This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.
Johnson and Kaplan (1987), the writers of Relevance Lost: The Rise and Fall of Management Accounting have addressed the problems aroused from the application of Traditional Costing System (hereafter, TCS). They proposed the use of Activity-Based Costing (hereafter, ABC) as the solution to the TCS weaknesses.
1.1 Criticism on Traditional Costing
The TCS as being criticized by the stated authors, is said to be giving wrong signaled to the managers. As the consequences, the managers wrongly promote the sale and expansion of products that do not contributes much profit to the company. The main criticism is the TCS derived results in contrast than what it was supposed to be. For example, the system showed product to be profitable when in reality it is not (Otley, 2008).
The TCS works on by assigning the overhead or expenses to each product, services or process based on the percentage of direct labor or material cost (Narong, 2009). This is mainly where the problem starts. As the indirect and overhead expenses keep on increasing, the TCS failed to incorporate the expenses as they apportioned the cost towards the production volume rather than on the activities. For example, when the company bought-in products, it might be regard as having little or even no overhead at all. The managers overlook the existence of overhead costs that might increase because of the bought-in for example, invoice clerks and storekeepers. The managers might charge these costs on the existing product where this will manipulate the pricing and profit of the existing product later on.
The TCS works closely with general ledger's chart of accounts (Narong, 2009). Thus, following the categorization of the account's chart, the expenses are allocated. The managers can only explain the cost of labor, material and other however, they are unable to justify whether the production process are effective, profit-making or not. They are also unable to clearly grasp the real cost attached to the process as their view is limited only to what is shown in accounts chart.
2.0 Activity-Based Techniques
2.1.1 Explanation of ABC
The ABC was introduced in order to solve the difficulty pertaining TCS. The main issue here is how TCS continually shown misrepresented information to the managers which eventually would lead to incorrect decision making.
ABC led the managers to calculate the actual cost from the beginning to the end of the production process, something that couldn't be achieved by TCS. Baines (1992) stated that ABC is driven by the information on costs of the activities undertaken. Information needed can be collected using such methods like historical analysis, details of activities recording and surveys. As the information needs to be collected on regular basis, ABC convinced the managers on continuous improvement and accurate costing systems.
The basis of the technique works on by disaggregating overhead resources into activity cost pools and a number of allocation bases. Once the allocation bases (i.e. cost drivers) have been identified, the total cost of the activity will be divided by the activity level of the allocation base. The total overhead charges derived from these activity cost pools will then be divided by annual demand; (say in a form of batches) to obtain the cost per unit. Due to the high level of accuracy in acquiring the product cost information, the product cost derived by using ABC, is more accurate than the traditional system.
2.1.2 Criticism of ABC
Kaplan and Anderson (2004) commented that the problem of ABC happens due to the conventional application of the technique. The data collection thru survey and recording basis may be suitable for small setting (like, a department, small factory or store) however it does not able to serve the purpose accurately on larger scale. Consider a company that holds thousands of workers, to collect data, analyze and evaluating the data would be time consuming. As ABC requires the system to be updated regularly, the evaluation of data becoming more and more inaccurate as the time passes by for larger corporation. To analyze and collecting the data, larger corporation may needs to hire extra workers who have the required knowledge. This causes ABC to be regard as both time and cost consuming. These weaknesses have been acknowledged by both Kaplan and Anderson.
ABC involves high capacity of subjective information for example in identifying activities, allocation bases, and amount consumed in each activities. Ray (2012) stated this as subjective arbitrary cost allocation. This will only base on the judgment made by the managers from the collected data. Data collected from staffs and customers may and may not be accurate, considering on how they answered the surveys or questions asked. Ray also stated that when there is a change in production volume, ABC does not able to predict the future returns, making it inappropriate for decision-making.
2.1.3 Development of ABC
In 2003, Kaplan and Anderson introduced the Time-Driven Activity Based Costing (hereafter, TDABC) with the purpose of overcoming the criticisms directed to the conventional ABC. This is mainly concerning the cost and difficulties in implementing and retaining the model (Gervais, Levant and Ducrocq, 2010). TDABC is said to be a straightforward approach as the model only need to consider the unit cost of used resources and the estimated time to perform an activity.
The distinct advantages of this model is that it eliminates the need to interview and long stages of assigning resources costs to activities before actually able to assign these resources to cost objects. By eliminating the long and detail procedures the company is able to save on their resources in terms of money and time which is something that is hard to accomplish with conventional ABC.
As per the name suggest, TDABC uses time equations to handle different type of orders that also varies in the amount of time taken to process. Rather than using separate activity to define and handle each transactional activity the model suggests a simpler method; the use of time standards. All that it needs to be concern on is the standards remain consistent with practices and are regularly updated. The time equation is used in order to accurately determine the amount of resources each group consumes. Let say that there is an additional demand of products, the users of TDABC only need to add the additional time required to process the order to the basic established equation. Due to this simplistic method, TDABC is much preferable as compared to conventional ABC.
2.2 Activity-Based Management (ABM)
2.2.1 Explanation of ABM
As ABC measures the cost and performance of activities, ABM works on by providing analysis towards the cost drivers, activity, performance management (Institute of Management Accountant, 1998). Gupta and Galloway (2003) stated the movement of ABC to ABM actually involved the shifting of cost-assignment view to process management view. Using information derived from ABC model, ABM concentrates on conveying and utilizing the information in order to promote continuous improvement and helping the firm in making correct decisions in both operating and strategic level. What is interesting about ABM is that it is not only provides performance measurements based on financial outlook, but also on non-financial viewpoint.
Thus, defining performance measures of a company might differ from a competitor in the same industry. Certain company would prefer to use non-financial aspect as the whole performance measure system, while others would focus on physical measures. What is important here is to implement a measure that does not only focusing on measuring performance but also provides controls, performance evaluation and motivates the workers. Correct implementation of performance measure helps the company to categorize non-value added activities. CIMA (2001) defined this as the activity that does not contributing or creating value to the firm. Once identified, the company will focus and examine on this activity to search for the critical causes. Eventually, these causes will be eliminated.
2.2.2 Criticism of ABM
The issue arises here is that management may require multiple performance measures in order to be able to reflect activities of the company. Problems in identifying the correct measures might be one of ABM limitations. This approach is rather subjective. Even after a measure had been identified, how to evaluate this measure in order to ensure that it is correctly reflecting company's objectives?
2.3 Activity-Based Budgeting (ABB)
2.3.1 Explanation of ABB
ABB focuses on creating budget to assist the activity-based model of an organization. It involves structuring the organization's activities and processes in line with analysis produced by ABM (Neely, Bourne and Adams, 2003). ABB primarily will focus on operational budget followed by financial budget. This is known as the Closed Loop Model (Hansen, Otley and Van der Stede, 2003). In operational loop stage, estimated demands are converted into activity requirements using the activity consumption rate. This will then be converted into resource requirement based on resource consumption rate. Based on requirements consumed, available resources (such as workers) will be assigned to fulfill demands. During the financial loop, cost assigned on resources, processes and products will be determined. This assignment will be based on the data constructed by operational loop. As such, financial balance is derived when the financial results match with the predetermined data.
Data adjustment may take place in any one stage if the plan leads to discrepancies or imbalance. Hansen (2011) confirmed this statement in his recent work. He agreed that the flexibility to react to unexpected events (for example sudden increase in demand) is the most important features of ABB. The unique approach of ABB of considering operational budget first then financial budget helps it to convey the information and objectives of the budget effectively to the employees. More importantly, inclusion of batch, facility and other related cost drivers makes it easier to detect inefficiencies and plan the budget system in a way that it can address the problems efficiently.