The Activity Based Costing Accounting Essay

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1.0 Introduction

Over the years, there is hardly any innovation done in the management accounting field, all that was done was just minor improvements. Then Johnson and Kaplan came along and critique that management accounting is outdated. (Otley 2008) The management accounting during that time was said to be too simple and impractical for decision making. Things were made worst as modern managers tend to ignore the valuation of inventory which in fact is closely tied to managerial decisions. (Character 2001) Johnson and Kaplan criticize that the management accounting system is giving the wrong signals to managers for implementing the wrong decision. (Otley 2008) According to Kaplan's 1984 paper "Yesterday's accounting undermines production", it puts the blame on traditional cost accounting at the same time brings up a new methodology to replace the flaws of traditional system which is known as Activity-based costing (ABC). (Geri & Ronen 2005)

2.0 Activity-based costing (ABC)

2.1 Introduction of ABC

Introduction of ABC system can solve the issues caused by traditional costing accounting and it is proven that ABC provides better information in many areas especially for budgeting and planning. It also enhances strength in strategic decision-making and brings improvement in other business areas. (Mansor et al. 2012). Besides, activity-based costing (ABC) was developed to solve the problem with extra capabilities because it includes direct task-resource costs as well as the allocated activity centre costs. (Stelling et al. 2010)

Needy et al. (2003) suggests that the steps to implement process of ABC system are cost system evaluation, ABC design, ABC implementation and system evaluation and validation. (Ezzamel et al. 1990) ABC process should be a process of "relentless and continuous improvement" instead of "one-off" event because it demands a basic mind shift by the management. (pg 173, Hughes 2005).

Activity-based costing has to go through several steps which are first identifying the cost centers/activities to familiar all the activities to produce a product. (Ben 2002) Next will be choosing the cost drivers used to perform activities. (Simpson & Park 2005) Thirdly, compute a cost rate per cost driver unit or transaction and lastly define activity drivers for each activity and find activity cost-driver rate. (Ben 2002)

2.2 Disputation on ABC system

ABC is said to be a great system to be implemented. In fact, its system is said to be a remedy for the limitations of the traditional costing system. (Mishra & Vaysman 2001) The system has numerous benefic such as provides accurate costing estimation, able to capture non-linearities in the production processes, helping to incorporate capacity-management and improve the profitability analysis of customers and suppliers. (Mishra & Vaysman 2001) Taking all that into consideration, ABC system has really played a good role especially dealing with high variance of managerial private information.

Though ABC is said to be a beneficial system to be implemented in an organization, the system itself is not perfect. This can be explain by giving too accurate data to the management may cause issue as there is a risk that these managers may used those information for their ownself interest rather than for the shareholders. (Mishra & Vaysman 2001) This is somehow like the agency theory. Besides that, it is also important to note that ABC is less likely to be compatible in industries where managerial knowledge, skill, and effort are not easily quantifiable. (Mishra & Vaysman 2001) A considerable amount of expertise is also needed for the successful implementation of this system such as software development and high-technology manufacturing. 

Furthermore, there are many firms who interested in implementing ABM system after accountants and operating managers had exposed to them. Even for small startup companies start developing ABC as PC-based modeling tool until today. (Mansor et al. 2012) However, according to the recent article by Ness and Cucuzza [1995], Player and Keys [1995], Pattison and Arendt [1994], many firms tried and failed using the ABC system. It is said that the usual reason for such failure is due to their poor implementation process which is most likely caused by the lack of agreement of what ABC is, how it should be deployed and that the software was not IT integrated (Sharman, 2003).

3.0 Activity-based Budgeting (ABB)

3.1 Introduction of ABB

Activity Based Budgeting (ABB) is a system that is useful in managing shared service departments by providing deeper insights to their capacity utilization and resource allocation than a traditional budgeting system. (Moustafa, 2005) It acts as a part of activity based management, being a budgeting methodology to determine forecasted costs of activities required for the production.

The usage of activity based costing in the budgeting process enables the managers to transform fixed costs into variable costs and to think about the costs more objectively (pg 114, Cooper and Kaplan, 1998). Moreover, ABB tends to ignore activities that do not create value. From this, we can see that ABB is a good cost planning controlling instrument as well as a booster for cost efficiency.

