Typically Cost System Can Be Classified As Direct Costing System Accounting Essay

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Critical views about activity based costing system

Activity based costing system, which developed in the late 1980's, is a relatively new technique of management accounting. It is considered to provide more accurate cost information for managers, but there are also some arguments against it. In this essay, this new technique will be critically evaluated, firstly by discussing the shortcoming of previous traditional costing system compared with activity based costing system, which may cause spreading of inaccurate cost information. And then it points out how this new technique tried to solve the problem accrued in traditional technique and how activity based costing system innovated the costing system by its new mechanics, with more accurate cost information. However, because nothing can be exactly perfect, in the end of this essay, the limitations of the activity based costing system, which may result in misleading the managers with possible inaccurate cost information, will also be disclosed.

Generally, cost information, especially the accurate cost information, is one of the most significant determining factors for decision-making in the firm. As what said by Cooper and Kaplan, "decisions about pricing, marketing, product design and mix are among the most important ones managers make. None of them can be made effectively without accurate knowledge of product costs (Cooper and Kaplan, 1988)". To obtain cost information, a cost accumulation system is required to be designed to cope with completed production costs and enable costs to be allowed to products in an acceptable manner. Therefore, there are needs for a cost accumulation system in generating relevant cost information for decision-making (Drury, 2008).

Typically, cost system can be classified as direct costing system, traditional absorption costing system, and finally activity based costing system (Drury, 2008). Direct costing system only assign direct costs to cost object, which could cause problems with the indirect cost information. Different from the direct costing system, traditional absorption costing system allows the assignment of indirect cost, and it try to solve the problem by using an overhead rate (factory wide), which most of them were based on a single production volume based measurement like direct labour hours or machine hours. It is useful and satisfied the firms during the previous period only when distortions from allocating factory and corporate overhead by burden rates on direct labour were minor (Cooper and Kaplan, 1988).

However, unfortunately, it could not be applying to development of technology, and the growing of the firms, where they were producing wider and more diverse product ranges, and the input of labour to the production process was declining compared to the start of the century (Cooper and Kaplan, 1988). It is the change in technology and the production process that made it more difficult to trace production costs to product lines, with the use of traditional costing system. As the main the function of traditional costing system is inventory valuation, traditional method ignores costs of activities outside the plant by only assigning indirect cost (also could be called overheads) directly to products rather than to activities, which causes problem of reporting inaccurate cost information.

As overheads, for example, marketing, distribution, engineering, factory support operations, and other overhead functions gradually become the major source of cost in most manufacturing companies, the traditional cost system is obviously no longer be suitable for the new environment, because it only simply tends to group all overheads and assigning them to products on the basis of volume of output. Additionally, traditional system seems not to indicate the reasons why the cost is happened to the firm, therefore, when the firm slash overhead costs, it is cutting the result, but not the cause (Peter and Turney, 2000). As a result, it is more likely to damage the quality of products and services than to reduce costs permanently.

Therefore, in the late 1980's, accountancy profession in the world begun to consider a new alternative costing system to avoid the shortcomings of the traditional product (goods or services) costing system. The answer suggested to this phenomenon, mainly by Cooper and Kaplan, was to apportion costs according to the extent to which products (goods or services) actually 'consumed' the time, activities, and costs of the various divisions of the firm which 'serviced' their production, and they referred to as 'activity based costing system' (ABC system). The logic of ABC system is that more finely structured activity-cost polls with activity-specific cost-allocation bases, which are cost drivers for the cost pools. And this new technique is considered to offer more accurate product costs, through the method of allocating costs to products by measuring the cost-allocation bases of different activities used by different products.

According to Cooper and Kaplan, the main theory behind this activity based costing system is that all of a company's activities should be considered product costs, as they exist to support the production and delivery of today's goods and services. And since nearly all factory and corporate support costs are divisible or separable, they can be split apart and traced to individual products. Consequently, based on the analysis above, activity based costing system provides an alternative and more accurate way of assigning indirect costs to products and services.

