Activity Based Costing System Accounting Essay


Activity Based Costing System was first clearly defined in 1987 by Johnson and Kaplan. Particularly, Activity Based Costing (hereafter ABC) is the main costs analysis technique; Activity Based Management (hereafter ABM) and Activity Based Budgeting (hereafter ABB) are techniques that use ABC information for management and budgeting purposes. In detail, ABC converts data into information; calculation of math, then ABM uses the information for analysis, insights and decisions (Cokins and Capusneanu, 2011). ABB is part of ABM; it is a financial planning tool for organization to forecast its production's costs of activities in producing certain products/services, to improve costs management (Bengu, 2010). Coupled with ABC/M, ABB establishes a solid foundation for both quality planning and budget reporting (Narong, 2009).

ABC, ABM and ABB were defined as an approach designed to solve the faults and frustration of traditional costing/traditional budgeting methods (Roberts, Muras and Paschall, 2000), because TC provides misleading information for management due to inaccurate overheads allocation. In today's manufacturing environment, TC is no longer sufficient in producing accurate performance for best management purpose (Jelsy and Vetrivel A., 2012), because TC allots overhead expenses to direct cost by a single volume-based cost driver, such as direct labour and Muskell also explained that TC was developed for decision-making in mass-production type of industries back in mid-20th century (Narong, 2009).

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However, in today's modern manufacturing environment, significant changes in organisation costs structure have proved TC to be out-of-date. Recent years, indirect costs are typically the largest proportion in organisation's total production cost, simple allocation of indirect expenses could result in presenting misleading information to management. TC normally uses direct labour as the cost driver to allocate indirect expenses, but direct labour is no longer a weighty content in today's organisation operations, costs allocation based on single cost driver is no longer accurate. Furthermore, there is a widespread use of computer and automation and increased use of Just-in-Time (JIT) methods to improve the performance of production. Besides, there is also a transition of manufacture industries from mass to lean manufacturing industries to remain competitive (Noreen 1987; Oker and Adiguzel, 2010). Therefore, practice of TC has become unsuitable for management of costs in this environment.

Due to the above-mentioned reasons, ABC advocates argued that managers are unable to make sound decisions due to failure of TC, as it provides distorted, incomplete and misrepresented information about the profitability of cost objects (Jelsy and Vetrivel A., 2012; Narong, 2009; Oker and Adiguzel, 2010). In today's competitive environment, risks of making decisions based on inaccurate and unprocessed data would not be allowed. Therefore, the transition from TC to ABC is preferred in this situation as it reflects actual costs by allocating the costs using suitable cost driver (Ahmed et al, 2011; Oker and Adiguzel, 2010).


ABC System

ABC is a "methodology that measures the cost and performance of cost objects, activities and resources based on the cause-and-effect relationships", meaning they were allocated based on their actual use of those resources. The relationship between cost objects, activities and resources is that, cost objects consume activities and activities consume resources. Therefore, cost of resources will be first allocated to activities based on each activity's actual usage, then activity costs will be reallocated to cost objects (outputs) based on the outputs' proportional use of those activities (Cokins and Capusneanu, 2011; Oker and Adiguzel, 2010). ABC is also known as "the horizontal or cross-functional cost view and can provide fact-based insight into the costs and profitability of products, services, customers, districts, distribution lines, and etc." (Narong, 2009)

ABM is defined as a "total quality management focusing on the management of activities within business processes as the route to continuously improve both the value received by customers and the profit earned in providing that value" (Cokins and Capusneanu, 2011). ABM includes several activities such as cost drivers analysis, performance measurement and process improvement opportunities (Narong, 2009)

As mentioned above, ABC converts activities data to information and ABM uses ABC information and performance measurements to reengineer, reduce cycle time and improve the processes/productions of cost objects (Roberts et al, 2000). An organization's management structure would change when ABC is implemented, managers could adopt ABM as a management technique to achieve its organization aims (Ahmed et al, 2011). ABC practitioners find that the usage of the term ABC and ABM are sometimes confusing. Technically, ABC only refers to the determination of the activity's costs and performance. The term ABM is only used when ABC information is used to assist with operating decisions (Cagwin and J. Bouwman, 2000).

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ABM aims at understanding the consumption of resources inside an organisation and aims to boost efficiency and improve effectiveness of internal process by redirecting resources from non-value added activities to value added activities (Maccarione, 1998). Together with ABC, ABC/M becomes a main source of information to for managers to improve product and customer rationalization, profitability performance and planning of production, and to reduce or eliminate non-value-added by activities to improve productivity (Cokins and Capusneanu, 2011). Managers could manage its activities by reducing the time required to perform activity, eliminate non-value added activity, and select alternate low-cost activities or share activities among products to achieve economies of scales (Ahmed et al, 2011).

