Problems In Traditional Costing System Accounting Essay

Traditional costing systems had been used for decades by organizations in making important decisions and there is not much change in the management accounting techniques since the 1920′. From the book published by Johnson and Kaplan in 1987, they stated that from 1920 to the mid 1980’s, there were no new innovation in management accounting techniques and concluded that the traditional costing were less adequate in reporting the proper cost allocation. Due to many criticisms towards traditional costing system, the development of Activity Based Costing has been brought up. This report analyses the development of the techniques of Activity Based Costing, Budgeting and Management from the early 1990’s to the present day.

Development of Activity Based Costing and its Evolution

2.1 Problems in Traditional Costing System

Absorption costing or the full cost method which is categorized under traditional costing systems is the most commonly used cost allocation method, past and presently, in the United States. The reason it is called the full cost method is because absorption costing assigns all manufacturing cost to the cost of the product (Garrison, 2006). The main use of absorption costing method is to report financial information to the shareholders and other external stakeholders. It has proved to be an important tool for managers to make decisions. However, in the late 1970’s, the cost structure within organizations began to change drastically due to rapid increase in overhead and indirect manufacturing cost because of the increase in cost of capital and technological factors within the manufacturing environment (Cokins, 2002). During that time, managers believed that a direct correlation exists between direct labour hours and manufacturing overheads but the problem arises when the nature of costs were changing and manufacturing overheads costs and direct labour costs were becoming more and more adversely correlated over time (Garrison, 2006).

In 1987, Kaplan and Johnson wrote a book about the problems in the management accounting practice during that time. In that book, they argued that the outdated management accounting systems was still somehow the same since 1920. They argued that the information systems were geared towards financial reporting, as was the decision making process which causes a general drift from cost management to cost accounting. They also argued that existing management accounting system could not adapt to a newly competitive environments, new style of management and production techniques in the modern organizational structure (Kaplan & Johnson, 1987). This book represents the beginnings of Activity Based Costing methodology.

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Implementation of Activity Based Costing

Activity Based Costing was introduced as the answer for an improved full-cost product-cost calculation as the model grew into a more full-fledged costing system for hierarchies of activities and cost objects. Activity Based Costing is a two-stage procedure where cost of resources in the first stage are allocated to activities to construct Activity Cost Pools, which in second stage are allocated to cost objects based on these objects’ use of the different activities. It is also a tool for cost and performance measurement towards activities, resources and cost objects (for example products and services). Activity Based Costing is knows as a “horizontal” or cross-functional cost view and it can provide fact-based insight into the spending and profitability of products, services and customers (Narong, 2009).

There are three guidelines to support cost allocation in Activity Based Costing. The first would be ‘Direct-cost tracing to product’. Trace the cost of flexible resources towards individual products that are exclusively related. These are cost of direct material and direct labour. There are also some capacity-related costs that will need to be included in the exclusively used for one product. The second guideline is the ‘Indirect-cost allocating to product’. There are three indirect costs that need to be allocated. The first would be the ‘Multipurpose resource costs’. It occurs when resources are consumed by multiple products. These are the overheads that need to be allocated into the products. Secondly is the ‘Cost Centers’ where only the three-step allocation process uses the cost centers to allocate costs of a group of consumables or indirect resources necessary to operate cost centers and it also includes major production machines and human resources. The third indirect cost is the ‘Activity Costs (cost pools). The principal of allocation of this indirect cost is to separate activity cost if the cost or productivity of resources is different and if the pattern of demand is different across resources. Every one of the activity cost has a cause and effect relationship with the cost driver. Lastly the third guideline is the ‘Activity cost drivers’. Cost drivers should relate to way in which activity costs are consumed. For example, setup cost is assigned to a product consuming a setup activity-based on setup time if setup time drives the costs (Park and Simpson, 2008). In a simpler term, Activity Based Costing is a costing system that improves and helps the organization to identify activities and allocate the cost to each respective activity.

In the article written by Geri N and Ronen B (2005), they stated that Activity Based Costing can provide more accurate and reliable cost data to the managers and decision makers so that they can decide which one is suitable for their decisions. There is another article by Tardivo G and Montezemolo G (2009), which they also have the same perspective with what Geri N and Ronen B stated in their respective article, where they both agreed that Activity Based Costing can provide more accurate data for decision making and also it may reduce costs and improvement in production processes (Tardivo G & Montezemolo G, 2009). Most companies that use Activity Based Costing have seen improvement in their performance with the reduction in costs and improvements in making the right decisions. This statement is backed by Cooper R where he stated that the product cost should be allocated evenly and it is essential in determining the performance of the company in the current competitive environment.

Activity Based Management

Activity Based Management is derived from Activity Based Costing itself with additional component to describe any application of Activity Based Costing data to management decisions. Activity Based Management focuses on managing activities or business processes in order to achieve organizational objectives. Activity Based Management also reduces cost drivers and transfers resources to economic value to create activities or business processes which customers’ wants and willing to spend money for it. It also measures performance for cost, time, quality and outcomes so that the users of the information would understand how their activities would contribute to the mission and strategy of the company. Activity Based Management supports Balanced Scorecard in creating performance measurements. One of the perks of Activity Based Management is it improves company’s cash flow, and increases the quality of the information produced and also reduction in cycle time. It can also be used as a foundation for a Business Process Redesign and supports gain sharing amongst the individual involved.

