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The objective for this assignment is to compare the Activity-based costing (ABC) with traditional costing. Andrade, Filho, Maia and Qassim (1997) found out that Activity-based costing (ABC) is being widely implemented as a substitute to traditional costing. They mentioned the cost of operations in an organization that are reflected by Activity-based costing (ABC) is more accurate and dependable compare to traditional costing. Turney (1996) defines Activity-based costing (ABC) as a method of measuring cost and performance of activities and cost objects. It allocates overhead to multiple cost pools, and it then assigns the activity cost pools to products and services based on cost driver.
In contrast, the cost allocation in traditional costing is based on labour hours or machine hours which are hard to reflect the actual cause and effect relationship between indirect costs and individual products. (Maliah, Nik Nazli and Norhayati, 2004). Carsten (2002) also pointed out that the approach of Activity-based costing (ABC) is trying to allocate overhead costs to cost objects more accurately than traditional cost systems or traditional costing.
In short, Activity-based costing (ABC) and traditional costing represent two competing product costing methods. Traditional approach use only unit-level drivers to assign costs to products. ABC varies from traditional costing where it uses more cost pools and more cost drivers (Shannon and Don, 2007). By reading through the background research and literature review, we will explain, explore and give more specific information about Activity-based costing (ABC) and the traditional costing.
2. Background Research
Base on Peter B.B. Turney (1998) and Jan Emblemsvag (2008), Activity-based costing (ABC) appeared in the mid-nineteen eighties due to the increasing of lower relevance of traditional cost accounting methods. Activity-based costing (ABC) method was first introduced in an organization, which is called John Deere Company in United States. Many prestigious United States companies such as Hewlett-Packard, Procter & Gamble, Tektronix and Caterpillar have adopted Activity-based Costing (ABC). However, organizations in Japan prefer to implement traditional method at that time. They prefer volume measures under traditional method like using direct labor hours to allocate overhead cost to products instead of applying Activity-based costing (ABC) (March and Kaplan, 1987).
On the other hand, Jan Emblemsvag (2008) also claims that the traditional cost accounting methods were designed around 1870 – 1920 and in those days, industry was labor intensive because there was no automation. On other hand, the product variety was insignificant and the overhead costs in companies were generally very low compared to this globalization age where human has achieved great success in the development of technology. Besides that, Shannon, James, Mark Young (1892) , N.S Ong, L.N Lim, K.T Yeo (1993), Gunasekaran and Sarhadi (1996) also found out that the development and promotion of Activity- based costing (ABC) have been stimulated and largely influenced by the work of Cooper and Kaplan (1987) especially in manufacturing sector. This method was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century. Though initial Activity-based Costing (ABC) implementation emphasise primarily on the manufacturing or factory, today the ABC approach has spread to key non-manufacturing functions such as marketing, engineering and research and development (Waeytens and Bruggeman,1994; Gunasekaran and Sarhadi ,1996).
Based on Kingcott (1991), John and Mitchell (1995), David and Robert (1995), the benefits and advantages for the Acticity-based Costing (ABC), which is also the new cost system are targeting cost reduction, performance measurement and different cost object. Besides that, Kingcott(1991), Evan and Ashworth(1995) also find out that the disadvantages or limitation of the new cost system—Activity-based costing (ABC) are ABC system can be expensive to use and some arbitrary allocations continue. More details about the pros and cons of ABC will be elaborate in Literature Review part.
3. Literature Review
According to Shannon and Don (2007), Activity-based costing (ABC) differs from traditional costing base on the number of cost pools and the number and type of cost drivers.
The activity cost pool is the total cost associated with an activity. In the meantime, a cost driver is a factor that has direct influence on the cost and performance of the activities. The cost drivers give the ultimate explanation of why costs in an activity cost pool change over time (Kennedy, 1996).
