronen B., 2005). For example, the freight cost and material cost. According to Cooper and Kaplan (1992), the cost of supplied may not be change in the short-term. Besides that, the cost allocation in ABC will also involve subjectively arbitrary even though the ABC has more cost driver compare to traditional costing (Geri N & Ronen B., 2005). The implementation of ABC also required to interview with the staffs to collect the information about the time required for their work. Hence, most of the staff will not honestly report the idle time and they will only report that they have fully utilized the time. Hence, this will cause the cost driver rate to be calculated based on full capacity and the cast driver rate will be overstated (Kaplan & Anderson, 2004).
Activity-Based Management (ABM)
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ABM means the management use the information that provided by ABC to improve the business process and help the company to be more competitive (Tardivo .G & Montezemolo .G, 2009). According to McConville .D (1993), the ABC identify the all activities that start from customer order until the product shipped and the ABM focus on how to reduce the non-value added activities thereby shorten the whole process. Tardivo .G & Montezemolo .G (2009) appears to be in agreement with McConville in that ABM can shorten the process and even argue that persisting eliminate inefficiency activities can help the company to continuously improve their activities and customer satisfactory. ABC focus on cost reduction and ABM focus on process improvement so the activity-based system can help the company to improve in qualitative and quantitative basic.
Activity-Based Budgeting (ABB)
ABB use the information that provided by ABC to set the budget for each activity (Grahame .S, 2007). According to Shane .J (2005), the management can base on ABB to make decision related to shifting or hiring personnel and decide the best practice. There have another 2 type of budgeting method other than ABB, they are zero-based budgeting (ZBB) and conventional budgeting. The conventional budgeting can provide precise budgeted cost if the budget cost is variable and it has clear relationship with the production or sales such as direct labour. However, the conventional budgeting cannot provide accurate figures if the budget cost is fixed or semi-fixed and it has driven by purchase order or sales order. The ABB will not face this problem because ABB use different type of cost driver to do budgeting. Hence, ABB can produce accurate budget figures in any type of activities. Besides that, the conventional budgeting and ABB does not evaluate the current activities whereas ZBB will evaluate current activities. Therefore a good ABB need to continuously evaluate the current activities to ensure the data is up to date. The estimated inflation rate will be included in these three budgeting method. The ZBB is not adopted by many companies because it is time consuming (Grahame .S, 2007).
Time-driven ABC is the simplified approach of ABC. In this approach, the resource demands from each activity are estimated by management. The cost per time unit of capacity and unit times of activities are required to calculate the standard rates. Hence, the management can base on this standard rate to allocate overhead. Precise is not required in this new system and small error in estimation is not importance. Time-driven ABC helps the management to save a lot of time if the company expands its capacity or add new activities. This is because the management can easily estimate the standard rates of new activities and no need to collect the detail data from new activities (Kaplan & Anderson, 2004). This time-driven ABC solve the problem that facing by many companies. Under this new system, the cost and time of collecting data can be reduced significantly because the management can use estimation instead of collecting precise data. Time-driven ABC is easy and cheap to implement and it also provide useful information to management at a lower cost compare to ABC (Kaplan & Anderson, 2004). In the case of Banta Food, the company was able to identify the profitability of their product after implementing the time-driven ABC. Hence they start to promote the profitable product, reduced the low profitable inventory and pricing their product according to the outcome of time-driven ABC. As a result, the company revenue increase by 35% and the profit also increase 43% (Kaplan & Anderson, 2004).
The Impact of The Developments on Companies
Implementing the ABC will have different impact to the company and the impact maybe positive or negative. In the following report, the case study regarding the impact of implementing ABC and ABB will be presented. Most of the insurance companies offer variety of product and it also incur high overhead. Hence, the implementation of ABC can help them to acquire accurate cost information and the cost of each activity. Besides that, the high overhead in insurance companies also very difficult to classify so the clearer cost information can help the insurance companies to attribute their cost accurately. Consequently, the management can easily control and reduce the overhead. The information generated by ABC can help the ABM to better measure the performance of the activity subsequently helps the insurance companies to be more competitive (Adams .M, 1996). The detail analysis into the overhead is very useful for the management to make decision. However the company also needs to spend more time to prepare and analyze data in order to get the detail information whereas this may not suitable for some company.