ABC system establishes a relationship between common expenses and the activities which generate these costs, and perceives shortcomings of traditional costing system of dealing with overheads (Innes and Mitchell, 2000). Figure 1.1 shows how the activity based costing system designed to provide product cost information. The first step of establishing the ABC system is to identifying the major cost activities that taken place in a firm. Then by given the activities that have been identified, cost drivers should be chosen in the next step. With ABC system, cost drivers are based on the level of activity at the firm's capacity rather than on the budgeted level of production as in traditional system, therefore, the ABC system could accurately measure the various products' consumption of activities. The third step is to create cost pool for each activity in ABC system. This stage of generating cost pools for the core activities could help firms looking for opportunities to improve their practices and could, in turn, lead to the potential for cost reductions. Finally, activity costs are attributed to cost objects based on cost driver rates, which are calculated by dividing a period's activity costs driver volumes, and the accurate cost information could be passed to the managers for decision-making.

Tracing to products

Creating cost pools

Determining cost driver

Indentifying activities

Figure1.1 the basic mechanics of an ABC system

By establishing such a technique, ABC system firstly innovate costing system with more accurate cost information by assigning costs according to the activity based on measurements of resources used (Innes and Mitchell, 2000). Figure 1.2 given below more visually indicates that how ABC system creates a different method for coping with overheads, avoiding the shortcoming of traditional costing system. In stage 1, overhead costs are charged to activity based cost pools in ABC system, instead of classifying overhead cost by production departments (in traditional system), which is more properly linked relevant cost with its products. ABC system relies on a greater number and variety of cost drivers, in other words, ABC system uses both volume-based [1] and non-volume-based cost drivers, which could also be called activity cost driver based rate [2] . Because using only volume-based cost drivers to assign non-volume related overhead costs can result in the reporting of distorted product costs. Consider an example of one activity - setting up a machine. Set-up resources are consumed each time a machine is changed from one product to another. As more set-up resources are consumed, the number of set-up, rather than the number of units produced, is a more appropriate measure of the consumption of set-up activity (Drury, 2008). Moreover, as shown in the stage 2, with ABC system, costs are assigned to cost objects based on their use of activities and use activity cost driver based rates, but not according to simple volume based overhead rates (Innes and Mitchell, 2000). As the multiple specific cost driver rate is more accurate than singe volume-based cost driver rate, therefore, managers could get more accurate cost information under ABC system.

Traditional costing system

Stage1: overhead departmentalisation Stages2: Tracing to products (by absorption rates)

Production volume based tracing cost into



Departments overhead rates products lines

Activity based cost system

Stage1: overhead cost pooling Stage2: Tracing to products (by cost driver rates)

Activity based activity cost tracing costs into

Cost pools driver based rates product lines



Figure 1.2 Difference between ABC system and traditional system in treating with overhead cost

Secondly, ABC system innovates costing system with more accurate cost information where costs are assigned to cost objects (Peter B. and B. Turney, 2000). ABC system assigns activity to cost objects based on the activity drivers that accurately measure consumption of the activity. An activity driver is a measure of the consumption of an activity by a cost object (such as a product). As a result, the ABC system corrects the inaccuracy of the traditional system by choosing the activity driver that could accurately measure cost consumption by each product.

In a sum, based on the discussion before, it could be confirmed that ABC system is generally superior to traditional costing system, reporting more accurate product cost information by its innovation. To begin with, it occurs because ABC system have a better understanding of what factors drive overheads, by using more activity drivers and more types of activity drivers (Innes and Mitchell, 2000). ABC system points out the fact that many overheads, conventionally classified as fixed costs (such as purchasing, and set-up), are in fact susceptible to variation, not in response to volume changes, but in response to changes in the activities which cause their incurrence. ABC information, which clearly links these overheads to the underlying resource consuming activities through the selected cost drivers, pinpoints how such influence can be exercised through decisions which affect the cost driver volume. Thus the manager are provided with a greater overhead cost visibility, a clear indication of overhead cost causality and can therefore exercise more effective process cost control (Innes and Mitchell, 2000). This could be concluded as a key benefit of ABC system and an important evidence for why ABC system providing more accurate cost information.