ABB is a financial planning tool that first identifies the customer requirements in terms of volume of products or services to the production. Then, ABB develops a forecast level of activity together with the forecast customer requirements and projected cost savings and potential economic changes for continuous improvement on costs and performance of production (Roberts et al, 2000). ABB integrates the essence of ABC and priority-base budgeting, and acts as solution to traditional budgeting problems.

Traditional budgeting methods merely set spending limits but do not identify resource needs for desired outputs, ABB identify waste by exposing the non-value costs. ABB is useful in discover cross-organisational issues and provide detailed activities information for managers to achieve more effective control (Wilhelmi and H. Kleiner, 1995; Moustafa, 2005). Together with ABM, ABB works as a powerful cost planning and management tool in improving cost efficiency by identifying non-value added activities, better allocation of costs and etc. (Bengu, 2010).

After 1980s, ABC system is an important method to solve the problems of TC/traditional budgeting. A major improvement of ABC is that, it do not use only a single volume-based cost driver to allocate overhead expenses, but it allocates costs using smaller cost pools, and uses causal cost drivers to assign it to cost objects based on their actual usage of the costs (Wegmann, 2009). ABC/M helps the management in identifying non-value-added activities and process improvement opportunities. ABC/M identify the actual cost of activities/cost objects, and allocate resource usage properly (Bengu, 2010; D. Ittner, N. Lanen and F. Larcker, 2002). Using the accurate information from ABC, managers could manage the organisation's pricing, profitability analysis, customer-relationships, distribution channels, and streamlining business processes and activities in the best manner (Bengu, 2010; Roberts et al, 2000).

Furthermore, TC have often neglected taking into account of the accumulated costs over the entire design, market or support cycle, but focused mainly on production costs of the cost objects, therefore producing limited range information to the managers. In contrast, ABC produces wide-range of information as it gathers both financial and non-financial data regarding a company's cost drivers, performance, resources and activities, it provides management with an accurate picture of cost objects' profitability (Roberts et al, 2000), therefore ABC could help managers in designing less resource-consuming products/processes, improve efficiency of existing products/processes, and also eliminate non-value added activities and etc. (D. Ittner et al, 2002).

Development of ABC System

Despite the benefits of ABC, over a few years of putting ABC into practice, several pitfalls of ABC have been identified. There are three major criticisms, ABC systems are costly to implement, difficult to adjust and time-consuming, therefore it never gained widespread acceptance (Wegmann, 2009). ABC required time-consuming surveys and interviews, and ABC depends on reports from employees, which could lead to bias and inaccurate information. ABC also requires time-consuming and highly expensive frequent updates due to often changes in production lines, processes or activities. Furthermore, too many cost drivers and cost activities caused the allocation of cost to be subjective. Thus, providing inaccurate, misleading and outdated information to management as a result to rare updates in the ABC system (Oker and Adiguzel, 2010). Some ABC practitioners also argued that ABC failed to capture the complexity of their operations (E. Stout and M. Propri, 2011).

However, this does not mean that, ABC should be completely abandoned. As a solution to the problems of ABC, the most recent development is Time-Drive Absorption Based Costing (hereafter TDABC), a rather simplified approach of ABC, which was designed by Kaplan and Anderson. TDABC simplified and improved ABC and re-introduced standard costing approach (Wegmann, 2009). The major improvement in this approach is the design of new cost driver. This approach uses equivalent-time cost driver, it is the principle of this approach where it translate the cost drivers into standards of working hours, which is time-equivalent (Wegmann, 2009). This simplified ABC in terms of having too many different and confusing cost drivers to having only one type of cost driver. This solved the problems of organisations with complex productions and ABC's determination of different cost drivers to different activities could also lead to inaccurate analysis (Oker and Adiguzel, 2010)..

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The difference in TDABC is that overhead costs are linked to departments instead of activities and the allocation of overhead or indirect costs to cost objects is based on the proportional demand from the cost objects' department (Oker and Adiguzel, 2010). This has benefited the management as the complexity of overhead costs allocation has been reduced from allocating to hundred of activities to fewer departments, it improved the time and effort required by ABC. Furthermore, TDABC no longer depends on the regular surveys and interviews of employees to determine the distribution of work time between different activities. "The time used to perform fundamental tasks is generally estimated and multiplied by the number of tasks and then by the hourly cost, thus creating less time-consuming system and simplified the maintenance of the system" (Gervais, Levant and Ducrocq, 2010).