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In this case, the financial service organization decides to abandon ABC after using it for seven years. In the beginning, the company use the information generated by ABC to price their service and improve the costly activities. However the process of collecting input data was time-consuming and the companies also need to use 2 days to calculate the cost of several hundred activities. Besides that, the time-consuming in updating data also cause the company to update their ABC system twice a year. Hence, this cause some of the data was outdated and irrelevant to decision making. The senior management also makes decision based on their intuition. Eventually, the company decides to abandon ABC although ABC can provide useful and accurate information (Geri N & Ronen B., 2005).
Although the ABC can help the insurance company to be more competitive whereas it does not ensure the other company can get the same result just like the insurance company. In the case of Queensferry Telecommunications Division (QTD), the ABC could not provide useful information to the product engineers. The management of QTD initially intends to use ABC to provide accurate cost information to product engineers so they could design the product with lesser cost. However the ABC could not provide accurate product cost when the major contract was postponed. This was because the expense generated by unused capacity was added to the product costs eventually increase product cost. Hence, the product engineers could not depend on the ABC anymore (Cooper & Kaplan, 1992).
The ABB is suitable for implement in police department because the ABB is more transparent. Hence, the public can know how the police department spends their money. ABB can help the supervisor of police department to observe the efficiency of the department. For instance, the process of arresting criminal accounted for 37% of total activity so the supervisor of each division can base on this information to find out the way to improve this process such as use new technology to reduce the activities (Shane .J, 2005).
The absorption costing always is the first choice of the company before the introduction of ABC. The ABC was developed after assimilate the deficiencies of the absorption costing and the ABC undoubtedly overcome most of the deficiencies in traditional costing. The traditional costing only use one or two cost drivers to allocate their overhead so the output of the traditional costing maybe inaccurate. For instance, there have many cost drivers can be used in manufacturing area but the direct labour hours and machine hours are the most common cost driver used by traditional costing. However, the ABC can commendably overcome this problem by using more cost drivers such as number of set up, number of order and number of inspection. Hence, the ABC can provide more accurate data than traditional costing. Besides that, the ABC also can provide more detail information from product cost so the management can identify the most cost-effective project. This benefit is inaccessibility in traditional costing because the traditional costing only uses few cost drivers to allocate their overhead. Hence, the result from traditional costing always inaccurate. In traditional costing, the administrative cost is ignored and its only focus on the cost arises in manufacturing process. Nevertheless, the ABC allocates the overhead to each activity that arises before, during and after the manufacturing process. Therefore the ABC can provide more information to management for cost reduction and process improvement whereas the traditional costing cannot provide such information to management. However, the ABC still cannot overcome the problem of arbitrary allocation of overhead. The ABC even required more subjective allocation in their overhead because the ABC has more cost drivers. Besides that, the implementation of ABC also required to interview with the staff so the staff may give dishonest answer. Therefore, this will result the cost driver rate can not be calculate accurately. ABB is a budgeting method that derives from ABC and it also help to overcome the shortcoming of conventional budgeting. The conventional budgeting cannot provide accurate budgeted figures to management if the budget factor is fixed or semi fixed cost. However, the ABB can help the management to overcome this problem by using different type of cost driver. Notwithstanding the ABC can overcome many shortcomings in traditional costing whereas some of the company still decides to abandon it. One of the reasons is the time-consuming in collecting the input data and the high maintenance cost. However this problem can be solved by using time-driven ABC. The main benefit of time-driven ABC is using estimation to calculate the standard rates of each activity. Hence, the management does not need to waste too much time to collecting and maintaining data. The insurance company can benefit from ABC because ABC provides precise and comprehensive data to them. Hence the insurance company can accurately allocate the overhead to their diversity of product. The ABB also help the government department to prepare their budget more transparent and ABB also help the government department to operate more efficiently. The combination of ABC, ABM and ABB can provide numerous benefits to the company but it still have some shortcoming that need to improve. Even though the time-driven ABC help to overcome some criticism of ABC but some basic problem still cannot be solved such as arbitrary allocation.
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