The Application Of Activity Based Costing In Modern Day Business Accounting Essay

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Abstract

Cooper and Kaplan introduced Activity Based Costing (ABC) in 1989 for providing more pertinent product-cost information. ABC systems presume that activities cause costs and establish correlations between activities and products through allocation of costs of activities to individual products.

This short study investigates the application of ABC systems in practice, their advantages and disadvantages in comparison with traditional cost accounting methods, and the reasons for their slow utilisation in mainstream business.

The research leads to the conclusion that ABC can be relevant for both large and small organisations in both manufacturing and service industries. Its potential has been underutilised and its deployment has stagnated.

Table of Contents

No

Content

Page

Abstract

2

1.

Introduction

6

1.1.

Standpoint and Background of Research

6

1.2.

Research Problem

6

1.3.

Objectives of Study

6

1.4.

Significance of Study

7

1.5.

Research Methodology

7

1.5.1.

Sample

7

1.5.2.

Data Collection

7

1.6.

Scope and Limitations of the Study

8

1.7.

Organisation of the Report

8

2.

Literature Review

8

2.1.

Cost Accumulation to Products

8

2.2.

The Basics of Cost Accumulation Systems

8

2.2.1.

Absorption Costing

9

2.2.2.

Marginal Costing

9

2.2.3.

Activity Based Costing (ABC)

10

2.3.

Comparison of Absorption Costing (AC) and Marginal Costing (MC)

10

2.4.

Comparison of Absorption Costing and ABC

10

2.5.

ABC and Modern Business environment

11

2.6.

Recent history of ABC Implementation (Success and Failure)

11

2.7.

Service Industry and ABC

12

2.8.

Problems in implementing ABC

12

2.9.

Summary

13

3.

Research Methodology and Framework

13

3.1.

Conceptualisation

13

3.2.

Research Problem

13

3.3.

Objectives of Study

13

3.4.

Sample of Study

13

3.5.

Methodology

14

3.6.

Validity of Measuring Instrument

14

3.7.

Data Presentation and Analysis Method

14

3.7.1.

Existing Cost Accounting System of JKL Plc

14

3.7.2.

Constraints of Present Cost Accounting Systems at JKL Plc

15

3.7.3.

Advantages of Introducing ABC Costing at JKL Plc

15

3.7.4.

Disadvantages of ABC Costing for JKL Plc

15

3.8.

Summary

16

4.

Analysis of Data

16

5.

Discussion of Findings

17

References

17

Index of Acronyms and Abbreviations

Acronym

Details

ABC

Activity Based Costing

ARR

Available Room Rate

GAAP

Generally Accepted Accounting Principles

MC

Marginal Costing

RevPAR

Revenue per Available Room

VBC

Volume Based Costing

VC

Variable Costing

Introduction

1.1. Standpoint and Background of Research

The ABC concept has been appreciated by academics and consultants since its introduction in 1989. Studies however reveal that a limited number of UK manufacturing organisations have implemented, or are implementing the process (Dugdale et al, 2005). Most firms, despite ABC awareness, continue to use traditional costing systems like AC, VC and marginal costing.

Factors like increased competition, deregulation and growing product ranges however necessitate more precise cost measurement for assessing profits generated from products, customers and markets (Drury & Pettifer, 1993).

1.2. Research Problem

JLK Plc in UK has of late witnessed a significant drop in sales because of increased competition, as well as by the need of customers to get more value for money. JLK uses absorption costing for purposes of cost control and management.

With ABC considered to be an advanced and effective costing process, the research problem concerns the merits and demerits of JKL's present costing system, vis-à-vis introduction of ABC, for optimising cost control and improving competitive advantage

1.3. Objectives of Study

This study aims to investigate the history and current status of activity based costing in the modern business environment, especially in the UK. The objectives of the research are thus detailed as under.

To investigate the reasons and basis of cost accumulation for management planning and cost control purposes

To analyse and compare the costing systems, namely Absorption Costing, Variable Costing and Activity Based Costing being used by UK businesses, in the context of the modern business environment as well as the service industry

To study the recent history and problems of ABC implementation (for both successes and failures)

1.4. Significance of Study

Investigation into the utility of appropriate cost accounting systems in JKL plc will help students and practitioners in understanding complexities of cost management in specific business contexts as well as the challenges involved in implementation of ABC processes.

1.5. Research Methodology

The research methodology uses the case study method of financial research. Investigation into the costing systems of a specific business firm, along with study of matter available on costing systems in the public domain, provides substantial and relevant information. The literature review details the use of traditional costing systems in the UK, as well as the complexities and utility of ABC systems.

