Introduction To The Activity Based Costing Accounting Essay

Modified: 1st Jan 2015
Wordcount: 2105 words

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“Traditional managerial accounting is at best useless, and at worst dysfunctional and misleading.” (Shank, 1994)

The Relevance Lost: The rise and fall of Management Accounting published by Theodore Johnson and Robert Kaplan in 1987 marked as the revolutionary criticism of the traditional costing system. Traditional Costing System was developed in early 20’s when companies were almost 99% labour intensive (Kidd, 1994), no automation (Jan Emblemsvag, 2008) and production processes were austere.

Significant changes in most manufacturers’ product market and production technology demand more accurate cost allocations (Krumwiede and Roth 1997) and focusing more on labour productivity may not be the best solution for the present day manufacturing and service organizations (Gunasekaran et al, 1999).

It was hailed as the beginning of change for the better in the world of accounting (Sharman, 2003). In the notoriety book, their disparagement was centred on the passé cost allocation technique that distorts production cost for decision-making purposes. Instead of providing solutions to management, traditional costing system had failed in predictable ways (Daly, 2010).

Activity Based Costing

In 1988, Cooper and Kaplan disseminated the Activity Based Costing (ABC) system to overcome hindrances and the “peanut-butter spreading” cost allocation of traditional costing system. Gunasekaran and Sarhadi (1996) (Vol 1_1_4) found that the development and endorsement of ABC had been stimulated and largely persuaded by Cooper and Kaplan especially in the manufacturing sector. It is arduous to find an academic or practitioner journal that does not talk about ABC in the accounting world and it soon it began to widely spread to the non-manufacturing sector.

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It was perceived to be the solution to the management accounting needs of organizations (Sharman, 2003). It was also said that Activity-Based Costing is clearly the most significant managerial accounting development (Harrison & Sullivan, 1996). In fact some have portrayed it as cure-all for all kinds of problems (Doost, 1997). Since then ABC plays a significant role as a management tools and gained its popularity to the academicians, practitioners and industries.

ABC was initially designed by George Staubus in the United States during the 80’s. ABC was promoted as a system that would reduce the level of arbitrary cost allocations associated with traditional costing systems and result in more accurate product costs (Baird et al, 2004). Many authors often depicted ABC to one simple and powerful word which is accurate (Cooper and Kaplan 1988; Dugdale, 1990; Innes and Mitchell 1991; Morrow, 1992; Bhimani and Piggott, 1992; Turney 1996; Krumwiede and Roth 1997). Accuracy in product costing is vital particularly in making decision and also in alleviating organization in cost reduction and profitability purposes. Inaccuracies created by improper allocation of costs can lead disastrous pricing, product profitability and customer profitability management decisions (Hardy et al, 2002). (Working paper series 2004)

The core of ABC is the activity concept (Turney 1991). According to Turney (1996), ABC is a process which assigns costs to product according to the activities and resources consumed or generally a method of allocating indirect costs to cost objects. Cost drivers and cost activities are the terms synonymous to ABC. ABC enhances cost allocation by using smaller cost pools called activities (Wegmann, 2010) and costs are then traced to these activities by keys called cost drivers (Cooper, 1990).

Gunasekaran et al (1999) stated that the ultimate goal of ABC as a cost allocation system is to trace the production costs generated by the production of a good or service, as accurate as desired, to the causing activities. ABC is not only basis for computing accurate product costing, but it plays a vital role in management in managing costs.

The 1980s is seen as the advent and widespread use of management philosophies such as Just-in-Time (JIT), Balanced Scorecard, Total Quality Management (TQM), and Theory of Constraint (TOC). Huczynski (1993) described it as the age of the management guru. The appetite for new forms of managing is strong and ABC is quickly recruited to feed it and soon after, ABC evolved from a cost allocation method to a management philosophy (Jones and Dugdale, 2002). Two reputable systems which was derived from ABC philosophy was Activity-Based Management (ABM) and Activity-Based Budgeting (ABB) (Cooper and Kaplan, 1998).

Second Phase of ABC: Activity-Based Management

Johnson (1988) argued that companies should manage activities alongside with the costs based on the relying principle of ‘activities consume resources and products consume activities’ and this was supported by Ostrenga (1990). As discussed, ABC system was initially presented as new way to establish more accurate product costs compared to the traditional costing system. However, ABC soon began to enter its second phase, in which it became known as Activity-Based Management (ABM).

The second phase of ABC is perceived to be the rational development of ABC, in which it focuses on the management of indirect activities, at various levels beyond direct productions and activities where it still continues to draw its back on the existing ABC. This development is regarded as an improvement to the value received by customer and the profit achieved. Johnson (1988) still maintained and applies the existing ABC rules where the activity-based information would focus managers’ attention on underlying cost drivers and profit unlike the distorted cost provided by traditional costing system. This influenced Turney (1992) where he voiced a similar opinion and suggested that ABM system seek two goals, which are common to organizations which can be reached by focusing on managing activities. The first is to improve the value received by customers and the second is to improve profits by providing this value.