Additionally, by knowing that what activities costs helps in identifying important activities-those with greatest potential for cost reduction, this new method of activity cost could also allow managers to model the impact of cost reduction actions and to subsequently confirm that saving were achieved(Innes and Mitchell, 2000). Consequently, ABC system seeks to help firms gain more competitive advantages through better overhead cost attribution in a rapidly changing business world, and enables better control of overhead costs, and thus enhances the value for money, through greater understanding of the factors that drive them, at the same time, refreshing management accounting by its development.

In addition, by providing more accurate and detailed product information and process costs, ABC system as a valuable accounting pool, can be utilized by management in decision-making process(Innes and Mitchell, 2000). It enables better marketing and investment decisions as a consequence of more accurate and reliable product costs; and it is able to help managers to make better-informed management decisions concerning the real product pricing, product volumes, market segments, product lines, and target costing. As a result, ABC system exerts a far-reaching impact on management accounting of firms, and latterly use of ABC has shifted more form product costing to helping management with a better understanding of costs and facts that influence these costs, which can be listed as following.

ABC system could lead to improvement of the decision-making in the firm, especially, for the long term decision. Kaplan, Cooper, and Shank all link ABC system to the support three key areas of strategic decision-making within the firm: first, because of the greater accuracy of product costing brought by ABC system, it enhances reliability of the cost information, helping the firm to determine reasonable price for their products in order to intensify market competition; second, it improves the decision-making by changing the products range and mix through the promotion, demotion and discontinuance of existing lines; third, it could have effective influence on the development and design of new products. In addition, when use in ABC information will be the top managerial policy and therefore, there is the indication which it gives of long-term variable cost (Johnson and Kaplan, 1987) which is the most relevant cost information for long term decisions.

However, despite of the advantages of ABC system, there are still some limits to ABC system's ability to report accurate product costs, in other words, under some situation, ABC system may not really provide mangers with accurate cost information. The problem accrued because there are always some activities not directly associated with products or customers. Activities that sustain a plant, for example, are very difficult to assign to the products. Such activities may include cleaning, securing, and landscaping the plant ect. It is fairly easy, however, to assign cost to these sustaining activities. The cost of an alarm monitoring service, for example, can be assigned directly to the plant security activity. The cost of a landscaping service can be assigned to the landscaping activity. But we cannot assign the cost of these activities to products directly. We do not landscape products, and it is not possible to obtain information about the landscaping cost of each products. (Peter and Turney, 2000)

Not only the activities directly associated with products may cause problem in the accuracy of cost information, some other problems with ABC system could also increase the possibility of reporting inaccurate cost information. ABC information is historic and internally orientated and therefore lack of direct relevance for future strategic decisions. With the ABC system, the basic cost information is derived from traditional accrual based costing procedures. The end product, as a result, may suffer from the arbitrariness of temporal allocations such as depreciation and development. (J.Innes etc, 2000) And another problem accrued with ABC system may affect the accuracy of cost information is the selection of cost drivers. Sometimes it is difficult to find drivers with a direct relationship to each overhead cost. There is a doubt that whether even a very detailed division of costs into a large number of cost pools will ever achieve a perfect homogeneity within each pool.

As a result, after the popularity of ABC system in the 1990s, in the following decade, many surveys reported usage rates of ABC was about only 50 percentages. However, according to a recent survey about 384 manufacturing and service companies worldwide taken by Williamson Stratton ect., the ABC to continue to offer firms important value from strategic and operational perspectives.(Williamson Stratton,2009)

In a conclusion, although, ABC system seems to have some problems in identifying activities and selecting cost drivers ect. , it still benefits the firms by providing more accurate information for product pricing, at the same time including more accurate profitability analysis and improvement of cost control ect. And activity based costing system continues to be a logical, acceptable and comprehensible basis for costing work.