Traditional Method Of Costing Has The Essence Of Dealing With Overheads By Accounting Essay

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Abstract

In recent years the world of costing systems have shown major developments in costing techniques, specifically a major contribution of activity-based costing (ABC) in manufacturing and services organizations. This study aims to identify the reasons why activity-based costing is preferred to traditional costing tools in modern manufacturing environment; why managers are showing their interests in the adoption of ABC to improve their financial performance, managerial and production efficiency; how ABC helps managers to eliminate production inefficiencies; how ABC facilitates adaptive and generative learning in organizations and the usefulness of ABC in vendor selection, service sector and SME's. Traditional measurement methods of cost accounting proved insufficient on these issues, which leads to the invention of activity-based costing.

Introduction

Traditional method of costing has the essence of dealing with overheads by splitting them into variable overheads and fixed overheads. If we are using absorption costing, we will first decide the suitable basis for absorption (e.g. machine hours or labour hours), then we will absorb all the overheads on that basis. The traditional costing methods were designed around 1870-1920. In those days industry was labour intensive, there was no automation, product variety was small and overhead costs in organizations were generally very low as compared to today. However, it changed rapidly from 1960's - particularly 1980's due to the problem of increased lack of relevance of traditional cost accounting methods.

Activity - Based Costing (ABC) is based on the insight that activities create costs, while products consume activities. ABC is a costing technique that first identifies the major activities that give rise to overhead costs, then groups activities having same cost drivers into cost pools and finally assigns total overhead costs to each product or service by calculating absorption rate for each cost pool. So we can say that ABC is a costing technique in which multiple overhead cost pools are created on the basis of one or more non-volume related factors. There is a concept of cost pool and cost driver that distinguishes ABC from traditional costing. Cost driver can be any factor that causes change in the cost of an activity. Under ABC overhead costs are assigned to products on the basis of cause and effect relationship.

Traditional systems often rely on unpredictable allocations of indirect costs; particularly they rely extensively on volume-based allocations. Volume based activities are those which have high correlation with number of units produced. Most of the indirect costs are not volume-based. If volume-based allocations are used high volume products are likely to be assigned with greater proportion of indirect costs than they have consumed, whereas low volume products will be assigned lower proportion. It will lead to over costing of high volume products and under costing of low volume products, which will further provide misleading information. So, traditional systems fail to recognize the relationship between costs, activities and products by employing volume-related overhead absorption rates only.

For Example, a company produced two products - product A and product B. Product A which is a low volume item is produced according to customer specifications that may demand certain activities such as special engineering, additional testing and any machine setups, whereas product B which is a high volume item demands little attention, no special activities and running continuously. If this company is using traditional costing technique it will allocate all of its overheads to products based on number of machine hours, which will result in the allocation of little overhead cost to product A because it did not have many machine hours but remember it demanded lots of engineering, testing and setup activities and costs of these activities have been ignored by traditional system. In contrast, product B will have enormous amount of overheads due to all those machine hours, but in reality it demanded little overhead activity. It will lead to miscalculation of each products true total cost of manufacturing. ABC overcomes this problem by assigning overheads on more than one activity. It recognizes that special engineering, testing and machine setups are also activities which consume resources of company, so costs of resources used in those activities should also be calculated and included in total overhead costs of only those products that demanded and consumed those activities.

So if you want to control your costs, you have to first control the activities that cause the costs to be incurred. ABC may help to identify value added activities and non-value added activities, which will help managers to control their costs by eliminating non-value added activities or at least reducing number of cost drivers of non-value added activities. The beauty of ABC is that it reveals unused capacity and help managers to eliminate those capacities so that there would be no product cost distortion. There are two phases of activity accounting. First phase is called Activity-Based Accounting (ABC) where it tells us how we can improve our competitiveness by managing our resources more efficiently. It does not only provide accurate costs but it is a mechanism for managing costs. Second phase is called Activity-Based Management (ABM) which is an important tool for achieving continuous improvement. In ABM, we use information obtained from ABC to make strategic improvements in organizations. Managers generally achieve improvements by managing activities in four ways:

Activity reduction - by reducing the time required to perform activity.

Activity elimination - by eliminating the entire activity.

Activity selection - by selecting the low-cost activity from set of activity alternatives.

Activity sharing - here managers make such changes that allow them to share activities with other products to achieve economies of scale.

