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Activity-based costing emphasizes the need to obtain a better understanding of the behavior of overhead costs, and thus ascertains what causes overhead costs and how they relate to products. ABC recognizes that in long run, most manufacturing costs are not fixed, and it seeks to understand the forces that cause overhead costs to change over time. (Colin Drury, 1995 p. 275)
The definition of accounting supplied by Zlatkovich, et. al. (1966) is the process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information.
ABC also can be defined as a method of costing activities that are necessary for the production of products or services (i.e. activities being undertaken) (Dandago, 2003).
Whatever the definition of ABC, this method was originally developed by Cooper and Kaplan in 1988 as a solution to the inadequacy of traditional management accounting techniques that used volume based methods to allocate overheads to products. ABC is a method of allocating overhead costs. Eventhough, it is similar to the direct method of overhead costs allocation found in traditional method, but there are two significant different. In the traditional direct method, overhead costs are identified by service and production departments while in ABC overhead costs are identified by activities which probably not the same as departments.
In the traditional direct method, service department costs are allocated directly to production departments and then overhead allocation rates are prepared from these combined costs. Overhead costs are then assigned from the production department cost pool to the products processed through this department. The different with ABC method this intermediate step has been eliminated. Overhead costs are collected by activity and then directly allocated directly to the product. In traditional method direct, the cost object is the end product or service. And the prime costs and production costs are charged directly to product or service whereas non-production costs will not charge to product or service.
There are five (5) main advantages of adopting ABC methods are:
ABC offers more accurate estimates. Businesses typically have to compare an item's price and selling record to see if it is worth producing, and one of the benefits of ABC is better analysis of both profitable and non-profitable products. Overhead costs can be a major problem with some products, but this method will identify the costs and helps reduce overhead. Managers often can work better under this costing method, because they have more accurate information.
Accurate Product-Creation Cost
Another benefit of ABC method is a more accurate product-creation cost. By adopting this costing method, analysts can figure out the per-product cost and, thus, more realistic metrics are used for estimation.
ABC is helpful in selecting which products are profitable and which ones should be eliminated. If a product is identified as non-profitable, the businesses rarely continuously sell a product. This is because the ABC method enables the businesses to determine more accurate product pricing and hence competitive positioning of the product in the marketplace.
Better Decision Making
Since ABC provide accurate information on costs, more appropriate capital investment decisions can be made as a result of better weighting being determined on various aspects.
ABC helps the businesses estimates the cost of all activities or processes that associated to future product planning accurately determined before it is launched. This can then help with determining pricing, and any associated expenditure. By implementing ABC method, the businesses also could identify which production line is inefficiently. This enables the businesses to decide whether to continue the process or activity in-house or outsourcing the process or activity to third party.
Despite the advantages of implementing ABC, the method also has disadvantages and limitation. The disadvantages of the method are elaborated in the next paragraph.
The most obvious disadvantage of ABC is complexity in nature. It prevents the system to widespread into other companies. This resulting the ABC methods usually remain difficult to comprehend and costly to operate. ABC requires management to not only estimate the costs of each activities and identify and measure the cost drivers for such activities, but also update the same on a regular basis. This utilise much of the organization's resources such as management time and cost.
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ABC while it institutes a complex methodology to assign costs to activities, the method remains far from perfect. The major shortcomings include:
Certain overhead costs remain impossible to divide and allocate on a per-product usage basis.
Not all productive activities will add value to products.
Most activity based costing methods assign such 'business sustaining' costs to products on a proportionate basis or based on assumptions, and this makes the method far from perfect.
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The Big Picture
ABC places too much attention to detail and control on processes. This causes a severe constraint in that it obscures the bigger picture by causing the organization to lose sight of strategic long term objectives in a quest for short term savings.
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Confirmation to Standards
This method, while providing for better management control over the business process, does not conform to generally accepted accounting principles (GAAP). This means that for the companies that practicing GAAP need to double their efforts by maintaining two cost systems and separate accounting books for internal use and external reports.
Finally, ABC method does not replace an existing job order or process cost system, but rather supplement the same. Indirectly, this will be seen as redundant process.
Eventhough the method has disadvantages; it has proven that it still leading method to produce the most reliable, accurate costing information especially for manufacturing companies today. Although this method may not be easy to implement, since it using activities to trace costs but it provides more accurate information resulting in better strategy, better planning, and better forecasting. However, the most influential aspect of ABC is the ability to save cost. If company has a more accurate picture of costs, then it is in a position to achieve higher profits which directly maximize the shareholder wealth.