1.5.1. Sample

The sample, or case chosen for the study, is JKL plc, a medium range hospitality firm in the UK. The firm own and operates seven hotel properties.

The firm uses absorption costing for its traditional cost control and management functions. Contribution/margin concepts of marginal costing are used jointly with monthly and annual budgets and rolling forecasts for internal reporting purposes. These systems have been traditionally followed. Reducing occupancy levels, as well as reduction in ARRs and RevPARs, caused to a large extent by the ongoing economic turmoil has necessitated attempts to investigate the role of cost accounting and management systems in containing drops in margins.

1.5.2. Data Collection

Information sources are categorised into primary and secondary sources (Newman, 2005). Secondary sources are the bedrock of qualitative research and are largely sourced through library research. Such information sources are accessible in the public domain and are obtainable from organisational websites, or from the study of pertinent publications like books, magazines, journals and media (including newspaper) reports.

It is felt that focused and careful library research, along with case information from the organisation under study, will be adequate for accessing apt and pertinent information for the study. The research method adopted is qualitative in nature and focused on intensive library search and case analysis of the actual costing system of JKL plc.

1.6. Scope and Limitations of the Study

The study is limited by the data accessed from the public domain on the subject under study. Whilst information obtained from JKL plc provides relevant information, the study of more organisations would have helped in validation of findings.

1.7. Organisation of the Report

This research is sequentially organised, the introductory section is succeeded by a review of existing literature, followed by the research questions, a description of the selected research methodology and framework, the data presentation and analyses and finally the discussion of findings.

Literature Review

2.1. Cost Accumulation to Products

Cost accumulation is an important facet of managerial accounting for manufacturing processes. The data accumulation inherent in the process helps managers in areas of control, planning and decision making (Rushinek, 1993).

Various overhead costs are allocated to products, leading to progressive accumulation of costs. The process enables organisations to (a) to quantify full costs of products (b) encourage efficient product management by managers, and (c) evaluate different alternatives for management control, planning and decision making (Putra, 2008).

2.2. The Basics of Cost Accumulation Systems

Cost accumulation systems identify not only the objects of costs but also the method of allocating costs to production. There are two important cost accumulation systems, viz. job order and process costing systems. Job order costing systems are utilised by organisations that produce comparatively small quantities of different products or services to the specifications of clients (Kinney & Raiborn, 2009). Jobs, depending on the context of business verticals, can relate to projects, contracts, engagements or clients (Kinney & Raiborn, 2009).

Process costing systems on the other hand are used by organisations that manufacture large volumes of homogeneous goods, such as detergents, bricks or gasoline (Kinney & Raiborn, 2009). Overheads, unlike direct material and labour, (which are easily traceable to specific products or services), need to be accumulated over time and then allocated to the products produced or the services provided during such periods. Cost allocation, represents the allocated charge of an indirect expense to one or more products through the deployment of a reasonable method (Putra, 2008).

2.2.1. Absorption Costing

Absorption costing systems distribute a part of all incurred expenditures to each and every product or service offering of businesses. The use of such systems can help in the ascertainment of the long term generation of profits of each product or service.

Absorption costing systems conventionally categorise costs by function. Sales amounts less production costs quantify manufacturing or gross profits. Operating or net profits are determined by accounting for costs of other business functions from gross profits (Coulthurst, 2000).

The profits reported with the use of absorption costing system for manufacturing firms for particular periods are dependent on both production and sales levels as fixed manufacturing overheads are absorbed both in work-in-progress and in finished goods stocks. Closing stocks at the end of accounting periods render fixed manufacturing overhead costs that are absorbed into stock valuations to be shifted to subsequent periods (Coulthurst, 2000). Absorption costing systems require assumptions about allocation of many costs and are thus prone to greater degrees of subjectivity.

2.2.2. Marginal Costing

Marginal costing systems highlight behavioural as opposed to functional attributes of costs. Such systems segregate costs into variable and fixed elements. Variable cost elements are those where costs per unit stay unchanged and total costs change in line with activity levels. Fixed elements are those for which total cost stays unchanged for specific periods and are independent of activity levels (Coulthurst, 2000).

Marginal costing systems, whilst not implemented easily, can help in planning, control and decision-making, particularly for multi-product businesses (Coulthurst, 2000).

Contribution of discrete products/services towards the entire fixed expenditure of businesses, in marginal costing systems, is determined by reducing variable costs from sales. The fixed costs are considered to be period costs and are offset from contributions to determine the net profits for specific periods (Coulthurst, 2000).

