Exploring the vital nature of cost accounting

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The cost accounting is an important aspect of any management accounting. It is utmost important for survival and profitability of an organisation to determine the cost accurately for each cost unit.

The quotes presented in the given assignment shows the importance of one of such costing accounting method called activity-based costing (ABC). The concept of ABC was studied from Durham MBA FCP Material and related reference supplied.

Initially, Cooper and Kaplan proposed Activity-based costing in Harvard Business Review. They term it as a revolutionary concept in management accounting that can be used to measure right cost for a product or service. The ABC empowers manager to design & lunch new product, increasing profitability on existing products by effectively managing product portfolios. Even to discontinue the existing non-profitable product line.

The concept of ABC has, gradually, gained popularity in academics and management accounts since its inception. In last 20 years, it has matured and lots of research done and wide knowledge base available for its implementation. In the following sections, ABC is explored covering history, main feature, implementation and major critics.

Introduction

The cost accounting is an important aspect of any management accounting. It is utmost important for survival and profitability of an organisation to determine the cost accurately for each cost unit. Managers with help of cost accounting decide cost of product and service and make strategic decision which can result into reduced operating cost and hence better profitability.

The quotes presented in the given assignment shows the importance of one of such costing accounting method called activity-based costing (ABC).

In recent years, ABC has gained much popularity and has formed basis for effective management technique.

History of Activity based costing (ABC)

Back ground on Cost accounting

There was strong competition & challenges faced by western companies especially in electronics and automotive sectors by Japanese companies like Toyota and Honda. The competition originally started with low-wage labour and undervalued currencies and then spanned on to innovative management practices such as just-in-time, quality, reliability aspects of the business (Turnery 2008, p.3).

The impacts of these challenges were severe and the western companies started developing new management practices to counter balance. As part of strategic move, new approaches on to cost accounting were devised. The companies realized that the traditional cost accounting systems were inefficient to measure the true cost of a product or service (Turnery 2008, p.3).

The costing systems are basis to determine the production or service cost. Costs are reflecting the value of product or service in units of currency. The cost accounting can be viewed as translating production activity and basis material cost into financial values (wikipedia 2010)

There are various managerial accounting approaches

Standard cost accounting

Lean accounting

Activity-based accounting

Resources consumption accounting ( Wikipedia 2010).

Activity-based costing (ABC)

Traditional, cost accounts methods were found in earlier industrial revolution period. The traditional methods were presenting inaccurate cost calculation because the way indirect cost calculated. The new challenging environment demanded more relevant cost and performance information on business activities as per Cooper and Kaplan (Kaplan and Cooper 1998).

As per Cooper and Kaplan (1998) the companies requires enhanced cost system to:

Design & lunch products and services meeting customer expectation and delivering profit

Decision making in continuing or discontinuing of product or service

Supplier management

Negotiate price, product features (Kaplan and Cooper 1998).

The Activity based costing (ABC) an innovative approach in the product costing estimate was developed in 1988. It is claimed that the ABC offers a sophisticated method accounting indirect cost (Dixon 2003). The activity based cost systems meet the need for accurate information about cost of resources. The ABC method enable managers a clearer picture of the economics of the business operation as stated by Cooper and Kaplan (Kaplan and Cooper 1998).

Evolution of ABC to ABC/M

As per Turney, start of 1987, loads of articles on activity-based costing appeared in Harvard Business review. The enthusiasm in ABC was at its peak, there were many conference organised and survey & research conducted. Large consulting firms started offering ABC practices to their clients. The enthusiasm of ABC was leading into new concept of ABC/M (Turnery 2008).

In the period of 1991-1995, as per Turney, over-enthusiasm, limited implementation knowledge, complexity of determining activity, limitation in terms of support systems and some failures were presenting the challenges to popularity of ABC (Turnery 2008, p.5).

The period of 1995-2000, Turney, terms these period as second generation of ABC and emergence of ABC/M. With technology development, ABC implementation becomes easier. The scope of ABC widened beyond cost accounting and to areas such as administration, marketing, supply chain. Even the industry wise, it expanded into insurance, healthcare, banking, service industries & public services and government (Turnery 2008, p.6).

The period of 2000-2006, Turnery terms these period as third generation of ABC. ABC penetrated into many industries and countries. Many searches and survey claimed its wide spread use as management tool. The interest in ABC was fuelled by several factors such as evidence of financial benefit, emergence of advance ABC software (Turnery 2008).

The evaluation of ABC leads to a new concept in management accounting called activity-based management. The Activity based management is a method in which set of actions that can be taken depending upon outcome of activity-based cost information. ABM largely relies on implementation of ABC in an organisation. The accuracy of ABC is important to make correct decisions (Kaplan and Cooper 1998).

Anthony and Govindarajan (2007), argue that computerisation and automation are main drivers behind changes in systems for collecting & apply cost information (Anthony and Govindarajan 2007, p.341).