Lere (2000) mentioned that in order to appreciate the potential power of Activity-based costing (ABC) cost data in pricing, it is important to understand how Activity-based costing (ABC) cost data is different compare to traditional method. The feature of Activity-based costing (ABC) is although a cost does not vary with volume, it may vary with some other measure of activity. Activity-based costing (ABC) recognizes that activities cause cost.
According to Cooper (1990), the first group of activity, unit level activities refer to activities that must be performed for each unit of a product manufactured. The second group of activity is batch level activities. Batch level activities refer to other activities that are performed for each batch of units. The cost of batch activities vary with the number of batches and not the number of units manufactured because batches can contain different number of units. The third group of activity is product-level activities. Once product-level activities were performed, it will benefit all units of a particular product. Cost incurred to perform the groups of activity mentioned before this all vary in response to changes in some measure of the activity called the “cost driver”. This means cost of the 3 groups activities can all be changed by changing the amount of the activity’s cost driver.
Under Activity-based costing (ABC), some costs do not change in the short-run because these costs are associated with providing the capacity necessary to undertake the manufacturing operations, marketing operations, or administration. They include facility-level costs such as depreciation, property taxes and insurance on the facilities. Facility-level costs are like fixed costs under traditional cost behaviour classification and will be treated the same way. However, the amount of facility-level costs are smaller because they represent only that portion of the traditional fixed costs that does not vary with batch- or product-level activities (Cooper, 1990).
If traditional cost behaviour is applied, industrial marketers would not be competitive with non-manufacturing costs. This is because traditional cost behaviour assumes that an order is typical of overall operations such that all activities are performed in proportion to the volume measure with which variable costs vary. Activity-based costing (ABC) will indicate a number of activities, such as shipping and order processing, that may be modified in negotiations with a customer to yield a more competitive bid and this is why Activity-based costing (ABC) allows industrial marketers to be more competitive with non-manufacturing costs (Lere, 2000).
The difference between traditional cost behavior and Activity-based costing (ABC) is traditional cost behavior divides cost into variable and fixed categories while Activity-based costing (ABC) divides the costs into those that vary with unit-level activities, batch-level activities and facility-level costs. Activity-based costing (ABC) can be a powerful tool in 3 ways when the cost is recognized to be varying with something other than volume. First is it reflects significant differences among product specifications since Activity-based costing (ABC) influences cost estimates to use in pricing. The cost estimates under traditional cost behaviour assume that overall company resource usage is typical of resource usage for each product. Second, Activity-based costing (ABC) guides the industrial marketer to determine which product specifications may be adjusted in negotiations to yield important cost reductions which may result in a more competitive price. Under traditional cost behaviour estimates, a change in volume is the only way to reduce costs. Third, Activity-based costing (ABC) permits cost reductions that will allow the company to satisfy customer wishes better by indicating areas for change in operations (Lere, 2000).
Generally, traditional systems tend to be simplistic, mainly because they are inexpensive to operate, make extensive use of arbitrary cost allocations, and have a low level of accuracy, high costs of errors and so on. On contrast, Activity-based costing (ABC) systems tend to be more sophisticated, because they are expensive to operate, make extensive use of cost and affect cost allocations, have a high level of accuracy, low cost of errors and so on (Drury, 2000).
In this era, there are a large number of companies that have converted to the Activity-based Costing (ABC) system since as far back as 1980 as the system has shown its usability in the appropriate product mix decision and overheads management (Gunasekaran, 1999). However, some companies still stick to implementing the same traditional costing system that was developed decades ago in this globalization age (Cooper and Kaplan, 1991). The question that lingers in our brains is why those companies still implement traditional costing instead of Activity-based Costing (ABC)? It is because the Activity-based Costing (ABC) has it pros and cons (John, Evans and Ashworth, 1995).