2.2.3. Activity Based Costing (ABC)

Activity based costing is a modern day costing system, wherein costs are allocated on the basis of the cause-effect correlation of costs with the activities that drive costs. Conventional costing systems tend to allocate indirect costs on somewhat easily identifiable criterion like direct labour hours (Bradford, 2008).

ABC can be utilised by most industries because of its adaptability for establishment of costs at different levels (Bradford, 2008). ABC is however best utilised in complex organisations that are not completely service-based. Organisations with complex structures can find ABC systems useful, because of its value in situations where costing information is difficult to assess or evaluate. ABC can also become inaccurate in situations with low correlation between the costs being allocated and activities. Such circumstances can render evaluation of costs complicated and inaccurate (Bradford, 2008).

2.3. Comparison of Absorption Costing (AC) and Marginal Costing (MC)

An important difference between absorption and marginal costing systems relates to the deferment of fixed manufacturing costs. Increase in inventory, under AC, leads to the deferment of a share of current fixed manufacturing overheads to subsequent periods through inventory accounts (Nurre, 2010). Subsequent sale of such inventory units sold leads to deferred costs passing into income statements as elements of the cost of goods sold (Nurre, 2010).

Estimates of values of closing inventories differ between AC and MC systems. Only variable manufacturing costs are included in inventory in VC, whereas all manufacturing costs, whether variable or fixed, are included in inventory in AC (Nurre, 2010).

2.4. Comparison of Absorption Costing and ABC

Use of AC often leads to misstatement of product costs because of its simplistic cost assignment process, which is based on plain measures like direct material, labour prices or units, or machine hours. ABC however attempts to closely investigate cost behaviour in order to enable the development of precise product costs (Agui, 2009).

ABC systems emphasise on the costs of complex production activities, compared to conventional AC systems. Its use enables costs of complexity to be separated out with product line costs being mapped directly to products. This leaves lesser overheads to be assigned using labour hours (Agui, 2009). ABC helps in better understanding of cash flows, with more costs being directly traced to products. Its use facilitates production of precise product-line or product costs, thereby correlating costs to actual production. ABC also aids certain businesses to better comprehend their activity flows (Agui, 2009). ABC however requires determination of relevant cost drivers, which can be manipulated as much as conventional overhead allocation systems by smart managers (Agui, 2009).

2.5. ABC and Modern Business environment

Management Accountants, until the early 1990s, depended on established cost accounting methods to present information on product and service costs. Traditional cost accounting systems were however felt to be inadequate for the growing complexity of modern day businesses, because of their rather arithmetical simplicity, and liable to provide misleading information (Zeisel, 1997).

Most organisations paradoxically continue to use inadequate costing systems, because of their need for costing information and their limited choice of available systems (Geri & Ronen, 2005). They need costing systems for decentralisation and control of decision-making, financial reporting, price justification, and performance measurement. Most firms cling to their established systems because of the complexity of ABC systems and the greater effort required for delivering improved outcomes, (Geri & Ronen, 2005). ABC however recognises that the majority of manufacturing costs in modern businesses are established by a number of activities and that effective cost control depends upon optimising the effectiveness of these activities (Moral-Basco, 2010). 

2.6. Recent History of ABC Implementation

Many large firms facing stiff global competition have acknowledged the inadequacy of traditional volume-based costing systems in furnishing of reliable cost information and are now implementing ABC to develop their costing knowledge. Whilst ABC is now being implemented in many large organisations, there are few reports of smaller firms adopting its usage (Narcyz, 2003).

The majority of studies that have tackled the effectiveness of ABC have focussed on identification of factors that influence effectiveness of ABC systems. One such study found ABC relevant for determination of competitive strategies, performance evaluation and compensation, and non-accounting ownership (Malmi, 1997). It has been suggested that key problems associated with ABC implementation relate to dearth of sufficient internal resources, especially computer resources and personnel time (Malmi, 1997).

2.7. Service Industry and ABC

Service organisations are different from manufacturing businesses because of their greater involvement of labour in their operations. Most labour costs can be directly traced to organisational service outputs. The balance costs are typically charged to distinct overhead cost pools, which are then assigned to particular engagements, generally on the basis of a percentage of direct labour cost (Pirrong, 1993).

Such charging of overheads misrepresent overall engagement costs, if dissimilar types of jobs lead to incurring of costs that are disproportionate to direct labour costs incurred, or to quantity of hours worked. Organisations will measure performance incorrectly if accounting systems randomly assign costs to jobs, instead of assigning costs that reveal true inputs (Pirrong, 1993).