ABC/M

Main features and mechanics of ABC/M

ABM is accurate cost accounting system with performance enhancement process. It can be considered as a system that can be used to correctly determine the full costs of services and products. Under process view, it can be said to formulate the performance indicators for the output of each activity centre (Trussel and Bitner 1998, p.441-442).

As per Trussel and Bitner, the two important aspects of ABC/M can be summarised in following figure (Trussel and Bitner 1998, p.442).

The cost view helps to determine cost of a product or service & the process view helps to gauge the performance (Trussel and Bitner 1998, p.441).

ABM system is two-stage process. The first stage is to assign resource cost to activities then assigning activities cost to objects. All tasks are aggregated in each activity centre. The second stage the costs of activity centres are traced to objects as per Trussel and Bitner (Trussel and Bitner 1998,p.441).

ABC/M Implementation

As per cooper and Kaplan (1998), ABM consists of two complementary approaches; operational and strategic ABM as show in following figure (Kaplan and Cooper 1998).

Figure 2. Using ABM for operational Improvements and Strategic Decisions

(Source: Kaplan and Cooper, 1998)

Operational ABM

Operational ABM is doing things right. Operational approach focuses on increasing efficiency, lowering operating expenses. Operational ABM helps to reduce downtime, effective use of resources like equipment and people & eliminating unproductive activities (Kaplan and Cooper 1998).

Operational ABM takes demand for resources as given and focus on reducing spending or increasing production so that effective use of resources like physical, human and working capital could be achieved (Kaplan and Cooper, 1998).

As per Kaplan and cooper (1998), Benefits of operation ABM are

Effective use of resources like physical, human and working capital;

Exploring possibility of higher revenue;

Cost avoidance by effectively using available resources and hence reducing spending avenues;

Concentrating on operational process and increasing process efficiencies (Kaplan and Cooper 1998).

Strategic ABM

Strategic ABM is doing the right things. Strategic approach is an attempts to alter the demand for cost activities such that profitability enhancement from that product or service occurs. There is underlying assumption that that activity efficiency remains constant for products (Kaplan and Cooper 1998).

There could be some products or services whose production cost are higher than the earned revenue. Strategic ABM enable aligning the resources such that cost driver requirement for such unprofitable activities can be reduced. The ABC model helps to determine which products or services are highly profitable and when. The information obtained from ABC application can be used by sales or marketing managers to align their product or service portfolios to make more profit for organisation. The ABC information can also be used to choose low-cost suppliers (Kaplan and Cooper 1998).

Strategic ABM further even plays very important role in design and development phase. It is very critical for success of a product or service to get initial effective designs. The many products or services fail after lunch, mainly due to initial design and development issues. There also opportunity exists to make use of companies' strengths or existing resources in initial design phase. The right decision on design and development can bring biggest competitive advantage to organisation. It also helps to achieve cost avoidance and cost reduction. The ABC application will provide right information to make right decisions. Therefore, ABC contributes significantly in organisation strategy (Kaplan and Cooper 1998).

With traditional cost accounting methods, product designers and technical staff will receive faulty signals about economics of the product under development. The traditional cost methods provides inadequate and incorrect cost information, leading to incorrect decisions in terms of using unique versus common parts, using new vendor or existing and using simple versus complex production methods (Kaplan and Cooper1998).

The incorrect cost systems may provide overestimated cost of direct and indirect cost and thereby making company to do overinvestment or drop the new plan. The overinvestment may require more internal funds or securing loans. Therefore, initial incorrect cost system information can distort the business & financial plan of a company (Kaplan and Cooper 1998).

Implementation of ABC/M

There has been lot of confusion & misconception around Activity based management and its implementation (Dixon, 2003). Many critics of ABC state that there are many allocation models & the sector specific models. The implementation of ABC more confusing and requiring more computer based software. As per the Gosselin (1997,p.106), surveys have shown that the implementation of ABC not so intense. Some firm have stopped implementation of ABC or delayed. As per the Gosselin (1997), ABC is considered a level of activity management (AM). He classified AM into three basic categories called activity analysis, activity cost analysis and ABC as shown in following figure (Gosselin 1997,p.106).

As shown in the figure, out of three levels, the outer level is activity analysis level and the inner most final level is Activity based costing. Each level requires the previous stage to be completed as a prerequisite (Gosselin 1997, p.106).

The first level activity analysis level consists of activities & procedure findings that can be used to produce output using input resources. The activities which do no contribute to the output are not considered. AA is considered to be a prerequisite of applying Activity based costing system (Gosselin 1997, p.107 ).