The first and most dominant benefit of an ABC system mentioned by John, Evans and Ashworth (1995) is targeting cost reduction. The detailed analysis of activities and costs that are required for costing provide an enrich visibility and a new perspective on allocation of overhead costs (John, 1995). It provides a profile for management of what is being done with resources provided. This information has proved adequate for screening against different criteria relating to the value of each activity to the organisation. Where the costs are high and the value of the product is low, the activity becomes a target for cost reduction and improvement.
Carolfi (1996) claimed that Activity-based costing (ABC) may allow managers to eliminate costs related to non-value added activities and improve the efficiencies of existing processes since Activity-based costing (ABC) may provide greater visibility into business processes and their cost drivers. When information visibility is improved, it may also enable the deployment of quality-related initiatives by identifying activities that are associated with poor product quality, and their cost drivers (Ittner, 1999; Cooper, Kaplan, Maisel, Morrissey & Oehm, 1992).
Apart from that, another advantage of this system is performance measurement. Kingcott (1991) said that the information provided by Activity-based costing (ABC) on cost drivers and cost driver rates shows that they are potentially powerful affect on the deed of staff and they are used as performance measures (Kingcott, 1991). Cost drivers provide volume measures on a different kind of operational performance which reflect the effectiveness and accuracy of the activity concerned. So, they can help in assessing the efficiency with which activities are carried out when it is linked to cost.
Traditional costing systems use bases like direct labour and machine hours to allocate expenses to products and services (Banker et al., 2008). The bases are associated with indirect and support activities. The expenses of indirect and support resources are segregated by activities under Activity-based costing (ABC), and then those expenses are assigned based on the drivers of these activities (Cooper & Kaplan, 1991). This is why Activity-based costing (ABC) provides plant managers with a more structured approach to evaluate the expenses associated with specific activities used to support a product.
Different cost object is also one of the advantages of Activity-based Costing (ABC). John and Mitchell (1991) have found out that the Activity-based costing (ABC) methodology can be applied to cost objects except for the product. Indirectly, this allows customer profitability to be analysed and so provides management with a market-oriented view of how proceeds have been earned. Activity-based costing (ABC) can also be used as a tool for decision making especially for product mix costing and pricing decisions (Kee, 2008).
Supporters of Activity-based costing (ABC) have argued that Activity-based costing (ABC) can help to capture the economics of production processes more closely and may provide more accurate costing data than traditional cost-based systems (Cooper & Kaplan, 1991; Ittner, 1999). There is a suggestion from prior research that Activity-based costing (ABC) should lead to operational and strategic benefits within organizations (Anderson & Young, 1999; Cooper & Kaplan, 1991).
By identifying all the work activities and their costs that go into manufacturing a product, delivering a service, or performing a process, Activity-based costing (ABC) helps to fill in the gaps of traditional method. A clear picture of the total cost of a process becomes transparent when the individual costs are added. Activity-based costing (ABC) can even differentiate the cost of serving the different segment of customers (Shank, 1996).
Advantage of Activity-based costing (ABC) according to Qian and Ben-Arieh (2008) is Activity-based costing (ABC) is a more accurate cost-estimation method. They argue that Activity-based costing (ABC) can help managers to become aware of original parameters that create demands on indirect and support resources which can identify and remove non-value adding activities. Ben-Arieh and Qian (2003) and Qian and Ben-Arieh (2008) think that Activity-based costing (ABC) approach has demonstrated to be accurate than the traditional cost estimation.
Singer and Donoso (2008) conducted test on validity of Activity-based costing (ABC) cost estimation and they concluded that the accuracy of estimation of costs made by Activity-based costing (ABC) was valid. Activity-based costing (ABC) is a more accurate product-costing system than traditional volume-based costing systems especially when organizations are facing higher product diversity from the findings of Charles and Hansen (2008).
