Critical evaluation of activity-based costings success


ABC or activity based costing systems have taken the place of traditional cost accounting systems in the manufacturing industry over the recent years. Even after this type of development in the manufacturing sector, there have been hardly any penetration in the hospitality and services sector by ABC systems. In the current research, an activity based cost model would be made for the hospitality industry and in hospital operations the success of activity based cost systems would be examined. The hypothesis would also be made so as to decisively examine the ABC and its accomplishment in the hospitality industry.

In order to offer the manufacturing firms with a better understanding of costs and improved profitability, the activity based costing system was effectively implemented during the 1990's in the manufacturing industry. Cooper and Kaplan (1988) pointed out that diversity of resource consumption and the reality that there is no relation of product and resource consumption with the conventional allocation methods makes the manufacturing organizations a fit case for implementation of ABC systems as suggested by Cooper and Kaplan. Rotch (1991) stated that these conditions are applicable to service organizations also as per Rotch. In spite of application of ABC in service companies like health care and financial institutions, in hospitality sector literature there is still a rareness of ABC applications.

2. Research Objectives

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The research objectives of this study stem from a proposed ABC model for the hospitality industry. This will analyze the critical factors involved in ABC in the chosen sector. It further recommends that the application of ABC reveals true costs and the correct profit margins of individual menu items. The objective is also to suggest the changes in ABC systems to reduce inefficient processes and waste reduction.

3. Research Question

The main research question is:

"Will an ABC study calculate accurate overhead rates that can be assigned on various prices?"

4. Background

Conventional price mechanisms were structured so that they could be applied in production scenarios in which direct expenses constituted a major share of the gross expenses. This mechanism assigns hidden or extra expenses to items on the basis of how its size is calculated in relation with direct expenses such as normal working hours, price of raw materials as well as the time taken by a machine to do its job. Even if the assignment of extra costs is not precise, this mechanism was apt since earlier only direct expenses such as manpower and raw materials comprised a sizeable chunk of the total price and extra costs did not account for much. Earlier it would not have been possible to defend the energy expended and the price incurred in gathering and sorting the information.

During the last two decades, a host of firms have witnessed a lot of shifts in their pricing mechanism. (Hardy and Hubbard, 1992). Extra expenses have shot up and are often the main expense ingredient while calculating total expenses For instance, a particular reputed firm dealing in semiconductors had to shell out extra expenses which were almost 1400 per cent of just the expenses incurred in deploying manpower.

Further, for a host of firms, the characteristics of extra expenses have also altered-initially these were mainly impacted by the size of production and now they are primarily influenced by the sophistication and variety of produce. Conventional pricing methods have not been able to solve this and may end in distribution of resources in a way that does not connect with real using of these materials. A usual difficulty encountered is that conventional pricing methods tend to underestimate expenses, results in less production, and pricing distortions of regular output items. Even a very basic item of output may require the same amount of manpower as a sophisticated item. The elementary item which consists of a few components needs little time for conceptualising, regulating and shifts of raw materials. However more sophisticated items need a lot more conceptualising and catering for, customised tools and troubleshooting help- none of these figure in direct expenses. Expenses are dispersed through conventional extra cost assignments to encapsulate the entire range of a company's production; hence sophisticated items become more expensive to produce and even basic items become difficult to manufacture.

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Evidence indicates the urgent need for a unique pricing mechanism. As per Miller and Vollmann (1985), extra expenses as a component of total worth and gross production expenses have been escalating in a sure paced manner since more than a century while the contrast between direct manpower expenses and gross value has reduced.

In this day and age, manpower expenses normally account for approximately only 15% of the gross expenses-while historically it accounted for at least 80 per cent at the time conventional pricing mechanisms were created (Needy, 1993).

Much of the direct manpower related expenses are lower than 10 per cent of the gross expenses. (Toomey, 1994). Thus rising expenses have been assigned to a weakening resource. Some relatively new studies in the US demonstrate that unhappiness with the existing output expense mechanisms and also anxiety over assignments of extra costs (Drury, 1989). Some other study has also noted that almost 50% of business bigwigs in the US feel that their pricing system is redundant while 78 per cent felt that their expenses were not stated right for some items (Farmer, 1991). Flentov and Shuman (1991) have said that items are periodically overestimated or underestimated in terms of expenses. Sophisticated items may be underestimated by a quantum of almost 500% (O'Guin, 1990).

