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Activity Based Costing. Discuss the main issues faced by managers in emerging economies who want to implement ABC.
This essay purposes to discuss the following topic: Activity Based Costing is an example of a successful management accounting technique that has been widely adopted in different sectors in the UK. Primarily, the meaning of Activity Based Costing (ABC) will be explained. Secondly, is demonstrated how the implementation of ABC accounting technique in various sectors such as manufacturing, financial services and banking, retail, health and government, influenced negatively or positively some companies. Lastly, is presented whether or not the Activity Based Costing method is an appropriate accounting technique that should be implemented in organizations or should be rejected.
As manufacturing environment turns to be computer-integrated field and, at the same time the manufactured products diversify, traditional cost methods can critically differentiate product costs. The idea of activity-based costing (ABC) was firstly designed and introduced by Robin Cooper and Robert S. Kaplan. ABC could find solution for the distorted problems that occur. A definition of ABC is "the collection of financial and operation performance tracing the significant activities of the firm-to-product cost". This accounting technique is divided in five stages: a) aggregate actions into activities, b) report the cost of activities, c) identify activity centres, d) select first-stage cost drivers and e) select second-stage cost drivers. In order to be properly implemented, this method has to be organised in seven parts: an ABC seminar, a design seminar, design and data gathering, progress meetings, an executive seminar, result meetings, and interpretation meetings (No and Kleiner, 1997).
2. What is Activity-based costing
The activity based costing method was initially presented by Cooper (1988) and Cooper and Kaplan (1988) (Baird, 2007). ABC is an appropriate method of evaluating the product/service costs more accurately when diversified. The traditional cost accounting methods aim to manage the units of a specific product which means that the evaluation of the costs depends on the units allocated in a product, for instance, number of direct labour hours, machine hours or material costs consumed in making the product. On the other hand, ABC method targets to the activities utilized for the manufacturing of the products at the final stage of the production process (Cooper, 1990a; cited in No and Kleiner, 1997).
The main difference between ABC method and the traditional cost accounting methods is that the former emphasizes in finding the costs in activity level, that is in unit-level, batch-level (i.e. number of set-ups) and product-level characteristics (i.e. number of parts, number of times ordered) and not in the unit-level characteristics as the latter (Raffish, 1991; cited in No and Kleiner, 1997).
3. Implementation of ABC method
An example of ABC implementation in the manufacturing sector is the case of a large Chinese manufacturing company, Xu Ji Electric Co. Ltd. The most significant indicators of a successful application are the top management support and the significant presence of devoted professionals. Especially the developing countries, such as China, try to enhance manufacturing technology and Information Systems (IS) due to the assist of foreign investment capital and technology transfers. The continuous search for improved accounting methods, though, cannot promise that will give solutions to the emerging economies (Liu & Pan, 2007).
The success of ABC is totally connected to the right design of the method, which means that understandable and realizable objectives have to be introduced, objectives that express completely the strategies of the firm. Top priority is the devotion and support of top management, the provision of adequate resources in a timely manner, the participation of employees and the collection of information (Liu & Pan, 2007). After a long-term period of research upon ABC in GM, Anderson (1995) refers six implementation stages based on Kwon and Zmud's model: initiation, adoption, adaptation, acceptance, routinisation and infusion (Anderson, 1995; Liu & Pan, 2007).
In other words, the success of ABC can be summarised in four crucial factors:
Technical factors: The knowledge of the application of such system. This consists of the recognition of cost drivers and activities, activity selection for each product, connection among organisational strategic goals and ABC and the awareness of the ability of existing computer systems to support ABC method (compatibility issues).
Organisational factors: Top management support, training investment, adequacy of resource and structure of organisation and culture.
Behavioural factors: Participation of staff members when ABC is applied and understanding of individual users' behaviour.
Other associated factors: Competition, commitment, quality and relevance of cost information to managerial decisions, size of organisation, compensation and reward, general need for change and culture (Liu & Pan, 2007).
Financial services and banking sector
ABC can be also applied on service sector. Service companies consider the labour cost for employees as the most critical cost whereas in service corporations dominate professional labour costs. Overhead costs are part of a firm as well. When taking place a service, occur overhead costs in every firm and they can be easily categorised as service overheads in order to be compared with factory overheads in a manufacturing company (Hussain & Gunasekaran, 2001).
In a financial institution the services that provided to the customers are recognised as indirect costs. Due to automation, indirect costs replaced with direct costs which confuse the cost of resources consumed or utilised and the real customer services rendered. ABC method differentiates from the traditional cost methods because it can provide accurate cost data about products and customer profitability (Sapp et al., 2005).
The structure of ABC approach in financial institutions consists of two-stage model. Firstly, creates the relation between resources and activities and then the cost per unit of activity is implemented to the consumption of activities such as customers and products for the evaluation of the aforementioned categories. Costs like wages, depreciation, possession and data processing are located to activity costs pools based on a calculation of each activity's require for the specific resource. The first stage is finished, when the tracing of overhead resources to activity cost pools is achieved. The second stage aims to evaluate the activity unit cost relied on cost drivers. In other words, costs drivers measure the cost units of activities to each product/customer relied on the amount of the activity that product/customer demanded. For example, an appropriate cost driver associated with the activity cost pool, such as a new car loan, is the number of new car loans (Sapp et al., 2005).
