Examining how and why traditional costing systems have been called into question


Traditional costing systems have been called into question because they are often unable to determine accurately the actual costs of production and the costs of related services. As a result managers who use traditional cost methods are seen to be making decisions based on inaccurate data especially in organizations which produce more that one product. Standard traditional cost systems have the advantages of simplicity, consistency and they are well understood by auditors but they are however deemed meaningless and considered misleading as a tool to assist in making effective management decisions. The reason for this is in the way the business environment has been changing. The business environment for which traditional cost systems is being used today is not the business environment for which it was designed for. From the length of the period of their practice we have the assumption that in the past, traditional costing methods met the needs of organisations to some degree. However every one of these traditional methods have been questioned and deemed to have failed to meet the full requirement for management information that will adequately support decision making in today's competitive environment. In the days when traditional management accounting practices were being formed, the dominant industries were in the manufacturing sector. In a typical large manufacturing company, there would be large numbers of employees concerned with direct manufacturing and a much smaller number in the overhead departments. Absorption costing which is a traditional costing method was designed for such industries and not necessarily for the modern automated technological environment. The traditional system accommodates all production overheads to be absorbed by all the production. In the past, overheads were only a small part of the total costs therefore it did not matter how mathematically accurate it is. But today, overheads often account for more than 50 % of the total costs. It is therefore important to estimate each cost contributing factor and look what activity gives rise to such costs.

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In a situation where the direct labour costs could be as high as 90 per cent and overheads 10 per cent of total costs it was important to get some accuracy in terms of the hours, and therefore costs, of actually making components and assemblies. These discrepancies in cost estimation using traditional methods are effectively corrected by another method called the Activity Based Costing (ABC).In this document I have identified three areas which have exposed the ineffectiveness of the traditional cost systems and these are:

(1.) Activity Based Costing, (2.) Strategic Cost Analysis and (3.) Strategically Oriented Performance Measurement Systems

Activity Based Costing:

Activity Based Costing (ABC) is an approach that takes the traditional costing method much further into the process of determining how each aspect of a product should be assigned respective costs. Activity Based Costing was designed and defined by Robert Kaplan and Robin Cooper in 1987 as a chapter in their book, "Accounting and Management: A Field Study Perspective". Initially, the focus of ABC was on the manufacturing industry which had seen technological advances begin to reduce the affects of direct labour and material costs to the increase of relative indirect costs (overheads). According to Robert Kaplan and Robin Cooper, Traditional Costing Systems allocated a percentage of a products cost into direct costs to cover the indirect costs. Kaplan and Cooper saw this as a flaw and argued that this method misallocated certain portions of overhead to products and that this either drove their cost up or down, in turn, misconstruing management decisions. This mode of thinking was based on the fact that that direct labour and material can be defined very easily as compared to indirect costs of products. Thus, Activity Based Costing was developed to help better allocate "hidden costs" of a product or service, essentially the indirect items such as general and administrative office overhead. Examples of this type of overhead include depreciation, management salaries, building and facility amenities such as electric, as well as testing and engineering. The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost methods or systems.

Strategic Cost Analysis.

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Traditional costing systems have been seen as failing to provide accurate or precise information in regards to the cost of the product. As a result this provides managers with misleading data to formulate and make strategic decisions .The strategy is to remain competitive in whatever business sector the organisation is in .Increased competition and vocal customers have made it imperative for every company to upgrade its processes constantly to stay ahead of the competition. In the midst of an overabundance of products and choices for the customer, it becomes increasingly important for any company to make its products better, faster, and cheaper. Cheaper in this case is in terms of making the process of production less expensive than that of the competitors and in no way has it been deemed cheap in terms of quality.

Comparing a firm's cost position relative to key competitors activity by activity from the purchasing of raw materials to the price paid by ultimate customers. Assessing if firm's costs are competitive with those of rivals is a crucial part of company situation in formulating strategic analysis.

During the period when the traditional cost accounting systems were developed most organisations had limited ability to collect data and homogenous products. In the modern business environment with the advancement of information technology, organisation has an overabundance of data and a wide variety and complexity of products and services. Statistical techniques can then be used to develop and simulate a strategic cost analysis model for firms in the modern business environment due to the abundance of data .This would not be possible if an organisation is using traditional cost systems. Strategic Cost Management (SCM) is quantitative methodology grounded in qualitative and structural strategic thinking. This approach develops a model based on Value Chain Analysis, Cost- Driver Analysis and Competitive- Advantage Analysis.

