Traditional cost accounting
1.0 A Brief Look at Traditional Cost Accounting (TCA) and Accounting-Based Costing (ABC)
Before the advent of activity-based costing (ABC), costing systems can be classified into the direct costing, the conventional costing in accordance with the difference in distributing the overhead costs. Kwon (2002) defined “The direct costing does not consider the overhead costs and the conventional costing distributes the overhead costs using the estimated production rates based on the direct costs. The ABC, however, allocates the overhead costs to activities.” It is believed that the traditional cost accounting (TCA) system does not flow with the development in the manufacturing environment.
It is proved by the fact that TCA today still places same emphasis on direct labour cost as what it did during its early period of development. True enough that today's manufacturing life in which more automation is required, has led direct labour to lose influence and cause the TCA to become obsolete technique. By contrast, ABC has overcome these deficiencies and in fact ABC has been called one of the most important management innovations in the last hundred years (Emblemsvag, 2008). Despite the enormous difference in performance between ABC and traditional costing, there are three major differences:
Traditional Cost Accounting (TCA)
Activity-Based Costing (ABC)
It is assumed that cost objects consume resources.
It is assumed that cost objects consume activities.
It mostly utilises volume related allocation bases.
It uses drivers at various levels.
It is structure-oriented.
It is process-oriented.
(Sources: Emblemsvag, 2008)
Traditional methods of cost accounting show some other weaknesses (Bellis and Develin, 1995). There are, companies do not know whether their products or services are profitable and they cannot distinguish profitable from unprofitable customers. In addition, TCA focus on the short term at the expense of the long term and thus TCA is becoming ineffective (Entrepreneur, 2001). Consequently, according to Kaplan (1984, cited by Geri and Ronen 2005, p.134), ‘Yesterday's accounting undermines production, was one of the first among many publications to depict the faults of traditional cost accounting, and the time was ripe for the rise of the new methodology - “activity-based costing”.
ABC allocates costs to products and services. According to Hicks (1992), the ABC philosophy, defined “Activity-based costing is a cost accounting concept based on the premise that products (and/or services) require an organization to perform activities and that those activities require an organization to incur costs. In activity-based costing, systems are designed so that any costs that cannot be attributed directly to a product, flow into the activities that make them necessary. The cost of each activity then flows to the product(s) that make the activity necessary based on their respective consumption of that activity.”
Besides, Cooper and Kaplan (1991) stated ABC developed into Activity Based Budgeting (ABB) and Activity Based Management (ABM) to assist managers in making decisions that can lead to higher profits. Moreover, Cooper and Kaplan (1992) started to describe it as a resource consumption, rather than resource allocation model. Resource consumption looks for unused capacity and utilizes it to a profitable advantage.
Hence, even though some of the TCA's problems had been overcome with the development of ABC, the companies who use ABC models are always necessary to be aware of these problems when developing such a model.
2.0 Criticism of Accounting-Based Costing (ABC)
The ultimate goal of any company is simply to make more money. In order to gain more, there must be greater swiftness of system in producing the money. Tom Johnson who had worked closely with one of the developers of ABC, came out with his scathing article on the approach—“Let's set the Record Straight on ABC.” His conclusion is unambiguous: “To become global competitors, American businesses must change the way managers think, and no cost system, not even ABC, will do that” (TOC Center, 1999). This is supported by Corbett (2000) who provides examples where ABC gives false performance results. In the first example, individual cost per product is increased. Theoretically, this would decrease profit margin as the cost view assumes. Unfortunately, in reality, costs traced to products may not give accurate profit forecasts. Therefore, the examples show that ABC does not always present a clear picture of profitability.