It depend on manager's ability that how he will use all these four ways efficiently and effectively to achieve strategic improvements in organizations. The most accurate costs under ABC allow management to plan more effectively, improve quality of cost control and finally evaluate manager's performance on meaningful basis. To implement ABC in any organization is not an easy task, you have to update your activity systems as products and processes diversify.

This study aims to present that ABC is preferred to traditional absorption costing in the modern manufacturing environment because now indirect costs constitute greater proportion of total product costs due to product's complex specifications, widespread use of computer control and automation and increased use of just-in-time (JIT) production methods which will ultimately improve the financial performance of organizations. The use of ABC with strategic approaches like total quality management (TQM), JIT methods etc, can make it more useful. ABC is not only adopting by manufacturing companies but now many services organizations are showing their interest in the importance of costs for decision making purpose. When you implement ABC in your organization a change in the management structure should occur, managers can adapt ABM by using the information provided by ABC to achieve required profits. Application of ABC is a team work and requires a lot of manpower training.

Keywords

Activity-based costing, activity-based management, modern manufacturing environment, sport organizations, cost accounting, management accounting.

Literature Review

Cagwin & Bouwman (2000) reported that there is an association between use of activity-based costing and improvement in financial performance of organization and results show that there is indeed a positive association between ABC and improvement in financial performance when we use ABC with other strategic initiatives (p, 04) such as total quality management (TQM) approach, just-in-time (JIT) manufacturing methods, business process reengineering (BPR) and flexible manufacturing systems (FMS), these strategic methods will help to reduce non-value adding activities (Gunasekaran, Marri, Grieve 1999); when we use ABC in specific conditions such as in complex and diverse firms, where mangers give importance to costs in decision making process (p, 13), where there is limited number of intra company transactions and unused capacities and where there is huge competition (p, 14).

Whereas if company is having sophisticated technology, data collection, compilation and processing cost will be reduced, this will make the use of ABC more beneficial. It shows that usefulness of ABC is having positive relationship with sophistication of technology. So never underestimate the cost of data gathering to implement ABC. If you do not have enough technological resources first update your resources otherwise you will have to bear huge costs (Gunasekaran, Marri, Yusuf, 1999; Sohal & W.C. Chung, 1998; Cagwin & Bouwman, 2000).

ABC provides most accurate cost information where non-volume related overheads are significant and company manufactures diverse products. It is ABC's beauty that it deals with non-volume related costs and provides true and accurate costs of products (Sohal & W.C. Chung, 1998 - p, 137).

You can achieve better results by allocating indirect costs to total product cost (Snyder and Davenport, 1997) and in this way management will have better control over decision making process.

We can also combine the benefits of ABC with the benefits of cash flow based accounting with the help of logistics management accounting structure to support logistics administration decisions (van Damme and van der Zon, 1999).

People should understand the difference between value-added and non-vale added activities by understanding the reasons why an activity is called as value or non-value added (Miller 1996). ABM helps mangers to eliminate inefficiencies by redirecting resources towards value adding activities (Needles & Crosson 2002).

Horngren (1977), Miller & Vollman (1985) and Johnson & Kaplan (1987) argued that if you want to increase managerial and production efficiency, you have to deal with some hidden factors very carefully that influence the general industrial and manufacturing expenses. Because of the deficiency of traditional costing technique in improving global competitiveness, organizations hesitate to use it (Johnson, H. T., 1990).

Roztocki & LaScola Needy suggests in a study that we can integrate ABC system with Economic Value added system (EVA) as an engineering management tool that will help us to manage our cost and capital successfully and create shareholder's value through cost structure improvement.. ABC is a tool that helps managers to think about organizations more effectively and about how value and worth is produced (Driver 2001; Cokins 1999; Cooper et al. 1992; Lebas 1999). In ABC and EVA system, rate of consumption of resources and capital demand is included in cost of activities. This proposed ABC and EVA system adds capital charges to the activities and will help managers to understand capital cost associated with the manufacturing process and protect company leaders from making short term decisions on profit alone that will destroy economic value over the long-run (Roztocki and LaScola Needy).

Gunasekaran, Marri, Yusuf (1999) suggests the application of activity-based costing with some case experiences. They say that the most important decision to be taken now-a-days is what type of costing technique should be used in a specific organization. In current manufacturing environment because of high level of technology and increased competition, role of direct labour is diminishing, whereas support service is increasing. But conventional methods do not take into account this requirement of present manufacturing atmosphere; they still allocate overhead costs on diminishing labour bases. This increased competition and technology has led manufacturing companies to adopt new manufacturing techniques and methods such as TQM, JIT and FMS (p, 286) (Cagwin & Bouwman 2000). In this study researcher developed and created a conceptual model regarding realization and execution of ABC (with the help of appropriate case experiences from Belgium and Dutch companies). This model suggests us that if u want to implement ABC in your organization, you have to first consider conditions and factors that favor and are against the application of ABC (p, 289). In this way you can achieve your profit objectives with the help of ABC and ABM (p, 292). ABC is a guide that gives management actions a direction towards high profits (Cooper and Kaplan 1991).