Activity Based Management able to support businesses growth by providing information to monitor long-term strategic decisions. It allows product designers to have a clearer view and understand the impact of different designs on cost and the flexibility therefore; designers may modify their designs appropriately. It opens the choices to the management by supporting quest for continuous improvement by gaining new insights into activity performance by concentrating on the source of demand for activities and by allowing management to create incentives based on behavior to improve single or multiple aspects of the business.

According to Tardivo G and Montezemolo G, Activity Based Management helps organizations to be more competitive by identifying key aspects that needs to be improved in the business process. Activity Based Costing would first identify all the activities that start from customer order up until the shipment of products to customers and after that, Activity Based Management would be used to focus on ways to reduce the non-value added activities, thus these shortened down the process duration (McConville D, 1993). The question is are Activity Based Costing together or separate from Activity Based Management? The answer would be it is working together as Activity Based Costing would focus on reducing costs while Activity Based Management would focus on the improving processes so that both systems would improve the company’s performance and profitability and also improvement in qualitative and quantitative basis.

2.4 Activity Based Budgeting

Activity Based Budgeting was introduced by Brimson and Antos in 1999. Brimson argued that using traditional approach for planning and budgeting, it often leads to destruction of value since the traditional approach on focuses on resources rather than activities. There are many factors that can be identified as the problems with resource approach, one of the factors would be, it focuses on resources that are inputs to a process rather than outputs or customer requirements. It focuses on functional departments rather than the interdependencies between departments, suppliers and customers. Traditional budgeting tends to look more of an accounting exercise towards operational people thus resulting in a low commitment towards operational activates. Budgets amounts based on traditional budgeting tends to lean towards the past periods rather than forecasting the future budgets. It lack towards identifying the main causes of slow performance by not taking seriously wastes and inefficiencies and does not clearly show the relationship between business strategy and employees’ actions.

Therefore, by implementing Activity Based Budgeting, it would place the accountability and responsibility of an employee to manage their activities towards achieving positive performance targets. This model provides the insight and the ability to understand how products or services able to create demand for specific activities and incidentally able to drive the requirement of the resources. Management is more responsible and able to create the ability to monitor and control at a more responsive level. Activity Based Budgeting can be linked to the Zero Based Budgeting approach because of its similarity. Activity Based Budgeting can be said to have the same principle as Zero Based Budgeting but without the multiple decision packages for each activity or program. According to Grasso, both ZBB and ABB share the same focus on the activities and the analysis required within the framework for each model which does not applicable to traditional budgeting approach but it might come in handy if the company has already introduced Activity Based Costing. Grasso stated that implementation of Zero Based Budgeting may not be as expensive as many people would have thought. As of now, many companies prefer to use Activity Based Budgeting because of the its popularity in management accounting techniques. (Grasso 1997).

Time Driven Activity Based Costing

Time Driven Activity Based Costing is the most recent technique based on Activity Based Costing model designed by Kaplan and Anderson in 2004 and 2007. It is an approach where it measures the equivalent approach which composed in using equivalent-time cost drivers. The main principle of Time Driven Activity Based Costing is to translate the cost drivers in time-equivalents (standards of working hours) and it reacts to the change in production conditions. Kaplan and Anderson stated that Time Driven Activity Based Costing is a system that simplifies the original Activity Based Costing by reducing the number of activities and the analysis is made at the departmental levels or of the processes. They also stated that different types of drivers are categorized in only one equivalent-time driver. TDABC helps decision makers to save more time in making decision if the company are expanding its capacity or adding new activities. It also reduces the time needed to collect data based on estimation therefore management can focus on increasing profitability rather than wasting time to work out the correct data.

Impact towards Companies and Consultants

Based on an article by Landry (1997), she describes what happened to one of the Hewlett-Packard’s divisions in Colorado Springs when they tried to implement Activity Based Costing. The system did not work for Colorado Springs division due to the use of many drivers and no follow through on the implementation of the cost driver information thus leads to improper administration. The division also puts a lot of emphasis on consensus rather than the benefits.

A case study on Thai telecommunication in 2011 was conducted to study the implementation of Activity Based Costing in Thailand. Factors that influences the success of the implementation of ABC are, it requires a competitive environment it would influence everyone involved to be more attentive. Although the studied company did not have a professional costing system, the implementation of ABC went smoothly. Top management played an important part in the success of implementation of ABC. Adequate training and understanding of the ABC systems were one of factor that give success. The only downside towards this case study is, it was only one company, and thus does not represent the other telecom company in Thailand for the success of implementation of ABC.

Time-Driven activity based costing helps Charles Schwab, a leading stock brokerage. TDABC assigns all company’s resources costs to cost object using a framework that requires two sets of estimates. The company were able to identify the key factor that able to decrease costs and Charles uses TDABC information to lower process costs by several hundred million dollars annually.

Conclusion