Putting TDABC into practice, management could identify company's excess capacity as TDABC adds capacity utilization analysis, for the purpose of eliminating extra costs of the company (Oker and Adiguzel, 2010). It also avoids misrepresentation of capacity usage by expressing capacity in units of time. Thus resulting in an accurate presentation of over/under capacity (E. Stout and M. Propri, 2011). With the support of an effective Enterprise Resource Planning system (ERP), TDABC intensely reduced the complexity and time to process information, therefore it is a lot easier to maintain than ABC method (E. Stout and M. Propri, 2011). Having a maintainable approach, maintenance and updates can be run monthly to account for the performance of the most recent operations and it supplies granular information to support in investigating of problems (Oker and Adiguzel, 2010).

Case Study

When putting TDABC into real practice, the outcomes were shocking. A case study was done on a wholesaler's logistic operations. This firm provides services in distributing plant-care products. This company has increasing sales over three years, but decreasing profit due to the greater increase in costs. ABC was implemented in the management system but soon changed to TDABC after realizing the problem of it.

The research has showed that the time-equation of TDABC fully captures the different complexities of logistics' operation whereas it was too complex to be modelled by ABC. In contrast, different cost driver for cost allocation also caused ABC to misallocate 55% of the indirect costs. Assisted by ERP, TDABC also collects data efficiently and less time-consuming than ABC. Compared with ABC, TDABC provided better insights to profitability, this information improved better decision-making and efficiency in managing the logistics operations, especially through resources allocation and renegotiations with customers. TDABC also encouraged the involvement of managers in managing the operations (Everaert, Bruggeman, Sarens, R. Anderson and Levant, 2008).

Another case study was done on a manufacturing company, Aysan Company. Firm that manufactures high-quality sheet metal and plastic parts. In Aysan's situation, TDABC helps in proper allocation of indirect overhead costs to products, and generates an accurate profitability analysis whereas ABC underestimated the cost of products. The managers also highlighted that TDABC work best at producing capacity utilization analysis for better allocation of capacity to improve efficiency of company's resources. Furthermore, TDABC is also proved to be easier and less time-consuming to maintain an updated system. The TDABC model also has a simplified cost allocation, which is less complex and reduces the effort and time required (Oker and Adiguzel, 2010).


ABC system is the cost management technique of which it recovers overheads according to the number of activities used by cost objects in the production, it allocates costs based on the actual proportional usage. ABM is the technique of using ABC information to improve organisation management in improving outputs profitability, reduction of cost, boost performance and etc. However, ABB as a part of ABM is a financial planning tool that uses ABC information to forecast future operations to achieve organisation's aims. ABC was first clearly defined by Johnson and Kaplan in 1987.

Internal and external factors have caused TC to be no longer effective in continuously practiced by today's organisations. As a solution to the deficiencies of TC, ABC system was developed. In today's environment, direct labour is no longer a weighty element and indirect overheads have covered a large proportion of the total costs in today's organisation. Thus, TC often provides distorted results due to misallocation of indirect overhead costs based on single volume-based cost driver. ABC solved this problem by assigning causal cost drivers to different cost activities and allocates costs based on their actual usage. Therefore providing accurate information than TC. Besides, the strength of ABC is to help managers in eliminating non-value added activities and allocates resources more efficiently.

However, ABC never gain widespread acceptance due to its difficulty in capturing organisation's complex operations, hard to adjust and maintain, and implementation incurs high consumption in terms of time and cost. ABC requires frequent updates to maintain accuracy, but maintenance and updates of the system consume huge cost and time. It also depends on unreliable source of data through surveys of employees and allocation of cost drivers is subjective. Thus, failing to meet the requirement of providing accurate results. Consequently, TDABC was developed to solve the problems of ABC. This approach commendably improved and simplified ABC by introducing a time-equivalent cost driver in solving the confusion of having too many costs drivers. It reduced the numbers of activities by allocating cost to departments and eliminated the needs of interviewing for data. Coupled with ERP system, updates and maintenance of system is no longer costly and time-consuming.

The case studies done on both manufacturing and servicing sector have proven that TDABC wins ABC in terms of time consumption, easiness to update, maintain and accuracy of outputs for management. TDABC is able to capture the complexity of the organisation's operations and helped to efficiently allocate resources/capacity of the organisation.

After several years of developments, ABC and TDABC have overcome all the criticisms of TC system. As direct labour element is decreasing in today's organisation structure, the single volume-based cost driver no longer allocate overhead cost accurately. In the introduction of different methods in cost allocation from ABC's causal cost drivers to finally time-equivalent cost driver, organisation no longer allocates indirect overhead costs based on a 'blanket' overhead recovery rates, but properly allocates costs based on their actual usage. Subsequent developments also solved the problem of inaccurate outputs by taking into account of wide-range of data ranging from financial to non-financial data and the direct and indirect costs into the cost analysis. Thus, TC's mere concentration on just manufacturing cost has been eliminated. Also, ABC and TDABC not only serve the need of financial reporting but also act as important assistants in organisation's management and planning, for both historical evaluation and future forecasts.

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