The next paragraph discussed on the implementation of the ABC method in four (4) different countries with different culture and industries. The analysis was based on the research papers conducted in these countries.
The first research paper by Wen-Hsien Tsai and Jui-Ling Hsu. The study was carried out to analyze the operational costs of a hot spring inn in the Yang-Ming-Shan area of Taiwan. The ABC method was used to compute lodging, hot spring use and meal serving costs per customer. Based on the result of the research, it was reported that the cost of products was lower than using other methods eventhough during winter season. The researcher also compares the ABC method with the traditional costing method and concludes that the ABC method is practical and appropriate for such a hot spring country inn and yields more accurate information for cost management and pricing decisions.
The next research paper was carried out by Ahmet Agca and Ali Cagri Buran in implementing ABC method in Third Party Logistics (3PL) firms at Turkey. This study was carried out for selected enterprises that are expertise in logistic activities at Turkey. The successful factors for these firms are the service they provide and adapting their customers to their processes in an optimal way.
The 3PL firms can design their services in a two different way to meet their customers' expectations i.e. service-oriented and customer-oriented. By adopting ABC, it shown that either service-oriented or customer-oriented, both models need to determine the optimum cost level for accurate pricing decisions to enable them to determine the profitability of customers or services. Therefore, the costing method they use need to be qualified enough to meet the need for accurate cost data.
The firms have found out that, ABC method has proved the optimal method in both situations. As this method allocates costs by the activities; so, it is the method providing the most accurate cost data both in costing logistic activities and determining the costs of customers and services/products.
The third research paper was carried out by Francesca Bartolacci for logistic process in Italy. In this case study, Francesca defined logistics as part of the supply chain process that plans, implements and controls the effective and efficient flow of goods, services and related information from the point of origin to the point of consumption. Nowadays, the market very competitive, the products, price and quality are easily imitated and the speed of the physical and information flows plays a fundamental role for the achievement of the company objectives. Excellence customer service can be the key element for the company to be at the competitive edge and one of the functions obviously plays a vital role in the success or failure of a company is logistic.
Eventhough Francesca Bartolacci has identified some disadvantages and drawback in implementing the ABC method in logistic, however ABC method has addresses to solve the problems concerning the use of traditional cost accounting system based on volume and the improvement of business profitability. The method provides managers with useful information about labour and other resources, including consumption for products, consumers and supplying channels, leading to the management and control of the overheads present in the company.
The analysis also managed to identify the factors that determine the overhead consumed. By adopting this method it is possible to make the logistics activities more efficient by eliminating redundant or unnecessary tasks, and optimising resource allocations to activities adding more value to the product or customer.
Other advantage of the method is, ABC permits the planning of more efficient collaborative relationships among the companies in the supply chain. Francesca concludes that "the identification of costs reciprocally influenced allows for a choice of collaborations as a method which is more convenient for the whole partnership. Correct information about the differential costs arising from possible alteration of the collaboration relationships help companies to make those appropriate strategic decisions with their logistics activities. This in turn helps them realise, with other companies, how best to modify the object of the cooperation in order to make the whole supply chain more competitive".
The final research paper was analyzing the results of adopting of ABC methods in service sectors at United State of America by Ashford C. Chea.
It was reported that the adoption of ABC to effectively allocate resources and to determine prices was the primary objective in the case of a large regional bank. Previously, the bank had no clear way to cost services or determine how resources were being consumed by different activities. In addition, since some of the customers were related parties, the bank wished to show that the charges being made to them were effort-and-use-based, i.e., there was a direct correlation between the nature of service provided and the charge for this service. ABC method assisted the bank to address both i.e. internal pricing and strategic pricing.
For global insurance company, the decision to adopt ABC method merely for tax purposes. The method was adopted to determine its allocation methodology for external transfer pricing purposes. This is because the company wanted to ensure that its charges to its overseas affiliates were accurate and defensible to tax authorities. By adopting ABC, the company ensured that the services provided to all overseas affiliates were tracked through the ABC systems, resulting in charges directly related to the economic benefit received by the recipient. As a result, the company was able to lower its effective tax rate.
ABC was introduced in the 1920's and over period of time the method continually improving. As shown in four (4) case studies, ABC is not only appropriate for use in a manufacturing environment; it is also reported to be most appropriate for service organizations such as financial institutions, the healthcare industry, and government organizations. In fact, some banking and financial institutions have been applying the concept for years under other names. One of them is unit costing, which is used to calculate the cost of banking services by determining the cost and consumption of each unit of output of functions required to deliver the service.