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Activity-based costing system gained popularity in the early 1980s as an alternative to conventional cost management systems that apparently produced inadequate results while allocating costs. Professor Robert Kaplan- a professor in the Harvard University- was an early proponent of the ABC system. ABC system links spending by an organization on resources directly to activities where support as well as indirect expenses are traced accurately by cost drivers to individual customers, products, and services. The rise of ABC has helped companies throughout the world to refine and improve their costs systems. Companies adopting ABC have successfully managed to improve cost accuracy and precision by emphasizing managers to reduce cost, to provide an effective management tool for making better decisions, and ultimately increasing profitability of companies based on a cost-effective and practical approach of ABC. Traditional costing approaches are based on calculating direct costs and subsequently adding proportionate overhead costs. These approaches, at times, lead to incorrect business decisions. Due to increased levels of overhead costs and small share of direct costs in the contemporary businesses, the cost allocations are not successful. ABC system has been devised to remove the deficiencies present in the traditional systems, ultimately allowing managers to determine the real costs related to each product or service.
Part I: Debenhams PLC
Debenhams PLC: Analysis and History of the Development
Debenhams is a leading international, multi-channel British-based brand which is available in 92 countries, through stores or online, including China, India, Bangladesh, Vietnam, Romania, Turkey, Cambodia, Morocco, and Egypt etc. The Company boasts placing customers at "the heart of everything we do and are truly passionate about the products that we sell, half of which are exclusive to Debenhams". Major products offered by Debenhams are accessories, electrical, flowers, home and furniture, and gift ideas. Also, the Company offers services such as wedding services, shopping assistance, and in-store cafes and restaurants (Debenhams).
History of Debenhams dates back to 1778 when a drapers store was established by William Clark in London. Initially, the Company sold expensive fabrics, gloves, bonnets, and parasols. The Company started to expand its operations when William Debenham made investments and the name was changed to "Clark & Debenham". Further investments in the Company were made by Clement Freebody in 1851 after which it was renamed as "Debenham & Freebody". A wholesale and retail was then established selling cloth and other items to dressmakers and other large retailers. The Company made several acquisitions of retail, wholesale, and manufacturing businesses in the nineteenth century. Offices were opened in South Africa, Australia, Canada, and China. Acquisitions continued in the twentieth century and Debenhams Ltd was incorporated in 1905. Debenhams was the largest department store group in the UK in 1950, owning 84 companies and 110 stores. The business of Debenhams was repositioned in the last two decades of the twentieth century introducing exclusive merchandize. The first international franchise was opened in 1997 in Bahrain (Debenhams).
The gross transaction value of Debenhams recorded an increase of 26% in 2012. The increase was driven by "like-for-like" sales growth in stores and online in the UK and international businesses as well as new store space. Other financial indicators were also healthy during last years. For example, Debenhams' revenue increased by 2.6%, profit before tax 2.5%, and dividend per share increased by 10%, compared with the previous year. In the aftermath of an economic recession, healthy growth signs indicate the success of Debenhams' approach and strategy. For example, Debenham continues to pursue its growth strategy and is continuously expanding through franchises (Debenhams).
Selling franchise has enabled swift expansion as capital is provided by the franchisees. Debenhams seems to be an ambitious service provider and retailer. Through acquisitions and franchises, continued growth is also expected in the future. The Company has planned a different approach for sustaining its growth in the future calling it "single view of the customer". This approach may facilitate Debenham to have a complete perspective on the customer behavior and shopping patterns. Another benefit of this approach will be tailored marketing customized to the need of the individual customers. Customization of the products will help the Company finds its way into different product categories. Present emphasis on growth shows the future objectives of Debenham are driven clearly by a strategy to increase market share and ultimately the profitability. The largest sourcing hub of Debenham is China/Hong Kong and the Company is planning to increase its presence in Far East market for example entering the prosperous market of Thailand. Besides growth strategy as a major success factor, Debenham is also successful due to its policy emphasizing cultural diversity making efforts to satisfy needs and demands of regional markets (Debenhams).
Part II: Critique of the Rise of ABC
Section 1: ABC System, its Comparison with Absorption Costing, and its Advantages
Costing systems may differ in relation to which costs are actually assigned by the companies to cost units or cost objects along with their sophistication levels. Cost systems are generally classified as; direct costing systems; traditional absorption costing systems; and activity-based costing systems. Only direct costs are assigned to cost objects in direct costing system. As indirect costs are not assigned to cost units of cost objects, they report contributions directly to indirect costs. As such, direct costing system may also be categorized as 'partial costing system'. This system is suitable for decision-making in situations where the cost especially of joint venture fluctuates. A main disadvantage of direct costing system is that they do place systems to measure as well as assign indirect costs. Contrary to that, indirect costs are assigned to cost units or cost objects in both traditional absorption costing and ABC system (Durry, 2007).
Absorption costing system is related to the collection of costs by cost object, cost unit, or product. Production overhead costs, under this system, are absorbed by the products through creation of overhead absorption rates. The absorption rates often used in manufacturing companies include those which are mainly based on direct labor. The changes that have recently been witnessed in many instances now preclude the usage of direct labor as a fundamental basis specifically for overhead cost absorption, and also other methods are being developed (Major & Hooper, 2005).