3.2 Discussion on ABB

Activity based budgeting is more accurate in analyzing costs and ease the profitability possibilities. (Sharman 1996) This is because through the implementation of this system, information regarding production process improvement, pricing and customer profitability analyses can be gained. (Sharman 1996) Furthermore, as the budgetary process gets worst in the "gaming" aspect, ABB is said to be able to help to counter this issue. The involvement of real employees will also be higher with the implementation of ABB.

To co-operate well with ABB system, firm's internal value chance have to be concerned to gain real strategic competitive advantage. (Portal 1993) The fundamental principle for value in the firm must be support of value to the final customer in every activity performed inside the firm. "For that concept to be operationally realizable, an ABC process-based approach needs to be developed" (Cook et al. 2000)

3.3 Development of ABB

Other writers (Navistar and McKinny 1999; Tinkler and Dube 2002) suggested that ABB could be developed from ABC system by turning the ABC "push system" process into a "back calculation" method in what may be called "pull system". First it starts with creating the basic ABC system which begins with the analysis of all jobs into their detailed activities. (Bengku, 2010) Next would be determining activity drivers, available capacity of each driver, rates of consumption for each, and computing the drivers' cost rates based on cost records. Then, the pull system is introduced through the prediction of the final output of the activity. (Bengku, 2010) Using consumption rates, the estimated demand on the available capacity will be calculated. The result of this would be the predictive model of ABB, which will reveal the level of capacity utilization.

4.0 Activity-based Management (ABM)

4.1 Introduction of ABM

ABM enables the organization (Kaplan & Cooper 1998) to accomplish its outcomes with fewer demands on organizational resources. As defined by CAM-I (Consortium for Advanced Manufacturing-International, ABM is a system whereby it concentrates on the managerial aspect of activities as a key to unlock the potential of the company to increase customer value which will then improve the profitability of the company.

There representing a shift from a strictly financial perspective to a 'wholesystem' perspective due to increase in users of ABM system. Furthermore, it regains over the traditional cost accounting system by including both financial and non-financial data in its reporting. (Gupta & Galloway 2003)

4.2 Operational & Strategic ABM

ABM works to enhance efficiency, lower costs and asset utilization. It can increase the capacity of resources by reducing machine downtime, improving or eliminating entirely faulty activities and processes and increasing the efficiency of the organization's resources. (Pete, n.d) Furthermore, it explores various ways a company can create and sustain a competitive advantage in the marketplace. ABM attempts to alter the demand for activities to increase profitability, encompasses decisions about product design and development where the biggest opportunity for cost reduction exists, improves relationships with suppliers and customers. (Pete, n.d)

4.3 Disputation on ABM

Just like ABC, ABM is said to be a great system to be implemented. The benefits from operational ABM can be measured by reduced costs, higher revenues through better resource utilization and cost avoidance. (Stefan n.d.) Besides that, ABM system helps in prioritizing quality improvement projects by improving the accuracy of cost data. They can provide information to help assess capacity decisions by identify bottlenecks caused by inefficient equipment. (Gupta & Galloway 2003)

However, ABM basically shares the same limitation as ABC system. According to the other researchers (Bescos et al. 2002; Cohen et al. 2005, Askarany and Yazdifar 2007), the main reasons for rejecting the implementation process of ABC/ABM might be satisfaction with the existing traditional cost systems, lack of management support and interest, implementation process associated with high costs and consumption of time and resources.

4.4 Evolution of ABM

Manufacturing has incurred some drastic changes during the last twenty years, for instance profits have shrunk and 'overhead' has risen dramatically. (Gupta & Galloway 2003) Due to such major changes, managers are supposed to find out why is there an increase in efficiencies but not in profitability and competitiveness. This is where ABM is implemented to assist in this issue. "There is a shift from ABC to ABM has been supplemented by the broadening of ABC/M application to different types of business, to different functional specializations within business and to the complementarities of ABC/M to other new high-profile management and accounting techniques" (pg 504, Bjornenak & Falconer 2002).