5. Relevant Literature

Traditional Cost Accounting

Towards the latter half of 19th century there was an increasing focus on cost accounting. The increasing attention on costing yielded logically from the growing magnitude and complex nature of business and their administration combined with a rising complexity in fixing prices (Davidson and Weil, 1978). A more organized system of cost determination was needed as a result of the effect of industrial revolution, as per Salomons (1968). For the manufacturing sector a system was developed which categorized costs by objects of expenditure, responsibility centers and by project. Categorization of costs by object of overhead consists of selected charges like direct labor, raw materials and manufacturing overheads, along with the sections of these categories. The class which can recognize particular labor costs with a definite job is termed as direct labor. At times a decision needs to be taken by the management on categorization of payroll taxes and other fringe benefits with direct labor. In the manufacturing sector, the costs with can be correlated with specific jobs are termed as direct materials or raw materials (Davidson and Weil, 1978). All the costs which are not grouped under the head of direct labor or direct material are termed as manufacturing overhead.

Activity-based Costing

Even though it originated more than 50 years ago, ABC has come into the forefront of corporate decision-making in the last decade. ABC became a formal discipline in 1986, as a result of a project conducted by the Consortium for Advanced Manufacturing-International (CAM-I), which instituted a project team including Robert Kaplan, Robin Cooper, and James Brimson (Daley, 2002). The project's goal was to improve cost accosting techniques, and CAM-I worked with the National Association of Accountants to create a collection of cost accounting techniques that later became known as ABC. According to this project, "Activity-based costing is a common-sense method of assigning costs." (Daley, 2002; pg 115). Managers can create ABC systems according to theory companies' needs.

There have been numerous case studies and applications of ABC in recent years. A number of authors, including O'Guin (1990), Harr (1990), Phillips and Collins (1990), Lee (1990), Jones (1991), Haedicke and Feil (1991), Pederson (1991), Brausch (1992), Plug (1992), Cooper et al. (1992), Rodgers, Comstock and Pritz (1993), Anderson (1993), McConville (1993), Mays and Sweeney (1994), Mangan (1995), Bharara and Lee (1996), and Sohal and Chung (1998) describe the implementation and impact of ABC on organizations. Many authors: Sharman (1990), Drury (1990), Chaffman and Talbott (1991), Raffish (1991), Ray and Gupta (1992), Stevenson, Barnes and Stevenson (1993), and Tippett and Hoekstra (1993), write articles describing ABC and how it can be used in different area of management.

Turney (1989, 1991) examines the role of ABC in manufacturing excellence. He extends the concept of ABC to product design and continuous improvement and discusses how ABC can be used to create behavioral incentives and reduce cost. Kaplan (1989) argues that ABC can be used to better justify flexible manufacturing while Ochs and Bicheno (1991) link ABC to manufacturing strategy. Steimer (1990), Beheiry (1991) and Youde (1992) describe how ABC relates to the concept of quality. Menzano(1991) shows how it can be used for information systems. Howell and Soucy (1991) discuss the benefit of ABC in outsourcing. They cite a firm that implemented an ABC system and discovered that it had previously outsourced products that were profitable to produce, while it continued to manufacture those that were unprofitable. Roth and Sims (1991) apply ABC to warehousing and distribution, Lewis (1991) applies it to marketing, and Roehm, Critchfield and Castellano (1992) apply it to purchasing. The use of ABC to forecast product cost, not just allocate historical costs, is advocated by O'Guin (1992). He argues that ABC must be integrated into MRP system in order to obtain valid unit costs for products.

6. Research Methodology

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On the basis of requirement, the primary research methodology will be chosen for the current topic. A questionnaire will be developed to study the success of ABC in hospitality industry. This dissertation will present an exploratory study of a previously under-researched area of cost management in the hospitality industry. The data will be collected through the questionnaire which will be collected at the chosen location. The information collected will be formalized and the analysis will be done using SPSS.

7. Chapter Scheme

Chapter 1: Introduction- This Chapter introduces the necessities of the study

Chapter 2: Literature Review- This will include a relevant literature related to ABC and its critical analysis.

Chapter 3: Research Methodology-This chapter presents the research objectives

Chapter 4: Findings and Analysis- This chapter will discuss about the findings on the basis of research methodology adopted.

Chapter 5: Conclusion- This chapter gives the conclusions of this research and suggests future areas of research.