THE DEVELOPMENT OF ACTIVITY-BASED COSTING

Published:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Although activity-based accounting system (ABC) has been considered as a significant innovation in the management accounting history since its emergence in 1980s, it has not been until recently that the "full potential" of ABC and its application in diverse areas have been recognized. (Turney, 1996) This report is hence composed mainly to discuss why ABC was developed and gives a brief overview on the theoretical evolution of this practice.

The appearance of ABC came after the traditional costing system, whose performance was quite phenomenal in the nineteenth- and early twentieth-century, a time when most enterprises were small and simple and the adoption of one cost system would be able to satisfy the needs for fair forecasting in the short-term run. (Johnson and Kaplan, 1991) However, as commercial environments had changed drastically along with rapid technological developments over the past few decades, sticking to the traditional way of allocating overhead costs might no longer be sensible at least in the following aspects: First, since operations within the company had become more complicated, it was harder to distribute cost reasonably; Second, as long-term strategies had been attached with greater importance, over-simplifying the allocation might provide the manager with improper suggestions; Third, as the business market had become more and more competitive, there was an increasing demand for the accuracy and timelessness of accounting.(Askarany, Smith & Yazdifar, 2007) Besides, the ROI measure was also problematic in use as argued in the book of "Relevance lost - The Rise and Fall of Management Accounting" (Johnson and Kaplan, 1987), in which case, the development of ABC was quite natural.

The origins of ABC can be traced back to the early 1980s, when western companies were urged to adopt and develop innovative management practices to confront the threats from Japanese companies, particularly in the electronic and automobile industries. (Turney, 1996) According to Kaplan and Anderson (1991), the increase in competition was at first assumed to be an outcome of low overseas wages of labour and low value currencies. However, it was in fact the result of new management practices such as just-in-time systems of material flow, computer integrated systems for manufacturing, Kaizen (continuous improvement of processes) and statistical process control. As a result, numerous manufacturing and assembly firms developed and adopted innovative approaches which led to reductions in the costs and improvement in the quality. (Anderson, 1989) The early version of ABC was only to improve the accuracy in cost accounting, which implied that its value was "its ability to drive change". (Turney, 1996) Later in 1986, the cases written by Robin Cooper on the practical use of ABC attracted researchers deeply, as academic essays on this subject begun to increase sharply in the next year. However, it waited until 1989 when the name of 'ABC' was finally given. (Cooper, 1989)

During the early 90s, newer versions and formats of ABC were being designed in order to increase their analytical capabilities. Changes such as the addition of customer and activity costs were made. Frameworks like cost hierarchy were introduced in order to organize production-related activities according to the level at which their costs are incurred (Kaplan-cooper, 1991, 1999).

A cost hierarchy appears when the expenses of indirect and support resources are segregated by activities and are then allocated on the basis of the drivers of the activities (Cooper and Kaplan, 1991). The activities expenses can be categorized into four cost dimensions: unit level, batch level, product-sustaining and facility sustaining (Collier, 2006), (Drury, 2005). Traditionally, the company often employed three unit-level bases (direct materials, direct labour and machine hour) to apply overhead costs. The underlined assumption hence was that all activities were performed at the unit level and fluctuated with the above mentioned factors being consumed.

When products are made in batch or production run, the resources consumed by that batch or run vary at the number of batches and runs instead of the unit volume. It means regardless of how many units of product made in a batch, the company has to pay the same amount of expense for set-up, purchasing, et cetera… for this batch. Similarly, product-sustaining activities such as the cost of product design depend on the number of variants of products rather than on the quantity of units or batches manufactured. Facility management (building maintenance, heating, security...) regarding to the facility as a whole rather than to individual products, should become part of another slice, for example a geographic one where the company monitors a number of facilities in an area. This information gives managers "a completely different picture of a product's profitability" (Cooper and Kaplan, 1991), which the traditional system had failed to signal. The hierarchy therefore suggested "a structured way of thinking about the relationship between activities and the resource consumption and ultimately profits" (Cooper and Kaplan, 1991).

The ABC analysis also points out that high-volume products are profitable than the low-volume ones. By eliminating or outsourcing the latter and replacing them with the former, the company can keep direct labour and machines just as busy while consuming far fewer part resources for batch and product-sustaining activities. Furthermore, if it can reduce setup times, achieve better factory layouts and material flows, fewer resources to handle batches are required. Or the products are designed with fewer and more common parts in or order to cut down the demands for product-sustaining resources. The company is thereby not only able to operate more efficiently but also to gain greater financial benefits thanks to the costs saved and more products sold. ABC besides "unravels" how to form an appropriate product mixes as well as to diminish expenses on expanding product category (Cooper and Kaplan, 1991).