Although Activity-based costing (ABC) often provide better product cost than traditional volume-based systems, it still has the limitations (Evans and Ashworth, 1995). First and foremost, Activity-based costing (ABC) systems can be expensive to use. The increase cost of identifying multiple activities and applying large amount of cost drivers deter many organisations from using Activity-based costing (ABC). Kingcott (1991) advised that if the costs of Activity-based costing (ABC) exceed the benefits, company should not apply Activity-based costing (ABC) systems. If not, the capital expenditure on the activity based system and its subsequent running costs can be a road block for firms.
Although Activity-based costing (ABC) systems are mostly more accurate compare to traditional method, the limitation of Activity-based costing (ABC) is ABC may utilize estimates because actual costs cannot be traced back. The costs of finding true costs may overshadow the benefits of finding true costs (Stapleton et al., 2004).
Gering (1999) mentioned that Activity-based costing (ABC) will work best with a minimum amount of detail and estimated cost figures. This means that Activity-based costing (ABC) designer will need to come out with more precise measurement tools if more accurate costs are needed.
Evan and Ashworth (1995) claimed that although more overhead costs can be allocated straight to products via ABC’s multiple activity cost pools, but, some overhead cost remain to be assigned with the help of some arbitrary volume-based cost driver like machine or labour hours.
The disadvantage of Activity-based costing (ABC) is it may increase the frequency of errors in product cost measurement through increasing in number of cost pools and improvement in specification of cost bases (Datar and Gupta, 1994). Another disadvantage mentioned by Noreen (1991) is Activity-based costing (ABC) implementation may provide beneficial results only under specific conditions. Some studies conducted by McGowan and Klammer (1997) suggested that many Activity-based costing (ABC) adopters have abandoned their implementations and this raised concerns on the potential impact of Activity-based costing (ABC) on performance.
The disadvantage of traditional costing systems is they do not provide non-financial information about Small and Medium Enterprises (SMEs). The traditional costing systems provide little information about the factors that matter to the customers like quality and service. Traditional costing systems report only financial information while non-financial information like defect rates and throughput rates in each activity is beyond the scope of traditional costing systems (Gunasekaran, Marri and Grieve, 1999). At first, managers viewed Activity-based costing (ABC) approach as a more accurate way of calculating product costs. However, Activity-based costing (ABC) has emerged as a tremendously useful guide to management action that can translate directly into higher profits (Cooper and Kaplan, 1991).
According to Dickinson and Lere (2003), one of the most significant weaknesses of traditional method is the cost of a sales representative’s engaging in nonstandard selling activities is often excluded from his/her performance review. This is a problem because most people tend to maximize whatever criterion is established as a performance standard. For example, when a sales representative is evaluated based on singular outputs such as sales volume or gross profit, they may engage in activities to achieve the end result without considering the actual cost of those activities and the resulting erosion of profitability to the firm.
Traditional costing systems are not relevant in such dynamically changing environments since traditional costing systems are based on assumptions of long production runs of a standard product with static specifications. Proponents of Activity-based costing (ABC) argued that Activity-based costing (ABC) may provide more accurate information on the activities and transactions that impact product costs in manufacturing environments characterized by production of smaller lot sizes, high broad mix, and frequent changeovers (Krumwiede, 1998).
Nowadays, a precise and accurate costing is necessary because a larger number of products are produced and competition among companies is increasing. However, traditional methods are still useful and accurate when an organization made a few products and indirect manufacturing costs are negligible relative to direct manufacturing cost. (Kaplan, 1989; L.Angote, Andrate, Espozel, Maia and Qassim 1996).
There are many types of costing systems available for businesses to use such as Activity-based costing (ABC), Just-in-Time (JIT) Processing, Job Order Costing and Process Costing. Most of these costing systems are designed to assign costs to products. (Gerhard Plenert,1999)
Mohamed (2003) stated that Just-in-Time (JIT) is a processing system dedicated to having the right amount of materials, parts, or products arrive as they are needed in order to reduce the amount of inventory. Under JIT processing, an organisation such as Dell receive raw material just in time for use in production and they complete finished goods just in time to be sold. The main benefit of JIT is to reduce setup time. Hirano, Hiroyuki and Makota, Furuya (2006) claimed that cutting setup time let the organization to reduce or eliminate inventory for “changeover” time. Overall, Just-in-time (JIT) is an inventory strategy that tries to improve a business’s return on investment by reducing in-process inventory and associated carrying costs. (Ohno, 1988).