Furthermore, Eric Noreen, who is the famous author of numerous accounting textbooks, concluded from this study and all of his other research: “ABC systems provide costs that are misleading for decision-making purposes” (TOC Center, 1999). However, Corbett (2000) stated that in the past, it has been accepted that ABC is more beneficial in long-term decision making. If the company feels that high local efficiencies will lead to good overall performance, ABC should be the choice. Conversely, Goldratt saw ABC as an obsolete technique which should not be used. He totally criticised the financial community as it does not want to move on and continually demands this rotten technique. Again, he repeated here that what matters most is not the product cost but profit generated. By the way, Waldron did not agree with his views. Waldron said that instead of seeing activity-based costing as a flaw, right selling price is still of great importance and thus, ABC will be needed as the product costing system (Dugdale and Jones, 1996a).
2.1Critical review of H. Thomas Johnson and Robert S. Kaplan's Relevance Lost
In a real world setting, not in academic terms, “Activity Based Costing/ Management (ABC/ABM) as H. Thomas Johnson, co-author of the seminal work on the subject Relevance Lost: The rise and Fall of Management Accounting, wrote: The belief that…ABC improves a company's long-term performance is a delusion” (TOC Center, 1999). It is because no company aims to downsize as its long-term corporate strategy. However, ABC and other cost-based accounting approach focus on controlling costs, putting expense at the centre of the decision-making and performance measurement process. Thus, the end result is data that does not match reality. Consequently, any veteran manager always criticised the flaws in the process and the need for extensive ‘interpretation' of the numbers to make sound decisions (TOC Center, 1999). The message from the veteran managers was quite clear here, no one trusted the system enough to allow it to make the decision on its own.
On the other hand, according to Noreen (1987), J & K criticize the research in management accounting by saying that all costs, whether sunk, variable or fixed are the result of managerial decisions at some point in time. However, what Noreen disagrees with is that “all costs should be assigned to product lines by estimating long-run costs. Therefore, these costs are controllable to some extent. A good product cost system should show how all costs vary with decisions. If we consider all costs as being variable in the long-run they can be traced to the activities that produce the costs. J & K say that we should abandon the systems that ignore fixed costs or the ones that allocate them on an arbitrary basis”.
Besides, J & K state that overhead costs are allocated by identifying “cost drivers” for each department and a cost pool is established for each driver. “To get an allocation rate, the total cost in the pool is divided by the total number of transactions that created the costs” (Noreen, 1987). However, Noreen does not think that it would be worth the cost to set up an allocation system that allocates all overhead costs. “He is sceptical that their “fully traced” costs could provide information to managers that would tell them what costs could be avoided. They assume there are no fixed or joint costs between the cost-drivers. Also, there is an assumption that the cost-drivers that are associated with a product line are directly proportional to capacity in that product line” (Noreen, 1987). From Emblemsvag (2008) also defined, “resource drivers that keep track of how the subsequent activity level affects the resource consumption. In early terminology activity drivers were referred to as 'second stage cost drivers' whereas resource drivers were denoted 'first stage cost drivers'. However, it is evident that the word 'cost driver' is misleading in this context because activity and resource drivers do not tell what drives costs in the general case.”
Although there are some deficiencies in ABC, the use of cost drivers is expected to increase even more and thus the solution to these problems is not to abandon the ABC. As the result, Kaplan and Anderson (2004) suggest the process be simplified through an approach call "time-driven ABC".
“In the revised approach, managers directly estimate the resource demands imposed by each transaction, product, or customer rather than assign resource costs first to activities and then to products or customers” (Kaplan and Anderson, 2004). Thus, “the new approach provides more accurate cost-driver rates by allowing unit times to be estimated even for complex, specialized transactions” (Kaplan and Anderson, 2004).
2.2Evaluates the Practicality
The use of TCA is now being considered by a number of companies as unprocessed and incomplete because “the raw data reported does not reflect a clear view of the relationship between the cost and the cost object” and thus TCA unable to supply the necessary framework for measuring cost accurately (Marivic, 2004, p.7-9). Consequently, at IMA's 75th Anniversary Annual Conference in New York City, the eminent Prof. John K. Shank of Dartmouth College said, “Traditional accounting is at best useless and at worst dysfunctional and misleading” (Thomson and Gurowka, 2005).