5.0 Impact of the new ideas on both companies and consultants

5.1 Xu Ji Electric Co. Ltd

Xu Ji Electric Co. Ltd is a large private limited manufacturing company in China (Fei & Yu 2011) Xu Ji implemented ABC to one of its main production divisions as the first trial and then extends the use of ABC in one of its subsidiaries and sales functions.

The implementation of ABC solved issue of inaccuracy in traditional costing system. It is able to trace direct labour costs directly to product as well as to allocate manufacturing overheads on the basis of up-to-date direct labour hours. (Fei & Yu 2011.)

There are rapid changes in internal management structure causes some activity cost drivers to be ignored. (Geri & Ronen, 2005) Although there is some issues incurred while implementing ABC system such as compatibility of information system and misinterpretation of ABC concepts by IT programmers, however it is solved and implementation was successful.

Overall, ABC has gained a positive feedback to obtain some accurate product cost information compared to traditional system. (Geri & Ronen, 2005) It also helps the manager to have better understanding in sales activities and to have a valid control over sales expenses and sales companies.

5.2 Surveys in Australia's overall firms

The study is conduct by 17 Australian companies listed by ABC Learning Centers Ltd (Australia 30/06/2006 Annual Report) which already practicing ABC system. It tells us how the impact of ABC affects the overall firms' performance in Australia. Survey is carried out by giving out questionnaires, by phone and mail. We got the approval for interviewing participants with several questions.

It seemed that the implementation of ABC has bring a positive results to the firms with the help of lowering production cost by finding out major costs for each of the products as well as lowers down customers cost. (Zaman 2009) Moreover, it helps in increasing efficiencies and effectiveness in managerial decision making which will lead to an increase in firm's revenue and performance

5.3 Transportation service: A Shared Service Department

This is a subsidiary of a large governmental authority in Egypt. In Egypt, a service such as the transportation service is regarded as part of a production line for contracts in the construction field.

This analysis is carried out by interviewing employees with a series of discussion as well. Here, it is concluded that ABB system can be implemented in traditionally managed environment and that this is beneficial to the company itself.

The company found that ABB is useful in cost tracking being able to detect cost of the service unit from each activity. (Moustafa 2005) The product transportation service process can be traced too with ABB. It is able possible for them to identify places which capacity not fully utilized in service departments with the aid of ABB. (Moustafa 2005) With that, it is able to establish objective control and performance evaluation measurements in the area of service department's activities.

But, it must be noted that there will be some difficulties while implementing ABB system. For instance, there is an issue concerning the examination of cost information at hand. (Navistar & McKinney, 1999) So, for the initiating stage of ABB, there is a need of using expensive resources to build the ABB database to serve as the foundation of this system. (Cokins 2003) Moreover, another limitation identified is the common one is setting measures for human labour based activity. It is always hard to decide which measure to use because of flexibility that characterizes human capacity.

6.0 Conclusion

As stated earlier, Johnson and Kaplan believe that "management accounting" is no longer a useful conceptual category for organizing research activity. (Otley 2007) Therefore, ABC, ABB and ABM are introduced and developed to overcome limitation of traditional costing system.

With reference to the criticisms of Johnson and Kaplan, traditional costing system tends to ignore selling and distribution cost and only focus on manufacturing cost. Thus, development of the three systems such as ABC, ABB and ABM can solve the issue by including both manufacturing and non-manufacturing cost in the calculation. Moreover, activities based on labour hours or cost has become insignificant because of its flexibility on which measure to use.

Through ABC system, the costing system is improved to provide better results cause of the various drivers based on different activities. 

Furthermore, to do costing under the blanket rate is unfair if all cost is charged using the same rate since different products have different consumption of resources. With the activity based systems, costing is carried out based on resource consumption which is said to be a fairer method.

Lastly, since after ABC system is implemented, it is now become useful in decisions making rather that just serves the needs of financial reporting.

As mentioned above, it is clear that ABC, ABB and ABM bring positive impacts by improving managerial decision in their respective fields.

(2317 words)

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