Application of ABC requires total commitment from top to bottom; management should clearly understand the benefits offer by ABC by communicating achievable objectives to everyone in the organization. It is management's duty to educate and train everyone in the organization about the system which is going to be implemented so that everyone understands the complexity of project and its impact on the performance of organization (Sohal & W.C. Chung, 1998 - p, 144).

ABC facilitates adaptive and generative learning (Driver 2001) by supporting continuous improvement at individual and organizational level and management of existing knowledge (Argyris 1977; March 1991; Appelbaum and Goransson 1997) as well as development of a learning culture to let organizations become more empowered and team-oriented (Cooper et al. 1992; Michelman et al. 1999).

Try to keep implementation process as simple as you can otherwise employees will get irritated. You must have enough resources and time to get ABC success. ABC/M success relates with top management support, training of staff, availability of resources required to implement this system, performance evaluation and compensation systems (Cinquini and Mitchell, p, 66; Shields 1995; young 1989).

Dogan and Sahin (2003) suggest the use of ABC in vendor selection by choosing supplier who minimizes total additional costs that relate to purchase decisions. The affiliation between supplier and purchaser is always critical. Changing customer preferences, environmental concerns, globalization and governmental regulations have great impact purchasing decisions (de Boer et al. 2001). Determination of selection criteria depends on the requirements of the firm and level of success of selection criteria to accomplish these requirements (Swift Owens 1995; Brown 1998).

By using ABC for vendor selection process, purchasing company will be able to predict and see internal production costs caused by the vendor, can design different situations by reducing different costs drivers, this system will help vendors to review their strategy by the indication of customer's satisfaction and offers improvement in vendor purchaser relationship (Roodhooft and Konings 1996).

Because of the usefulness of ABC/M, it is not even adopting by manufacturing companies to get competitive advantage but many services organizations (Innes & Mitchell 1995; Innes et. al 2000; Drury & Tayles 2000) and SME's are taking advantage from these management accounting systems.

Gunasekaran, Marri, Grieve (1999) suggests the use of ABC in SME's. The implementation of ABC in SME's can help them in improving their financial and non-financial performance. It will help to reduce direct labour components, continuous skill development, reengineering (p, 390) and developing positive attitude of workers that contributes toward successful implementation of operations (Sage and Fox 1989). Chan, Keung and Chung (2000) conducted a study to invoke an empirical approach with the help of which we can design an ABC template to use it as a tool for easy integration in an SME environment.

No doubt ABC was first designed to fulfill the cost management needs of manufacturing and industrial organizations but researches soon realized that they can also apply this system in services sector. Kaplan (1994) documents that since 1980's many firms working in services sector e.g. banks, hospitals and logistic companies had already developed their costing system similar to ABC. It means there was also a need for ABC like system in services organization which tells true and accurate costs. By implementing activity-based costing technique in English hospitals and British National Health system (King et. Al, 1994), to intellectual and business activities of university setting (Granof, E. Platt, Vaysman, 2000), libraries (Snyder and Davenport, 1997; Ellis-Newman 2003), sport organizations (Dimitropoulos, 2007) and for planning and controlling day surgery unit activities of hospitals (Antikainen, Roivainen, Hyvärinen, Toivonen, Kärr, 2005), firms can easily achieve strategic objectives.

ABC is likely to be adopted by larger firms than smaller ones because of having diverse mix products or services (Roztocki and M. Schultz, ). If organizations with diverse products and services use single cost driver to absorb high overheads, may distorts its cost estimates (Cooper and Kaplan, 1988).

Initially ABC was used only by manufacturing companies and industries and many researchers discusses it's usefulness in marketing decisions. Stevenson et al., (1993) introduces ABC as a powerful toll for business marketing decision makers with emphases on the effect of ABC on productivity measures.

John C. Lere (2000) states the importance of manufacturing costs in considering price negotiations The information provided by ABC captures the differences among customer's orders and helps industrial marketing decision makers to understand the influence of possible changes in customer's specification on manufacturing cost.