So, the identification of a cost driver for every cost pool is vital to compute the activity unit cost. Once this process is completed, activity costs can be allocated to products/customers relied on the amount of that driver is consumed. Summarising the costs of all activities that comprise a product/customer, a final product cost can be defined. As it seems, ABC is a dominant tool for financial institutions and banks because the cost data that provides can lead managers not only to profitable decisions but also to advance the competitive position of the firm. Finally, through this system, organisational and customer/product profitability can be easily recognised (Sapp et al., 2005).
ABC system has high installation and maintenance cost especially when the traced activities might be fossilised, mainly where this is written into software. It is also known that ABC depends on the expression that "activities consume resources" which is inextricably connected to the managerial decisions, decisions that can vary, be fragile, or enhance the aforementioned expression. An accountant, who implements this costing method, might face a number of problems such as non-traceable costs and more precisely the corporate advertising. Such a problem could lead to the failure of ABC implementation. A solution to surpass the problem is to group all non-traceable costs into one cost pool and transfer them across products. Nevertheless, this scenario could cause weaknesses in activity-based costing system (Tollington & Wachter, 2001).
Generally, it is worth saying that retail sector has short customer cycle and might be influenced less by variations in resource consumption and spending than other economical sectors. What is more, the percentage margins in this sector of economy have the tendency to be narrow, something that requires attention to the products' and services' costs offered to customers. ABC system is useful in terms of explaining the use of overhead resources, mainly in distinguishing among added value and non-added value activities. This costing method may be one of the most improved overhead absorption methods, though the search of a precise product/service cost might be indefinable (Tollington & Wachter, 2001).
Like the other sectors, ABC system has application in health sector as well. In the majority of the hospitals, management aims to improve the quality of patient care, to provide up-to-date technology (using large amounts of capital), and to be competitive among the other organisations. This is the reason that lots of managers choose to adopt the ABC method, helping them to have greater focus on the cost of activities in order to make better decisions. The difficulty is to identify the activities and the cost pools and to define the drivers (Aird, 1996).
The ABC system in a health organisation is divided in four cost activities:
Unit-Level Activities: This type of activity occurs every time a unit of service is provided. In other words, as the number of service units raises, the activities raise respectively. For instance, the inspection of each lab test counts as an activity.
Batch-Level Activities: This type of activity occurs every time a batch of service is provided. Hence, as the number of service batches raises, the activities raise respectively. For instance, this type of activity measures the required amount of set ups for a specific lab test or the required amount of set ups for a surgical procedure.
Service-Sustaining Activities: This type of activity supports the different types of services. These costs can be allocated to individual services but their total amounts are unrelated regardless of the amount of batches or the amount of the produced service units.
Facility-Sustaining Activities: This type of activity supports a facility's general service providing process. These activities are independent to the amount of individual services provided, the amount of batches run or the amount of different services. General management, security, landscaping, insurance, facilities maintenance, personnel and accounting can be some examples of this activity (Cooper, 1990; cited in Capettini et al., 1998).
The usefulness of ABC system in the public sector has not yet completely explained because governmental institutions started to show interest a decade after the private sector. This happened due to the existence of the competition in the private organisations. An example of comparison between traditional costing system and the ABC system is a fire department in a city and it is given to understand the different measures of costs and how this can be misleading for the organisations. Fire departments serve normally two functions; to fight the fire and to accomplish inspection services for fire-safety reasons. There are also two types of cost in the fire department namely overhead costs and direct labour costs (Brown et al., 1999).
When a traditional cost accounting system is utilised, the cost of fire inspections is a sum of direct labour cost and overhead cost. This cost data cannot be accurate because the inspection overhead costs include also overhead costs that are not connected to the inspection procedure (i.e. the maintenance cost on equipment and fire truck). Furthermore, there is no cause-effect connection among direct labour cost and overhead cost. So, what makes the tradition accounting costing method more attractive is the simplicity (Brown et al., 1999).
On the other hand, ABC implementation in the case of the fire department three types of cost is recognised: the overhead costs to fight fires, administrative overhead costs and inspection overhead. The results from this example have shown that the ABC system provides more accurate cost data because the traditional cost system uses total labour hours as an allocation base, whereas ABC uses multiple overhead pools and allocation bases, giving a more precise identification of the costs (Brown et al., 1999).
The key factor for the appropriate choice of the costing accounting method is that all corporations should look at the perspectives that could give them competitive advantage and better control of their costs. ABC system may have lots of potentials, but on the other hand a firm must be sure that such an implementation really worth. To be more precise, a trial period using another accounting system such as ABC could help the firm to realise if the cost data are going to be completely different compared to the old system and if this data could help managers to change their decisions (Brown et al., 1999).
To sum up, activity based costing system can be implemented in all sectors of economy such as manufacturing, financial services and banking, retail, health and government, as far as specific rules are not ignored. For instance, managers can be totally excited and overpass the disadvantages of ABC at the beginning or they cannot be prepared to give the necessary attention. Basically, one of the most important factors of a successful ABC implementation is the top management support and the investment in training.
Problems that can arise are the difficulties in cost driver and data selection. Moreover, the process activity data derived from ABC might be dissimilar with the functional structure of a firm. Another significant observation is that there are lots of companies that are not prepared to change their existing accounting system into ABC probably because they are not familiar with an innovative accounting system. Finally, ABC implementation is neither related to the costing or organisation profile of corporations nor is relied on which method is more sophisticated, but which accounting technique demonstrates better the needs of a firm.