During the second half of the 90s, it was becoming evident that with constant development application of ABC was possible to apply in areas outside the scope of cost accounting. Companies started using the technique in departments varying from sales and marketing to supply chain, R&D, logistics and even administration. New modified versions of ABC were developed which were particularly aimed at being useful for planning of resources and capacity and scenario analysis as well (which helped in decision-making). Numerous industries in sectors as diverse as packaging, insurance and energy started to adopt and implement ABC in order to remodel and ultimately reduce costs of their services and activities.

Later, at the dawn of the new millennium, emergence of new methods took place, aiming at the reduction of necessary maintenance efforts and costs incurring during implementation. Also, numerous firms desired to achieve a return on their investments and improve financial performance, which was solved by the new methods. However, the maintenance and implementation of these new methods was costly and difficult. The technique of time-driven ABC was also introduced during this period. Known as a simplification of the more complex ABC (McGowan, 2009), the method uses simulation modelling, a tool used extensively for achieving sound efficiencies in operations and smart cost reduction solutions. Time-driven Activity-based costing is considered as a significant enhancement to the traditional ABC costing methodology. (Wegmann, 2009)

"The roots of the problem with ABC lie in the way people traditionally construct the models... Traditional ABC models also often failed to capture the complexity of actual operations." (Cooper and Kaplan, 2004) To solve these problems, what managers should do is to "directly estimate the resource demands imposed by each transaction, product or customer rather than assign resource costs first to activities and then to products or customers" (Cooper and Kaplan, 2004). Two important parameters are the cost per time unit of supplying resource capacity and the unit times of its consumption by products/services and customers. The cost-driver rates now can be calculated by multiplying the two estimated input variances. These rates then can be used to "assign costs to individual customer as transactions occur" (Cooper and Kaplan, 2004) or to discuss with customers about "the pricing of new business" (Cooper and Kaplan, 2004). ABC cost drivers therefore provides "more accurate signals about the cost and the underlying efficiency of its processes" (Cooper and Kaplan, 2004).

Time-driven ABC also "allows managers to report their costs on an ongoing basis in a way that reveals both the costs of a business's activities as well as the time spent on them" (Cooper and Kaplan, 2004). Thanks to this report, they can know the cost of the unused capacity and take it as a reference to decide whether to "downside the plant" or increase the capacity. Ability to "accommodate the complexity of real-world operations by incorporating time equations" (Cooper and Kaplan, 2004) to show "how order and activity characteristics cause processing times to vary" (Cooper and Kaplan, 2004) is another highlight of time-driven ABC. Managers moreover can easily update their time-driven ABC models by changing unit time, resource cost per time unit or resource cost rate estimates to get more "accurate reflection of current conditions" (Cooper and Kaplan, 2004).

In summary, time-driven ABC approach "offers managers a methodology that has the following positive features:

Easy and fact to implement

Integrates well with data now available from recently installed ERP and CRM systems

Inexpensive and facts to maintain and update

Ability to scale to enterprise-wide models

Easy to incorporate specific features for particular orders, processes, suppliers and customers

More visibility to process efficiencies and capacity utilization

Ability to forecast future resource demands based on predicted order quantities and complexity

These characteristics enable ABC to move from a complex expensive financial systems implementation to becoming a tool that provides meaningful and actionable data, quickly and inexpensively, to managers." (Cooper and Kaplan, 2003)

As for the most recently period, we've seen the emergence of diverse management solutions which used ABC as a fundamental element. Such solutions included profitability management (a process which provides detailed cost and profit calculations (SAS® Profitability Management, (N.D) accessed 02.03.2010)), performance measurement (a process used to measure the levels of efficiency and effectiveness of actions taken (Gregory, Neely & Platts, 1995)) and human capital management (a strategic approach towards Human Resource management (Armstrong & Baron, 2007)).

Writing Services

Essay Writing
Service

Find out how the very best essay writing service can help you accomplish more and achieve higher marks today.

Assignment Writing Service

From complicated assignments to tricky tasks, our experts can tackle virtually any question thrown at them.

Dissertation Writing Service

A dissertation (also known as a thesis or research project) is probably the most important piece of work for any student! From full dissertations to individual chapters, we’re on hand to support you.

Coursework Writing Service

Our expert qualified writers can help you get your coursework right first time, every time.

Dissertation Proposal Service

The first step to completing a dissertation is to create a proposal that talks about what you wish to do. Our experts can design suitable methodologies - perfect to help you get started with a dissertation.

Report Writing
Service

Reports for any audience. Perfectly structured, professionally written, and tailored to suit your exact requirements.

Essay Skeleton Answer Service

If you’re just looking for some help to get started on an essay, our outline service provides you with a perfect essay plan.

Marking & Proofreading Service

Not sure if your work is hitting the mark? Struggling to get feedback from your lecturer? Our premium marking service was created just for you - get the feedback you deserve now.

Exam Revision
Service

Exams can be one of the most stressful experiences you’ll ever have! Revision is key, and we’re here to help. With custom created revision notes and exam answers, you’ll never feel underprepared again.