Service organisations generally do not employ cost driver techniques for cost measurement and assignment. They can however accumulate costs of various functions and assign them on the basis of activities, or cost drivers, which cause costs to vary (Pirrong, 1993). Such measures can lead to better assessment of costs of diverse categories of provided services, improve the evaluation of past performance and make cost predictions for potential engagements more meaningful (Pirrong, 1993).

2.8. Problems in implementing ABC

Organisations implementing ABC spend substantial money, time and effort in collecting and examining data. Too much of detail can frustrate managers engaged in ABC implementation. Lack of detail can conversely result in inadequate data. ABC initiatives also fail because of the lack of organisational application on working on outcomes provided by generated data. This largely occurs in organisations that were in the first place averse to introduction of ABC (Cokins, 2000).

Cokins (2000) states that the utilisation of average cost rates, the utilisation of excessively detailed information, and the failure to correlate information to performance can also obstruct ABC projects. ABC implementation is limited by high software costs. Time can be another limiting factor for organisations seeking quick solutions. It is observed that whilst some organisations get results from ABC swiftly, others typically take around one quarter to experience its paybacks. This time frame could however, depending on the product or business cycle, be much longer (Proctor, 2009).

2.9. Summary

The foregoing literature review suggests that ABC systems have many advantages over traditional systems. However, some problems, primarily of complexity and of economics of implementation, have limited its use by organisations.

Research Methodology and Framework

3.1. Conceptualisation

Research methodologies for studies in finance research need to be formulated after reflection on the character of research, as also on the wherewithal and infrastructure available with researchers (Laurel & Lunenfeld, 2003).

The Case study methodology is a valuable framework for research and is suitable for study of application of financial issues to firms. It helps in obtaining holistic perceptions of complex issues and facilitates combination of secondary study with primary research (Tellis, 1997).

3.2. Research Problem

The literature review, read in conjunction with the aims and objectives of this report, leads to framing of the following research questions.

What are the advantages and disadvantages of ABC as compared to the other managerial/cost accounting techniques?

Are the contemporary cost accounting techniques more useful than the traditional techniques

3.3. Objectives of Study

The major objectives of this research are twofold, firstly to evaluate the advantages and disadvantages of ABC when compared with other cost accounting/management techniques and secondly to determine whether contemporary cost accounting techniques being used by JKL Plc would be more useful than the conventional techniques.

3.4. Sample of Study

JKL Plc, the sample organisation chosen for study is utilising absorption costing for its cost management functions. It is using variable/marginal costing for internal reporting along with annual/monthly budgets. JKL plc updates its monthly and annual rolling forecasts to monitor and control costs and revenues and modify strategies for operations at each accounting location.

3.5. Methodology

Case study research helps in obtaining a holistic comprehension of the cultural systems of action. Whilst case study research is not considered to be sampling research, it enables the obtaining of multiple perspectives of the subject under study and is thus very suitable for subjective and interpretative research issues (Tellis, 1997).

A specific investigation into the cost accounting systems of JKL Plc can thus be very relevant for the achievement of the aims and objectives of this study.

3.6. Validity of Measuring Instrument

The unit of analysis is vital to the case study methodology. Case studies are inclined to be selective, highlighting one or two issues which are essential in understanding the scheme being examined (Tellis, 1997).

Validity, in the instant case, as JKL plc is representative of the hospitality industry, which in turn is established and well known in UK. The industry is furthermore evolving and contextual to the modern business environment.

3.7. Data Presentation and Analysis Method

Data has been obtained through interviews and consultations with the staff of JKL plc. Information obtained has been cross verified through checking from different sources and analysed carefully in order to arrive at the following findings.

3.7.1. Existing Cost Accounting System of JKL Plc

JKL plc uses traditional cost accounting systems. The system of costing is essentially based upon principles of absorption costing, even as some use is made of variable and marginal costing in internal reports. Budgetary control is done through formulation of budgets on the basis of historical figures, and monitoring through half yearly evaluations.

Direct and overhead costs are segregated at the level of booking of costs. Indirect costs are absorbed into the cost of services. Allocation of indirect costs is made on the basis of direct labour costs.

Costing systems are based on principles of departmental accounting and reflect the fact that costs related to rooms, foods and beverages, and other services are generated by departments. Approximately 75% of the costs of the hotel are fixed. Whilst rooms have fixed costs of 15 to 20% compared to sales, foods and beverages have both high fixed and variable costs. The firm's costing systems do not give much significance to valuation of stocks. Cost planning and control is focused on cost centres, as products do not form particular points of analysis.