There are certain disadvantages of traditional absorption costing due to which researchers have developed other costing systems. A main disadvantage of absorption costing system is encouraging production for the end stock. In absorption costing system, direct labor is often used as a basis for overhead costs despite the fact that a number of the overhead costs are either driven by direct labor or not incurred on the same basis. It is understood that other cost drivers are also there, and that several activities in the companies may lead to incurring of costs. In manufacturing such products, these costs may be driven by different issues related to production. Moreover, fixed costs, under absorption costing system, is moslty charged to products or services based on volumes as such; it is not possible to recognize the cost drivers or activities causing occurrence of such costs (Jackson & Sawyers, 2008).
During the decade of 1980, the limitations and constraints in traditional absorption costing system started to be publicized. The system was devised decades ago when many companies produced a narrow line of products. Also, materials and direct labor were the main factory costs. The share of overhead costs was considerably small while the distortions due to inadequacy of overhead allocations were insignificant. Costs of information processing were high and as such; it was difficult for the managers to justify overhead allocation methods (Cooper & Kaplan, 2007).
Companies today produce and deal with a wide range of goods and services. Direct labor costs form small proportion of total costs. Overhead costs are of significant importance. It is, therefore, difficult to justify overhead allocations by utilizing a reducing direct labor base, especially when costs of information processing are no more barriers to using refined cost systems. Furthermore, high levels of global competition during 1980s resulted in decision errors because of cost information more costly and more probable. It is against this backdrop, the rise of ABC system has been witnessed (Cooper & Kaplan, 1998).
Supporters of ABC system offer a number of arguments to justify its adoption. They argue that ABC is a fair method to charge costs to a wide variety of products. The products that use the organizational activities causing the occurrence of cost bear such costs related to these activities in a fair way. This addresses the shortcoming of absorption costing system in which general overheads of a company are spread over a range of products using methods often unrelated to the manner costs are driven or generated (Cooper & Kaplan, 1998).
Another argument signifying superiority of ABC system over absorption costing system is that the former takes into account product complexity. Different types of costs charged to a range of products are associated with the circumstances in which products are manufactured. Using ABC, complex products in particular might result in high unit costs than simple products. Therefore, this would have substantial impact in measuring profitability of the relative product than absorption costing method. Those costs that under the traditional absorption costing methods are generally considered as fixed in total may be regarded as variable especially in the long run under ABC system. Consequently, ABC supports measuring efficiency levels of managerial and administrative functions. Another advantage of ABC system is encouraging or adopting a more pragmatic approach to the policies related to stocks. ABC system does not suggest building stock of finished goods as in the case of traditional absorption costing system. The over-recoveries, in ABC system do not arise to the same level. The reason is that a greater fraction of the costs are regarded as variable instead of fixed (Horngren, 2012).
Section 2: the Impact of ABC System
ABC system is more appropriate than other costing systems and should be used by Debenham. This system offers accuracy and precision but at the same time requires more resources. The justification to adopt this method relies on the advantages of improved decisions due to more accurate costs. ABC will result in more cost pools to assign overhead costs to a variety of products. Costs, using this approach, can be assigned more directly to the relevant products based on the cost drivers (Chongruksut & Brooks, 2005). Debenhams' management can exercise more control on the Company's overhead costs. Under this system, Debenham can trace several overhead costs and assign them directly to activities. This will eventually allow identification of indirect costs. As such, Debenhams' management will be more aware of their task to control the activities leading to occurrence of costs. Another benefit that Debenham can have is better execution of management decisions. Due to accurate costing, Debenham can determine selling prices that will support in achieving the desired profitability levels.
A major benefit to implement ABC system is a rise in shared understanding between the accounting and sales personnel and also other employees in how effective and efficient the costing system is in relation to managing tradeoffs. This will have a significant impact on the organization change and also considerable change in company culture. Innes and Mitchell (1991) reported some factors that can help successful implementation of ABC system. These factors are; support from a company's top management; regular supply of appropriate resources; a participative way between different departments of a company in data congregating; and achievable objectives to implement ABC system (Innes & Mitchell, 1991).
Activity-based costing (ABC) system gained popularity in the early 1980s as an alternative to conventional cost management systems that apparently produced inadequate results while allocating costs. The rise of ABC has helped companies throughout the world to refine and improve their costs systems. Companies adopting ABC have successfully managed to improve cost accuracy and precision by emphasizing managers to reduce cost, to provide an effective management tool for making better decisions, and ultimately increasing profitability of organization based on a cost-effective and practical approach of ABC. As Debenham PLC deals with several products, ABC system will be suitable as its costing system. This is because ABC system is a fair method to charge costs to a wide variety of products. Adopting ABC method will enable Debenham to accurately measure the profitability of every product. More accurate data costs will help in setting realistic prices and also support to decide whether to buy a particular product and, in some cases, even consider eliminating a product. ABC method will help Debenhams' management exercise more control on the Company's overhead costs, trace several overhead costs, and assign them directly to activities.