Exploring the benefits and limitations of implementing ABC

Published: Last Edited:

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

Activity-based costing (or ABC) is one of the most widely used methods of costing management over the past decades. It is an attempt to identify more accurate costs to products or services (Collier, 2009). The purpose of this paper is to review recent research into Activity-based costing regarding the ideal candidates to implement ABC system. A variety of different arguments have been put forward about this issue. This paper begins by introduce the reasons why has ABC evolved. It will then go on to discuss the benefits of implementing ABC and its limitations. Finally, the use of ABC in organizations is carried out to demonstrate the relevancy ABC to current practice.

Activity-based costing emerged in mid-1980s, the main purpose of ABC is to use cause-and -effect cost allocations (Drury, 2009). At that time, as Drury (2009) stated most organizations use traditional costing systems which designed for meeting external financial accounting requirements, not for decision-making. For example, in 1994, GEI used traditional costing based on direct labor dollars which allocated manufacturing overhead costs to products till 1999. Then the manufacturing overhead rate of direct labor increased from 300 percent to over 600 percent. GEI was weak in competitive strengths in a high-volume, commodity business environment (Brewer et al., 2003). Traditional costing system cannot provide accurate costs of resources in an increased competitive business environment. Managers are likely to make wrong decisions by using inaccurate cost information. Also rapid global technological innovations reduced the measurement costs which accelerate the development of activity-based costing (Major, 2007). As a result, Kaplan and Cooper carried further the ideas of Staubus to develop the concepts of ABC systems. It has been asserted that Activity-based cost focus on organizational spending on resources to the activities, it drives activity costs to products in order to provide a better estimation of costs and the amount of activities for individual goods (Kaplan and Cooper, 1998). Therefore, ABC systems give better information to manage organizations than traditional systems do (Hughes and Paulson, 2003).

As Major (2007) explains valuing stocks and setting prices is the main features of ABCM in the beginning, but after it further developed, ABCM helps managers to understand cost information and to make better decisions accordingly. Because ABC information is of great help to reduce costs during product design and development, so managers could achieve desired products at much lower total costs with an accurate cost model and a disciplined target costing process (Kaplan and Cooper, 1998). This could lead to a better performance measurement with reconstruct activity-based budgets and products or services innovation (Innes & Mitchell, 2000). It is also argued that companies have better management decision support by using ABC model to acquire more accurate cost information and more accurate profitability analysis (Stratton, 2009) this leads to a better understanding of cost causation and reasonable pricing products for managers. Kaplan and Cooper (1998) go on to further claim that ABC could trace whether predicted profits have been obtained in the processes. This can be used to improve future processes and systems. Thus, it could help to improve efficiency and competitiveness in organizations (Drury, 2008).

However, the issue of the accuracy of ABC calculations has been a controversial and much disputed subject. There are difficulties in selecting cost drivers and identifying activities when ABCM implementing, because selection of drivers and activities is a tedious and time-consuming process, employees often face difficulties in understanding and categorizing activities when supplying data for the ABCM system, sometimes estimation still necessary. Moreover, Friedman and Lynne (1995) mentioned that to some extent, the success of implementing ABC systems depends on the top management support, which included that right amount of work in design the system and gathering data, ample resources and adequate IT support. Drury (2008) further claimed that a lot of service organizations were government owned monopolies which operated in a highly protected and non-competitive environment. Therefore, these organizations were not willing to improve profitability by identifying, improving and eliminating non-profit making activities. Cost increases could be covered by increasing the prices of services to customers. Less motivation was given to developing cost systems which improves costs measurement and enhances products profitability (Drury, 2008). It is reasonable to conclude from the above discussion that these limitations slow down the development pace of ABC systems.

It is essential to understand the fundamental features of organizations which ABC system best suited. First of all, the majority of costs in organizations should be indirect, especially when these costs have been increased (Kaplan and Cooper, 1998).

Secondly, the ABC systems are necessary if there are a vast various products, services or processes in business (Kaplan and Cooper, 1998). Because the ABC adopters used a great number of cost pools and different types of cost drives than those with few, which make it more sophisticated (Al-Omiri and Drury, 2007). Finally, a UK survey by Drury and Tayles (2005) indicated that company size and business sector had a significant impact on ABC adoption rates. The adoption rates were 45 percent for the largest organizations (Drury and Tayles, 2005), because the greater demand for activity management information and better ability to manage resources in order to achieve better management performance (Baird, 2007).

Kaplan and Cooper (1998) state that service firms are more likely to implement Activity-based costing than manufacturing firms. Drury and Tayles (2000) indicated that the implement rate of ABC was 15 percent of manufacturing firms in contrast with 51 percent of financial and service organizations. At that time, manufacturing organizations could trace almost all the costs to individual product, therefore the indirect costs, which are smaller parts of the total costs, could be directly traced to individual products by traditional costing systems. Whereas nine years later, a survey by Stratton (2009) stated that 54 percent of total 348 respondents which implement ABC systems are service companies, compared with 40 percent of manufacturing firms.

The possible reasons why more manufacturing organizations adopt ABC are a wider variety of products or services provided. So the indirect costs are at a much higher proportion of total costs than it was. In order to obtain a more accurate costs for products or services in intense competition, a better costing system is needed (Bowhill, 2008). Therefore, there are more manufacturing organizations implement Activity-based costing systems.

In conclusion, the current paper has described those types of organizations which benefit from the implementation of ABC. It has been shown that ABC is likely to be best suited where the indirect costs are high, companies running within a highly compete environment, and it has variety of products or services that do not to consume resources in proportion units of output. The main conclusion to be drawn from the preceding discussion therefore is that service and manufacturing organizations are likely to implement ABC systems. This has significant implications for organizations need to updating costing systems in order to obtain a cost-and profitability- measurement systems.