Strategically Oriented Performance Measurement Systems

The long-term survival of a business is dependent upon meeting market needs through a long-term value creation process. Traditional performance measurement systems have been criticized as being too narrowly focused on financial figures and functional level performance such that they often fail to capture organizational long-term business success. In contrast, the balanced scorecard calls on managers to first make a commitment to introduce a number of measures or scorecards that will guide their decisions away from the narrowly focused traditional financial measures. The Balanced Scorecard was then adopted as performance management tool and it has recently been proposed as the basis for a 'strategic management system'.The balanced scorecard (BSC) is a strategic performance management tool for measuring whether the smaller-scale operational activities of a company are aligned with its larger-scale objectives in terms of strategy and vision.The Balanced Scorecard was first introduced in the early 1990s through the work of Robert Kaplan and David Norton of the Harvard Business School

The Balanced Scorecard aims to provide managers with richer and more relevant information about activities they are managing than is provided by financial measures alone. This is achieved by combining financial measures and non-financial measures in a single report.

These scorecards, in turn, serve as dials and guide businesses into greater profitability as managers position themselves to better serve their employees, customers, and shareholders at large.


Critical Evaluation of Current Thinking of Activity Based Costing

Activity based concepts are used to produce more accurate product costs than those obtained in the traditional cost systems. Activity based Cost helps management understand what goes on in their companies, what it costs and where the impact occurs.ABC exposes hidden costs and provides ways to measure them .It assigns more indirect costs (overhead) into direct costs. ABC reveals the links between the performing particular activities and the demand those activities make on the organisation's resources .It gives managers a clear picture of how products, facilities, regions and distribution channels both generate revenues and consume resources. The profitability picture that emerges from the ABC analysis helps managers focus their attention and energy on improving activities that will have the biggest impact on the overall business.

Activity based Cost estimation has gained popularity in most company accounting systems mainly due to its preciseness and accuracy. The logic underlying activity based costing is simply that resources generate costs, activities consume resources and cost objects such as products, services and customers consume activities.  Resource costs are traced to cost objects in two stages. In the first stage, the costs of various resources are assigned to the activities that consume the resources. In the second stage, the costs associated with activities are assigned to cost objects that require and consume the activities.

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Activity Based Accounting (ABC) was developed to improve traditional costing systems. These traditional systems had a number of weaknesses: they under and/or overcastted products, they did not trace indirect costs (e.g. supervisor salaries) and it is not well suited to large indirect cost situations where cost management is critical to the success of the company or corporation. ABC first assigns costs to the activities in the production process and then to the goods and services produced based on how much of those goods and services use those activities. ABC is used primarily to establish product costs for decision making purposes, i.e. whether to continue offering a product, but they are not used for inventory valuation for external reporting.

ABC systems addresses a set of questions such as

What activities are being performed by the organisational resources?

How much does it cost to perform organisational activities and business process

Why does the organisation need to perform activities and business processes

How much of each activity is required for the organisation's products, service, and customers

Steps in designing an ABC system are as follows:

Identify the company's main activities. This is referred to as constructing an activity dictionary

Identify the resources and resource costs used by each activity

Identify what drives, or causes the activities to be performed.

Select a measurement for the activity driver. Types of activity measurements are discussed below

Calculate an activity rate for each activity as indicated below in a nutshell

Activity cost driver rate = Normal cost of support activity ÷ Normal level of driver where normal level is defined as the long run capacity made available.     

Use the activity cost driver rates to assign costs to cost objects.

To properly identify and organize activities, a 5 level hierarchy of resources and activities is used. This hierarchy consists of:

Unit level - where resources acquired and activities performed for individual units are assigned.

Batch level - Group or batch of similar products, product level, those resources or activities needed for production and sales of a specific product or service.

Customer level - Resources or activities needed for a specific customer.

Facility level - The resources or activities used to provide general capacity to produce products

The need to sustain and increase corporate profitability grows ever more arduous in most business sectors of the economy. To be competitive making products needs significant cost savings or reduction. For this reason managers, production and marketing people, accountants and others must examine thoroughly the activities that a product consumes. Through this analysis on a continual basis, how to rework those activities and make the product more efficiently should be decided and for success, a full understanding of costs and cost structures is necessary.