3.7.2. Constraints of Present Cost Accounting Systems at JKL Plc

The present cost accounting system at the firm has been continuing for many years and managers are familiar with its various dimensions. Whilst the system has sufficed in the past, managers now find the allocation of overhead costs on the basis of labour costs to be rather arbitrary. Considering the fact that overhead costs are very substantial, and in many cases more than direct costs, the present systems are resulting in skewed and unrealistic cost presentations.

The current costing system is not highlighting wasteful expenditure and processes that do not add value. It is also difficult for the hotel to introduce costing of supply chains, processes and value streams with the existing costing system.

The following indicators signal requirement for fresh inputs in the costing system.

Managers do not appear to trust the results of the costing system.

Marketing personnel appear to be unhappy with calculative costs.

Some services appear to be unprofitable, even though they are priced at above market prices.

Increases of sales of some products are being accompanied by declining profits.

3.7.3. Advantages of Introducing ABC Costing at JKL Plc

ABC systems can help by providing insights into different aspect of organisational working. Separation of costs into activity pools and identification of cost drivers for each pool will help in more accurate definition of levels of different costs that will take place.

ABC systems will provide more accurate costing of services and products. The use of such processes will lead to better understanding of overheads. ABC can further aid in ensuring that the firm can price its goods competitively. This will help in improving competitiveness. ABC systems will also facilitate benchmarking and support score cards and performance management.

3.7.4. Disadvantages of ABC Costing for JKL Plc

Implementation of ABC costing will involve incurring of some expenses by the organisation and significant amount of effort on the part of the management accounting department. Data collection will be more time consuming. The organisation could face change resistance, especially from executives who may not like hidden waste to become visible in the new reporting systems.

3.8. Summary

Use of the case study framework has helped in assessing the advantages and disadvantages of ABC implementation at JKL plc in relation to existing cost accounting and management practices.

Analysis of Data

Research Question 1

What are the advantages and disadvantages of ABC, as compared to other managerial/cost accounting techniques?

The advantages of ABC lie in its focus on activities that are related to competitive advantage; their use helps in making core activities more cost efficient. It is thus superior both to MC, where only part of the costs are recovered at the variable cost level, or AC, where only the total cost picture is available for scrutiny. ABC systems help shareholders to maximise their wealth by assisting in locating and improving activities that are considered to be important for competitive ability.

ABC systems are complex, challenging and costly to implement. Some costs like managerial remuneration are difficult to assign to activities. Such systems are not very relevant to single product manufacturing companies.

Research Question 2

Are contemporary cost accounting techniques more useful than the traditional techniques?

Both traditional and contemporary cost accounting techniques have their merits and demerits. Both can be useful, contextually and under particular financial and economic environments. Whilst AC provides a picture of total costs and MC helps in contribution analysis, the use of ABC leads to better profitability analysis of activities.

Whilst traditional systems have been used by organisations for many years and do have some uses, the growing complexity of contemporary business calls for more sophisticated analysis of costs and necessitates the use of newer systems like ABC.

Competitive business environments need analyses of organisations, businesses, profit and cost centres, activities and functions. The use of traditional systems, supported by contemporary techniques can be useful for these purposes.

Discussion of Findings

The study involved detailed examination of secondary sources of information and an assessment of the existing cost accounting systems of a medium sized chain of hotels. The findings of the study confirm that whilst ABC systems provide important insights into organisational working, their implementation is occurring rather slowly and continues to be restricted to larger organisations.

It is very obvious that traditional methods of costing, whilst useful in certain aspects and sufficient for small single product companies, are substantially inadequate for larger organisations with different product and service lines and numerous processes. The imposition of traditional costing techniques to such processes leads to arbitrary decisions on allocation of costs that are not representative of the true situation and can lead to unrealistic cost pictures and wrong business and strategic decisions.

ABC systems, whilst somewhat expensive and difficult to install provide useful insights into organisational working and by focusing on key areas help in improving competitive advantage.

It is thus essential that increase in complexity and size of business should be accompanied by suitable emphasis on modernisation of costing and information systems. Failure to do so can well lead to reduction of understanding of operations, reduce competitive advantage and negate the very reason of taking on complex and growth oriented business strategies.

It is thus imperative for organisations to introduce modern day costing systems like activity based costing, if they are serious about growth, expansion and improvement of profitability.

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