With the increased emphasis on controlling costs, ABC was developed as a practical solution and provided an improved cost allocation structure. “ABC makes cost accounting comprehensible and rational. Users of cost information can relate much better to aid in making favorable impacts on decision-making” (Marivic, 2004, p.7). However, the objective of the company is to increase profits, not just obtain accurate costs! A survey from Garg and et al (2003, cited by Linda) indicates that ABC implementations have failed to live up to the original hype. Industry has gone back to that old stalwart, standard costing. Besides, one of the requirements of ABC needs to identify and quantify the cost drivers. However, in practice, we cannot assume all cause and effect links a precise because there may be many things that “drive” a cost. Cost allocation has become arbitrary and variable for several reasons and its applicability is now unreliable because nowadays more companies have common process for a range of products. Hence, it is not easy to measure the activity which drives a cost (CIMA, 2008, p.5).
Additionally, according to Corbett (2000), ‘ABC focuses on identifying cost drivers and improving “all” links. In reality, improving one link without considering the others may ultimately damage another link and destroy the entire chain. ABC may improve several parts individually without improving the overall system'. Consequently, some of the company will feel that ABC is costly to implement and difficultly to maintain in practice.
2.3 Impact on the Companies
According to Lamond (1993, cited by Zaman 1997, p.25), “the result of ABC implementation in a few Australian companies, such as Park Davis, ICI Film Products and Comalco, have shown better investment decision-making and better resource utilization has been achieved as a result of more accurate product costs and more awareness among the managers and staff of the non-value added concept.” Moreover, “many companies in the USA like Hewlett-Packard, Procter and Gamble, Boeing, Caterpillar and IBM have recently implemented ABC and have revealed new information about the product costs” (Zaman, 1997, p.24).
Although many years have passed since large companies began implementing ABC, possibly because ABC is more favourable in larger firms that have a diverse mix of products or services, there are few reports about the implementation and use of ABC in small manufacturing companies (Needy and Bidanda, 1995). Because many small companies still do not understand that by configuring these costing systems to meet their own needs, they can gain better understanding of their operation's true cost structure (Benjamin and et al., 1994). Thus, a few case studies are written on the use of ABC will help small companies to learn more about the benefits and process of implementing ABC (Narcyz, 2003). In order to remain competitive, small manufacturers need more accurate and reliable costing information than their current traditional costing systems.
Further, the benefit of the ABC mindset is that it opens up for a much wider array of measures when it comes to improving productivity. For example, DHL Worldwide Express which is implementing ABC in services industries with success (Holton and Innes, 1998). Moreover, a UK survey by Drury and Tayles (2000) suggests that service organizations are more likely to implement ABC systems. They reported that 51% of the financial and service organizations surveyed compared with 15% of manufacturing organizations which had implemented ABC. Kaplan and Cooper (1998, cited by Drury 2005) also “illustrate how ABC was applied in The Co-operative Bank, a medium sized UK bank. ABC was used for product and customer profitability analysis”. Hence, the study reveals that ABC is suitable for service organizations while TCA is irrelevant for them.
However, on the other hand, Marivic (2004) is conducted “the study reveals that ABC System is not yet fully appreciated by most of the companies here in the Philippines. In spite of the inherent strengths in the ABC model, very few companies have opted to adopt it in their business operations”. The reasons for ABC's low adoption in the Philippines were: “(1) employees lack of basic knowledge of ABC techniques; (2) employee resistance; (3) organizational changes essential with the use of ABC” (Marivic, 2004, p.12). Hence, this research aimed to provide further evidence that why many companies have not to adopt ABC, not only in the Philippines but also in other countries. There are many companies are experiencing problems with implementing ABC.
3.0 Accounting Based Costing (ABC) - End of Traditional Cost Accounting (TCA)?
Nowadays, the use of ABC increases because of the companies realise some potential danger that the conventional costing approaches might generate inaccurate information and therefore cause the managers make wrong decisions. However, given the central role of management accounting in all business functions, is the impact on the business of shifting to ABC really great? ABC has caused the shift in accounting practitioners' mindset, but not all. Let's explore some case studies as illustrations of the required shift.