Some of the results of implementing ABC include a great variety of benefits in management reporting and decision making support. These benefits included identifying the "true cost" of each manufacturing entity, the value of producing units in various areas of the globe and identifying the processes which made production and selling of the product possible in a micro sense.

Activity Based Cost is all about tracing activities, and it is therefore essential to establish which activities takes more time than required, are not making much value addition, or can be eliminated .On the other hand which activities cannot be eliminated, which can be substituted, or which one cannot be substituted .These activities consume resources, time, space and they therefore, require management. And this has evolved into Activity Based Management .The clear picture from ABC systems led to Activity Based Management

What is Activity Based Management (ABM)?

ABM can be defined as an entire set of actions that can be taken on a better informed basis with activity based cost information. Using ABM management can improve operations reduce costs increase value to customers through identifying resources spent on customers products activities. Activity Based Management improves management focus on the firm's critical success factors and enhances its competitive advantage.

ABM enables the organisation to accomplish its outcomes with fewer demands on organisations resources; as such the organisation achieves results at a lower cost

Cooper and Kaplan classified ABM as having two complimentary applications namely Operational ABM and Strategic ABM

Operational ABM

Using ABM for operational improvement (doing things right).Performing and managing activities more efficiently. Advantages of Operational ABM include efficient assets utilization, lowers cost, focus on doing things Right and the use of general management techniques. Operational ABM takes the demand for resources as given and attempts to either increase capacity or lower spending. As a result fewer human resources and working capital resources are required to generate revenue. ABM also helps in business process reengineering, total quality management, and performance management

Strategic ABM

Using ABM for strategic decision making by doing the right things. ABM attempts to alter the demand for activities and increase profitability at the current or improved activities efficiency .Strategic ABM focuses on appropriate activities, eliminates non essential activities for the operations .It also improve profitability by reducing unprofitable activities, selecting most profitable customers .Strategic ABM encompasses decisions about product design and development where the biggest opportunity for cost reduction exists. Other strategic activity based management activities include product line and customer mix supplier Relationship, customer relationship, market segmentation and distribution channels

Strategic Activity Based Management -Customer (Customer Profitability Analysis- tracing their costs & revenue)

Activity based costing systems provide more accurate cost information about business activities and processes and of products services and customers served by these processes. ABC systems focus on organisational activities as the key element for analysing cost behaviour by linking organisational spending on resources to the activities and business processes performed by these resources .Activity cost drivers , collected from diverse corporate information systems, then drive then drive activity costs to the products , services and customers that create the demand for the organisation activities .These procedures provide good estimates of unit cost and the amount of activities and resources deployed for individual product, service and customers. With more accurate product-cost information, managers could take a variety of actions to improve product profitability.

Organisations are performing more comprehensive ABC cost analyses .They are extending the domain of analysis beyond manufacturing and factory cost, by getting below the gross margin line to items like marketing, selling and administrative expenses. Analysis reveals that many demands for organisation resources arise not only from products but also from customers and distribution and delivery channels. By tracing costs to customers and to distribution and delivery channels managers have more opportunities to improve their organisations profitability. The opportunities include:

Providing better services to highly profitable customers

Securing highly profitable customers from competitors

Setting prices based on the cost to serve;

Higher prices for expensive services and granting discounts, to gain customers requiring lower costs

Negotiating with customers to reach mutually beneficial levels of services.

Transforming unprofitable customers for negotiation on price...

Identifying and conceding permanent loss customers to competitors

These actions should enable managers with good ABC instrumentation to dramatically improve their profitability, especially in industries where their competitors do not understand the economics of their customer relationships. In a nutshell the strategic ABM with customer profitability analysis allows Managers to

Identify most profitable customers

Manage each customer's "costs-to-serve" to a lower level

Establish a surcharge for or re-pricing expensive "costs-to-serve" activities;

Reduce services;

Introduce new products and services;

Raise prices for demanders;

Abandon products, services, or customers

Improve the process

Strategic Activity Based Management - Budgeting

Activity Based Costing laid the foundation for activity based budgeting by improving the assignment of costs and clearly identifying non value adding activities. Adopting activity based budgeting to better understand cost structures and make reasonable projections of future product costs Managers can use ABC to make investment decisions based on a projected cost structure