According to Baker (1998), ABC is a methodology that measures the cost and performance of activities, resources, and cost objects. Resources are assigned to activities and then activities are assigned to cost objects based on their use. Chea (2011) indicates that concept of ABC was introduced by Robert Cooper and Robert Kaplan in the manufacturing sector in United State of America during 1970s and 1980s. They brought the ABC concept to the publisher and the body of knowledge was published in the Harvard Business Review in 1988. Cooper and Kaplan defined ABC method is an approach to solve the problems of traditional cost management systems that the conventional cost accounting systems are unable to identify correctly the actual costs of processes. Hence, managements are unable to make decisions based on the misrepresented data.
There are some salient features of ABC. ABC is an activity based system (Rajasekaran, 2011). Activities consist of different tasks that are associated with cost objects. Those activities involved in manufacturing sector are set up machines, repair and maintain machines and products deliveries, and in service sector are deliveries and servicing. Cost pools are established (Rajasekaran, 2011). Overhead costs like supervisors' salaries, rental and utilities are identified to activities and assigned to each activity cost pool accordingly. Cost drivers are being used (Rajasekaran, 2011). These are the causes of overhead occurrences. They are used to assign costs to products or services.
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Beside that, accumulations of overhead costs are done based on various activities (Rajasekaran, 2011). There is no blanket rate applied. Overheads costs are more accurate and appropriate. Overhead costs can be traced easily with the ABC system (Rajasekaran, 2011). Hence, the data are more accurate and reliable. Eliminations of non-value-added activities make the production costs lesser (Rajasekaran, 2011). Non-related activities are not added to the value of the products. Overhead costs are charged proportionally based on the cost-driving activities to different products (Rajasekaran, 2011). This leads to reasonable overhead costs absorption.
Drury (2008) states a two-stage process is being used in ABC system and traditional costing system. In the first stage, an ABC system traces costs to activities cost pools such as ordering materials and assembling products rather than departments whereas a traditional system allocates overhead costs to production and service departments and then costs of service department to be relocated to production department (Drury, 2008). In the second stage, an ABC system assigns costs to products by using many different cost drivers including non-volume-based drivers such as number of production runs and number of purchase orders whereas a traditional system assigns costs to products by using overhead allocation rate which vary directly with the production volume (Drury, 2008).
According to Drury (2008), there are four steps to implementing the ABC system. Step one is indentifying the activities in an organization. Step two is collecting costs to cost pools for each activity. Step three is determining appropriate cost drivers to each activity. Step four is assigning the cost of activities to products based on the products' demand for activities.
There are some advantages of ABC. ABC is a more accurate product costing (Crowther, 2004). More overhead costs can be traced to products costs and provides a more realistic assessment of how costs are incurred. It leads to more realistic product costing especially in a manufacturing environment where support costs comprise a high proportion of total costs. Control of costs can be improved by using ABC (Crowther, 2004). The activities which cause costs are recognised and therefore attentions on the real nature of cost behaviour are focused. It provides opportunities to control costs and lead to better use of managerial time.
On the other hand, production costs can be reduced in ABC system due to elimination of non-value-added activities (Crowther, 2004). ABC recognises the value added by the various activities in the production process by comparing costs with benefits and thus non-value-added activities are eliminated. It leads workers are able to concentrate their efforts on the value-added activities. ABC helps the managers to make strategic decisions on pricing, investment, product mix and customer mix with sufficient information (Crowther, 2004). Every decision in an organization will affect the achievement of meeting organization's goals. Hence, right decision makings play important roles.
However, ABC also has some disadvantages compared with traditional costing system. ABC is costly to implement (Crowther, 2004). For example, employees need to spend time out from their daily activities to identify significant activities and therefore additional costs or staffs are required. The costs incurred by account department will be increased as assigning costs to products requires a lot of times in the department. ABC is a more complex system of absorption costing (Bendrey et al., 2003). Absorption rates for each cost driver are required and a greater number of individual cost rates are required to be computed under ABC in order to recover the costs for each cost pool. More detailed analysis of cost pools and cost drivers are required. It is a more complexity for a large company.
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Furthermore, the benefits may not outweigh the costs for companies with homogeneous products (Heisinger, 2010). These companies require very little variation in production gain little from an ABC system. The overhead costs can be divided into many cost pools but all overhead costs will be assigned to the homogeneous products. ABC may mislead unitizing fixed costs (Heisinger, 2010). Fixed costs such as supervisors' salaries and depreciation on building and machinery are often a major part of the overhead costs being allocated to product cost. Fixed costs will be attributed to more product units and then reduce the product cost per unit. It is difficult to allocate on a suitable basis. Hence, managers must not simply make decisions based on the product unit cost information especially if a significant change in the production level.
Despite its disadvantages, is ABC still relevant? Stratton et al. (2009) reported ABC continues to provide organizations significant value for operational and strategic decision supports. The study shows many companies are still using ABC as it is allocated across the internal value chain and provides accurate overhead allocations and information on activity costs to managers on analysing products or services profitability. The study also shows ABC is also better integrated into budget and planning processes. According to Elhamma (2012), ABC brings significant and positive influences to large organizations but it brings insignificant effects to small and medium enterprises. The study shows ABC users considered the system helps improving in competitiveness, profitability and productivity more than traditional costing system in overall. However, based on the study, only 12.9% of 62 responding companies had implemented ABC system despite its popularity.
Khozein et al. (2011) stated ABC brings advantages for the users but lack of knowledge on implementing ABC system causes waste of financial and human sources in an organization. Five major factors affecting launching and implementing ABC were found and ranked in the study; there are organizational, managerial, environmental, individual and technical factors. The researchers concluded that organization can enjoy the benefits of ABC system by having awareness of the major factors and overcoming them, the organization value would be added. According to Chea (2011), ABC is more suitable for service organizations such as accounting firm and legal firm, the healthcare industry and government organizations compared to manufacturing sector. The costs are properly easier to trace to different activities in service organizations as the number of activities involved are much lesser than manufacturing sector. ABC is a simple term may provide very good payback for service organizations.
Moreover, Berts and Kock (1995) stated that ABC is an effective tool in service firms, and it is a helpful tool in order for encouraging managements to analyse the activities and determine the organization value to the customers. The authors documented successful implementation of ABC will help the service firms reaching profitability through satisfied customers, and the management must not spend all their time on cost calculations but must always focus on the customer's needs and wants and total perceived service quality. According to Kaszubski and Ebben (2004), ABC provides information tracking and sharing, and problem solving to organizations. The authors also stated ABC is a solution of facilities groups to look at their current service delivery models and build initiatives such as reduce cost and increase efficiency.