Though the deficiencies of TCA led many companies turn to ABC. However, in practice, most of the companies still prefer TCA even though TCA involves arbitrary allocation of overhead costs (Garg and et al, 2003). It is because “the use of TCA is that it is the mandatory generally accepted accounting principle for external financial reporting, and integrating financial and managerial accounting systems ensures better costing control” (Geri and Ronen, 2005, p.134).
On the other hand, ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas TCA methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations (Emblemsvag, 2008). Hence, according to 'cause and effect', ABC costs are assigned between activities (the actual process) and cost objects, which is captured using drivers. The drivers are therefore not allocation bases in the traditional sense (Emblemsvag, 2008). By contrast, Linda argues that “while ABC proposes to allocate costs more representatively to the products or services, ABC is still an allocation. Additionally while costs change frequently, the allocation model (ABC or some other variation) is typically not updated for these varying costs.”
Furthermore, Kwon (2002) agued “we study production planning models based on various costing systems which are direct, conventional and ABC costing for an automobile part manufacturing industry. However, we find out that production plan from the model based on direct costing and conventional costing cannot control the overhead costs appropriately, but ABC also has its defects which cannot generate plans in practical computational times due to the nature of the mixed integer programming (MIP).” Moreover, “Unused capacity of “fixed” discrete resources made available to perform an activity can and should be identified, but companies implementing ABC failed to identify unused capacity” (Lawrence, 2005, p.13).
According to Paul Sharman (2003, cited by Lawrence 2005, p.13), the truth is that many companies have not adopter ABC and many companies that have tried ABC but lastly also have abandoned it. He cited one study reporting that 80% of responding companies in the United States are still using traditional cost allocation systems. He also cited a study showing that of the 60% of U.S. companies that have tried ABC, as many as two-thirds have abandoned it.
As the result we can see that ABC has lost some of its usefulness since it requires more effort but without providing better results. Thus, some of the companies today remain to their traditional costing systems. However, the most important is how the companies seek and implement or even make the best use of both approaches because there are still many possibilities that both approaches can be combined to achieve the companies' overall objectivities.
4.0 Criticism and the impact of budgeting
Sharman (2003) defined “Planning and budgeting has been a fairly specialized field within the finance function of most organizations. It is often combined with analysis of business cases for new products, or acquisition of capital equipment.” Hence, let's explore some case studies to compare budgeting methods and consider the impact of the developments have been in practice.
According to Steven (2007), Conventional budgeting is an incremental approach which uses a company's existing operations and current cost structure to determine budget costs. It “will provide accurate budget figures for variable costs such as direct materials, direct labour and sales commission, because these have a clear volume-based link with production/sales. But this approach is unlikely to produce accurate figures for support departments, whose costs are largely fixed and semi-fixed and driven by other factors such as sales orders and purchase orders. In addition, no consideration is given to the cost of providing existing activities, since the focus is on incremental change. Inappropriate business practices may also be perpetuated, because no evaluation of current activities is made.”
Fortunately, the advent of Activity-Based costing Budgeting (ABB) which recognises that it is activities which generate cost in a business and the desire is to control these cost drivers. “For each identifiable activity, the cost of a unit is measured, the demand is measured, a budgeted cost is set for each unit of activity, and the budget is designed around activity terms (e.g. Laptop Z3200 Product Build) rather than the traditional functional areas (e.g. Manufacturing)” (Fintray Consulting Services Limited, 2004). Thus, “the activity-based approach to budgeting is a more sophisticated version of traditional absorption costing” (Steven, 2007, p.50).
Besides, “ABB means that costs can be assigned to activity and product level, rather than averaged out across a number of products or services. This means that real cost behaviour and cost drivers can be analysed, leading to better cost focus and more targeted customer pricing” (Fintray Consulting Services Limited, 2004). However, some deficiencies in ABB must be considered. “ABB requires a large effort to measure and analyse activities, and assumes a causal, linear relationship between activity and overheads. This may be erroneous, as multiple factors may drive the costs, including the sharing of costs over activities, and the method of allocating fixed and variable costs” (Fintray Consulting Services Limited, 2004).