Feature of ABC is its recognition that cost does not only vary with volume but it can also vary with some other activities i.e. unit-level activities, Batch-level activities and Product-level activities (Cooper, 1990).

Steve R. Letza and Ken Gadd (1994) examines the use of ABM with TQM in total quality organizations to identify their common features and compatibility as management tools. They stated that by using the accounting information generated by ABC, TQM can evaluate costs effectively.

Charles Praker (2000) comments on the use of ABC and balanced scorecard as the more modern approaches to performance measurement as it helps a lot in making judgments and decisions. We use ABC data as input to measure performances.

Methodology

This study is based on documentary analysis and based on secondary level. Extensive literature has been reviewed to arrive at the conclusion with regard to the significance and application of ABC in different organizational settings. Work of different researches helped us to gather information regarding usefulness of activity-based costing in manufacturing and services organizations. For that purpose a number of 36 research articles written by various authors and published in various research channels in different countries were studied. These authors belong to various countries. The common findings are generalized henceforth. Finally a conclusion was drawn.

Findings

Cagwin & Bouwman (2000) reported that there is a positive association between activity-based costing and improvement in financial performance when we use ABC with new manufacturing techniques and methods such as total quality management (TQM) approach, just-in-time (JIT) manufacturing methods, flexible manufacturing systems (FMS) etc. Gunasekaran, Marri, Grieve (1999) also supported this fact.

Gunasekaran, Marri, Grieve (1999) presented the fact that there is a positive relationship between usefulness of ABC and sophistication of technology, if u do not upgrade your technological resources you have to bear huge costs of data collection and processing. Sohal & W.C. Chung (1998) and Cagwin & Bouwman (2000) supported this fact.

Horngren (1977) argued that there are some hidden factors that influence the industrial and manufacturing expenses, if u want to increase managerial and production efficiency you have to deal with those factors very carefully. Traditional costing technique has failed in dealing with those factors. Activity-Based costing is a technique which helps us in finding the way to reveal those factors. Miller & Vollman (1985), Johnson & Kaplan (1987) and Johnson, H. T. (1990) supported this argument.

Driver (2001) reported that ABC facilitates adaptive and generative learning by continuously improving existing knowledge of individual employees and mangers in organizations and developing learning culture within organizations. Argyris (1977), March (1991), Appelbaum and Goransson (1997), Cooper et al. (1992), and Michelman et al. (1999) supported this fact.

Now mangers are taking interest in the use of ABC in vendor selection process. By carefully choosing supplier with the help of ABC can minimize total additional costs which relate to purchase decisions. Dogan and Sahin (2003), de Boer et al. (2001), Swift Owens (1995) and Brown (1998) support this fact.

Because of the usefulness of activity-based costing, many services organizations such as hospitals, universities, libraries, sport organizations, banks, logistic companies etc. and SME's are adopting this new costing technique to improve their financial and non-financial performance by reducing direct labour components, continuous skill development and reengineering. Kaplan (1994), King et. Al (1994), Antikainen, Roivainen, Hyvärinen, Toivonen, Kärr (2005), Granof, E. Platt, Vaysman (2000), Snyder and Davenport (1997), Ellis-Newman (2003), Gunasekaran, Marri, Grieve (1999) and Sage and Fox (1989) support this fact.

Usefulness of ABC in marketing decisions, importance of manufacturing costs information provided by ABC in considering price negotiations, use of ABC and balanced scorecard as the more modern approaches to performance measurement, use of ABM with TQM in total quality organizations as management tool and usefulness of ABC in firms having diverse products, services and processes let managers think that activity-based costing is the most appropriate costing technique in modern manufacturing and services environment than traditional costing techniques. Stevenson et al. (1993), John C. Lere (2000), Charles Praker (2000), Steve R. Letza and Ken Gadd (1994) and Cooper and Kaplan (1988) support this fact.

So all the authors irrespective of culture are of one view that activity-based costing is from pain to joy.

Conclusion

From all of the above discussion and findings, it is concluded that there are many issues which cannot be dealt comprehensively and meaningfully with the help of conventional accounting techniques. Traditional accounting has failed to address these issues in depth and in accordance with modern manufacturing which lead to the invention of a more improved and progressive accounting approach i.e. ACTIVITY-BASED COSTING. Many manufacturing and services organizations are increasingly adopting this new technique to improve their financial and non-financial performance, pricing decisions, marketing decisions and purchase decisions because of the growing importance of costs in decision making purpose.

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