Gosselin describes ACA as "adds the process of explaining the structural determinants of the costs of the activities" (Gosselin 1997,p.107). This level referred by many authors as cost driver analysis as per Gosselin. ACA helps to determine the cost of each activity & affecting factors. After detailed analysis of this level the managers can get better understanding on activities that can alter the cost. They can take suitable actions to reduce the effect of cost drivers. This also enables companies to prioritize the desire changes (Gosselin 1997,p.107).

The core level is ABC. ABC enables to determine the cost of product and service. It offers detailed analysis to identify the cost for each cost drivers. The whole process through AA, ACA and ABC can be viewed as a two-stage allocation process as described in Durham MBA study material (Dixon 2003, p.11) and illustrated in the following figure. The first stage is preparation of activity-based cost pools. The second of ABC is applying pooled costs to products by tracing all activities involved in producing that product (Dixon 2003, p.11).

The reversal of the whole process shown in the above figure, provides managers with opportunity to consider forward resource requirements during budgeting process. Reversal will convert the ABC resource use analysis into a resource supply one. The Activity Analysis also provides better visibility and legitimacy to the initial budget approval process (Dixon 2003, p.11).

If organisation decide to adopt AM approach, several key decisions has to be made. The foremost of these decisions are necessary trainings for managers and accountants. A consulting firm can also be hired and required ABC computer software can be purchased or developed in house. The responsible designated accounts and managers will have to identify activities & prepare activity cost pools. Then selecting appropriate cost drivers to specific cost objects. These preparation phases of ABC consist of AA and ACA. This phase will present opportunity to firm to rethink decisions made earlier on. Gosselin add further, some organisation may stop further implementation based on the outcome of AA and ACA levels (Gosselin 1997, p.107).

Activity based approaches can also be integrated with other business frameworks and initiatives, such as the balanced scorecard. Activity-based approaches can also be integrated with other manufacturing philosophies like Just-in time (JIT) (Dixon 2003, p.12). .ABC could also be used in conjunction with the Porter's 'Value Chain' or 'value curve' as show in following figure (Dixon 2003, p.13).

These can be used to examine and discover new customer value propositions (Dixon, 2003, p.13).

Exclusion of few costs

Cooper & Kaplan suggest that some costs needs to be excluded while working on activity-based costing. In their paper, they identified two of such costs; namely costs of excess capacity and research & development costs (Cooper and Kaplan1988, p.101-102).

They further added that the costs of excess capacity should not be accounted to individual products. With example, they demonstrated that one production plant with capacity of 1 million units per year with $5 million as total annual costs amount. Hence, cost per unit is $5. The cost of excess or idle item capacity should b treated as a separate line item than the costs applied to individual products. However, with traditional methods if demand reduce to 0.5 million units, then the cost of each unit will be $10. This comes to play even without workers or machine having performing at the same rate. This shows that in traditional costing the product cost fluctuate with changes in assumption of production volume. This can cause so called 'death spiral' with reduction in forecast demand. The less demand will cause ideal capacity and hence higher reported cost per product resulting in even loss of future product demand (Cooper and Kaplan 1988, p.101).

The second item cooper and Kaplan suggested is research and development cost. The research and development costs arise from invention or improvement of new product. They recommend dividing R&D costs into two categories a) Cost caused by improvements and modification of a product. b) Cost caused by innovation of entirely new products. They suggested that the first cost should be added to the product which gets benefit of improvement. Else, this cost could distort other products cost calculation that did not get benefit from improvement of R&D program. The second cost which is of innovation of new product is treated by financial accounting experts as a cost of the period in which it takes place. The accounting experts treat this cost as investments for better future business prospect. For the product with short life cycles, R&D cost should be spread across the life cycle of the product. This could mislead the assessment of product profitability (Cooper and Kaplan 1988, p.102).

Effect of Strategic management on Implementation

The strategy plays key role in success of any organisation. The SBUs decide to go for AM approach based on their needs to have better information on activities and their in turn costs. The information will help them to determine their impact on product cost and product profitability. Gosselin (1997) describes the prospectors are organisations which are highly active in seeking and exploring new market opportunity. Hence, a prospector needs information on wider range basis (Gosselin 1997,p.119).

Cooper & Kaplan (1988) present the strategic implication of ABC, with help of examples; Cooper & Kaplan demonstrate how activity-based cost system can presents different evaluations of product costs and profitability in comparison to traditional approaches. ABC helps to determine unprofitable products or services and enable firm to discontinue them. Business manager are equipped with more relevant cost information and hence they can decide on range of strategic options. Discontinuing unprofitable products or service is one of the strategies. They found that many low-volume products have low price elasticities. Customers with special requirement will be willing to pay extra price for firms' products. The customers may also react to a price increase and they may defect to competitors. Hence, company may loose revenue on some items. Cooper & Kaplan pointed out that more accurate cost information provides more strategic options for high-volume products. Managers could take several profit-enhancing actions after receiving input of revised cost data by distribution channels. The manager explore new market segment where the firm got competitive advantage and firm can produce at lesser cost than the marketing costs (Cooper and Kaplan 1988,p.102).