Hence, some of the industry such as hospitality companies which are seeking ways to improve their ability to predict future operations and related resource requirements. They chose to use other budgeting model such as the more information Zero-based budgeting (ZBB) method which is easier for hoteliers to use the more informative ZBB method and it is time to change the traditional methods used of incremental, fixed and flexible budgeting process. In traditional incremental budgeting, it is used as a starting point for the new budget and justifies only increases over the previous year budget. By contrast, ZBB requires the budget starting from the zero-base. Besides, ZBB drives managers to find cost effective ways to improve operations. This tends to force cost centers to identify their mission and their relationship to overall goals. In principle, ZBB leads to the most efficient allocation of resources, as they have to be justified and eliminated wasteful and obsolete operations and deployed to the most important projects on a cost/benefit basis and identified opportunities for outsourcing (Acosta, 2006). Thus, ZBB will ensure that inappropriate activities are not undertaken. However, since ZBB requires gathering, evaluation and analysis of large amount of data thereby the weakness of the ZBB is that it is time-consuming. Consequently, ZBB is used by very few companies (Steven, 2007, p.50).
As the result, it is not easy to change from one method to another. It would take time to get used to and to realise its benefits. Not all companies are flexible and can easily adapt with its changing environment. Another reason why many companies do not adapt ABC/ABB fully is because it is impractical to use the said system in the kind of business they have. It is important to note that ABC/ABB system is not appropriate or unsuitable for all companies and business operations. ABC/ABB can be a very useful decision making tool because it brings visibility of clearly understanding to the costs in the accounting system, which cannot be provided by TCA (Marivic, 2004, p.13).
There are various techniques and models in the real world which are adopted by each company to suit their own industry specific needs. Cost control is important but the most important that managers use cost accounting to help make strategies decision to reduce the company's costs and in order to achieve the company sales and earnings growth.
“ABC has become extremely popular in recent years. In fact, it is difficult to find an academic or practitioner journal that does not include at least one article on activity-based costing, Activity-Based Management (ABM), or activity-based budgeting. A powerful tool for measuring performance, Activity-Based Costing is used to identify, describe, assign costs to, and report on agency operations. Companies that adapted ABC believe that it is a more accurate cost management system than traditional cost accounting. They say that ABC identifies opportunities to improve business process effectiveness and efficiency by determining the “true” cost of a product or a service” (Marivic, 2004, p.10). Therefore, ABC provides improved insight into costs of product or service thereby providing easier access to relevant costs. The developments of ABC have overcome the original criticism of TCA and budgeting.
Although ABC has highlighted that clearly understanding of what it costs to provide products/services is at the same time a tool for better management. However, this may not be accurate enough to make business decision. Thus, companies have felt the need for a more responsive, more holistic system. The model available to them simply did not tell the whole story. In order to fulfil that, they sought to remedy the approaches such as ABC, traditional costing are needed. Still the search goes on. In the future, changing accounting models requires people to understand and adopt a new mindset, with new accounting systems, and ways of making decisions—no small task for an individual, much less an organization (TOC Center, 1999).
Last but not least, from a theoretical viewpoint, it is clear ABC contributes original methodologies to the product mix decision and ABC is an important development in modern accounting. Thomson and Gurowka (2005) indicated that “We believe that ABC and other strategic costing approaches don't fail because of the underlying methodology alone but often because of poor implementation principles.” Thus, even though the successful implementation of ABC systems has overcome the original criticism of traditional cost accounting and budgeting on a number of companies, one cost system is not enough for the companies to make accurate strategic decisions. Since the advent of new approaches, companies can have a better choice among all of these cost accounting models, seek to remedy the knowledge gap between the theory and practice to help make decisions to reduce the costs and the most important thing is to improve the company's profitability