Job order costing is a cost accounting system in which cost is allocated to each job or batch, while; Process Costing is an accounting system use to apply costs to similar products that are mass-produced in a continuous fashion. In other words, companies allocate costs to specific cost system in a job order cost system. Companies allocate costs via a series of relevant manufacturing processes or departments, rather than by individual jobs in a process cost system. (Hansen and Maryanne M. Mowen, 2006). Therefore, Process Costing works efficiently for the companies that are known to produce a single type of product.
In a nutshell, the costing system is one of the most important information systems in any business. It is the key to management’s assessment of the company’s efforts to accomplish the goal and generate profit. Since it is so important, the costing system must be carefully designed and properly maintained (H. James Williams, 1985).
Activity-based costing (ABC) is frequently applied together with other management concepts or techniques. Examples are total quality management (Carlson and Young, 1993), game theory (Charles and Hansen, 2008) and inventory control systems (Berling, 2008).
Activity-based costing (ABC) can also be applied to various manufacturing systems (Dhavale, 1993; Zhuang and Burns, 1992), including the manufacturing system for joint products (Tsai, 1996). Processes are the base use to determine the product cost of joint products.
Goldratt (1990) mentioned that many of the assumptions underlying traditional cost-based accounting systems are no longer valid and that these systems are leading many companies to disaster. He developed Theory of Constraints (TOC) as a process of continuous improvement. The priorities of Theory of Constraints (TOC) are factors that constrain the process of providing goods and/or services to customers. Both Activity-based costing (ABC) and Theory of Constraints (TOC) are popular managerial tools for evaluating product mix decisions (Tsai et al., 2008).
After reading through previous sections, more can be learned about both Activity-based costing (ABC) and traditional costing. First of all, we learn that Activity-based Costing is being widely implemented as a substitute to traditional costing from Andrade, Filho, Maia and Qassim (1997). This means that nowadays most organizations use Activity-based costing method which is also the new cost system. According to Turney (1996), Activity-based costing (ABC) is a method of measuring cost and performance of activities and cost objects. Both Activity-based costing and traditional are competing product costing methods.
From background research, it can be concluded that most companies use Activity-based costing base on Turney (1998) and Emblemsvag (2008). However, there are still some companies that prefer to use traditional costing. Work done by Cooper and Kaplan (1987) has largely influenced Activity-based costing (ABC).
There are many advantages and disadvantages of Activity-based costing (ABC) mentioned in the literature review section. The main advantages of Activity-based costing (ABC) mentioned previously are targeting cost reduction (John, Evans and Ashworth, 1995), performance measurement (Kingcott, 1991), tool for decision making especially for product mix costing and pricing decisions (Kee, 2008) and provide more accurate costing data (Cooper & Kaplan, 1991; Ittner, 1999). The main disadvantages or limitations of Activity-based costing (ABC) are expensive to use (Evans and Ashworth, 1995), increase the frequency of errors in product cost measurement (Datar and Gupta, 1994) and may provide beneficial results only under specific conditions (Noreen, 1991).
It can be concluded that although many companies have converted to the Activity-based Costing (ABC) system (Gunasekaran, 1999), there are still some companies that continue to use the same traditional costing system that was developed decades ago in this globalization age (Cooper and Kaplan, 1991). This is mainly because no matter what costing methods, all of them do have their pros and cons. It’s important for the organizations to know clearly what they need before deciding on which costing method to use. The organizations need to study the pros and cons of each costing method to know which is more suitable for their organizations. There is no such thing as the best costing method; there is only the most suitable costing method to use.
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