Cooper & Kaplan also suggested that the information derived by applying activity-based cost system can make companies to redesign their products and encourage exploiting existing resources or using common parts. The common parts bring advantage of versatility and easy availability. On the supply side, these parts may already be sourced from present vendor. Manager can encourage their engineering to modify or redesign the parts or use common parts such that cost and complexity can be reduced. This can only possible if company's cost system can identify the benefits to redesign products. The activity-based costing techniques can help to quantify the resulting benefits of parts standardization (Cooper and Kaplan 1988,p.103).

Similarly, activity-based costing operational aspects can enable mangers to evaluate new technical process. It helps managers to streamlining the process to reduce setup times, revisiting plant layout for better material handlings and enhancing the product quality such that post production inspections , package, storing and after sale support can be reduced to minimal. These reduction will further bring cost save. Advanced Computer-integrated manufacturing can also be introduced for some specific product manufacturing. Activity-based costing helps managers make correct decisions about product or service design, pricing, marketing (Cooper and Kaplan 1988, p.103).

Empirical studies of ABC

Many survey and empirical studies have been conduct to get some insight into the adaptation of ABC in real world. In spite of high interest of academics and business accountants, ABC has not been implemented widely into industries (Gosselin1997,p.118).

Gosselin (1997) findings indicate that the adoption and implementation of AM approach relied upon several factors. The strategy of organisation will decide the requirement for innovation in activity management. Studies show that the prospector organisation are innovative, they tend to adopt innovations in accounting & operational management. The outcome shows that organisation structure plays a critical role in the choosing type of AM approaches. The firms with higher vertical differentiation tend to adopt ABC. Some experts argued that the some organisations stopped ABC implementation at the level of AA or ACA. The outcome of Gosselin (1997) study shows that the organisation with centralised structure or more formal tend to implement ABC in contrast to decentralised and less formal organisation. The results infer that strategy and organisational structure affect decisions regarding AM model selection and its implementation. Firms believing in competing through innovation tend to be more open to new ideas which can bring advantage to firm. Managers of such firms improve processes and enhance profitability. Therefore, Gosselin believe that the prospectors firm adopt AM approaches. The further study reveals that firm that adopt AM approaches irrespective of their nature of strategic style, the type of AM model selected does not differ significantly. (Gosselin 1997).

According to Gosselin, the organisational structure influences the selection of type of AM approach. He added that the mechanistic firms prefer formal systems in comparison to organic firm. Therefore, mechanistic firm select ABC which is more formal accounting system at the same time organic prefer AA or ACA. This also gets some formal support from Gosselin studies. Gosselin also pointed out that the degree of vertical differentiation is directly proportionate to the adoption of ABC (Gosselin1997).

The results of his study also confirm that in mechanistic firms, committed manager can align all resources to ensure that implementation will be a successful and control the whole implementation process (Gosselin 1997).

Critics of ABC

Activity-based approached have been criticised by many experts. As per Turney(2008), there are much confusion prevailing about method itself, many models, method limitation and inadequate supporting systems and some well know failure made the ABC unpopular during 1991-1995 (Turnery 2008).

As stated by Turney, some experts 'argued that ABC was inconsistent with the principles of continuous improvement and total quality management'. They commented that ABC does not address customer focus requirement which is key to success of any business in competitive world. It is not process oriented as well. It does not achieve employee participation and much more of top down approach. Other camp of experts argued its inconsistency with the theory of constraints (Turnery 2008).

The much of these criticisms shows a misconception around objective of ABC. The objective of ABC was not to provide daily guidance on the process and quality while producing goods or service. The immaturity of initial ABC approached also contributed towards its criticism. Other factor contributed much towards its unpopularity was adequate computer based technology innovation in that era. The computer software or processors were not powerful to handle such complex algorithms. The initial ABC computer software was much basic. Moreover, the ABC methods of that time were difficult to implement and integrate as whole software (Turnery 2008).

The study shows that there were cases where in ABC failed because of poor implementation knowledge within that organisation. Managers and accountant responsible for ABC did not have enough knowledge to implement ABC. In some cases, managers were not trained and not equipped with right resources. In the time period from 1991 to 1995, interest in ABC declined, the firms started exploring other tools like enterprise resource planning (ERP) system, balance scorecard, and business process reengineering (Turnery 2008).

Some critics terms ABC as just another method of guessing overhead allocation for calculating the full costs. While some critics terms as ABC promise for competitiveness but usually misleads in determining the cost of a product or service. ABC is also criticised to ill-consider the activities relating to constrained resources (Dixon 2003). Firms may mislead to stop costly activities in search for alternative methods and damaging quality of the product or service. The quality degradation, sometime, results into product or service failure. In such cases, ABC fails on reliability criteria.

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