Activity-Based Budgeting

In today’s arduous economic environment with the growing inflation rates, shrinking sales volumes and rocketing business expenses, the Activity-Based Budgeting (ABB) system could be a safeguard in stabilizing and strengthening an organizations’ operation (Pockevi

iÅ«tÄ-, 2008). Countries worldwide then began to practice and implement such strategy into their organizations.

ABB is developed based on the management philosophy of activity-based costing (ABC), which is considered to be similar to zero-based budgeting (Shane, 2005) and it measures how members of an organization allocate their effort among activities performed and effortless to design. Pockevi

iÅ«tÄ- (2008) conducted a study and tested ABB on the agricultural sector in Lithuania. With an ABB system in place, major constraints can be identified while maintaining the future operations of the organizations. It can measure the efficiency within an organization process with a clear picture and understanding by linking all the individual budgets and the department in the organization. ABB is also known for its exposure of non value costs where waste can then be eliminated to reduce cost.

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ABC’s pitfall and Time-Driven ABC: A new ABC development?

Despite much attention on the ABC model since the appearance in the 1980s, interest gradually decreased during the 90s (Gosselin, 2006). ABC slowly began to experience its pitfall. As the global competition increases, the need of efficient and effective tools to fit business strategy are greatly in demand and ABC gradually went into the accounting world’s slump. Gosselin (2006) argued that ABC failed to succeed in practical use in today’s management practices; this was also supported by few authors such as Ã-ker and Adigüzel (2010) and Velmurugan (2010).

Gosselin (1997) began to argue that a so-called ABC-paradox existed. Despite the various articles published in journals, books, and its involvement in the academic world and also being endorsed by consulting companies, it is quite ironic of how implementation of ABC is still relatively low. Innes and Mitchell was the first few to conduct surveys on the implementation of ABC in companies in 1995, their studies showed that only 21% adopted ABC in the UK. Bjornenak (1997) followed their footstep by conducting surveys in Norway and found that 40% implemented ABC in their companies whereas in the other part of the world such as the Australia, Ireland, the US, Dutch and Italy reportedly to have 12.5%, 11.8%, 17.7%, 12%, 10% respectively (Nguyen and Brooks, 1997; Clark et al, 1999; Groot, 1999; Cinquini et al, 1999).

Many large companies, which tried to implement ABC in the 90s, abandoned it due to change in competitive circumstances and the birth of new and develop management tools.

Many of those who argued that ABC, although effective in allocating cost, it does not necessarily contribute to the overall effective of business decisions (Fladkjær and Jensen, 2011). The information provided by ABC may be extraneous and not as accurate as most users believe. ABC is also regarded as not necessary for most companies’ systems (Fladkjær and Jensen, 2011). Kaplan and Anderson (2007) brought up the case of Hendee Enterprises which is a Houston-based manufacturer of awnings where they argued that the ABC software took three days to calculate costs for the company’s 150 activities, 10,000 orders and 45,000 line items (Wegmann, 2010).

In 2003, Kaplan started to redesign the ABC system when many argued that it is too complex and time intensive to implement. This has led to the much anticipated new approach of ABC, the Time-Driven ABC (TD-ABC). He claims that the new ABC development, TD-ABC, reveals excess capacity, processes faster, able to provide high accuracy and can be well supplied from existing IT-systems, such as ERP (Kaplan and Anderson, 2007). Kaplan (2007) went again to argue that TD-ABC skips the activity-definition stage and hence the allocation of costs to multiple performed activities.

They also argued that TD-ABC is a simplified version of the current ABC system at that time (Everaert & Bruggeman, 2007; Everaert et al, 2008; Kaplan & Anderson, 2004; Max, 2007; Ã-ker & Adigüzel, 2010). This was also supported by Demeere et al (2009) and Wegmann (2010) where TD-ABC is hail to be an improved activity-based costing system compared to its previous development.

TD-ABC differs from the existing ABC system where the time estimates require to calculate driver rates can be obtained by direct observation or by surveying managers (Kaplan and Anderson, 2010). This saves time and is able to reduce the cost of implementation and updating the system. He further argued that managers are considered the more reliable source concerning accuracy of information on time consumption and activities compared to existing ABC system where information are derived from employees who tend to be bias. Consequently, with TD-ABC, managers are able to generate accurate information and encounter fewer blunders.

Impact of the new ideas on both companies and consultant

Soon after its establishment, TD-ABC began to receive a growing interest among academicians and a growing number from 9 to 67 in the period of 2003 to 2009. This was presented by Google Scholar and since then TD-ABC has shown a positive trend in the online world (Alsamawi, 2010).

Demeree et al (2009) also began to notice the story behind TD-ABC and tested TD-ABC at an outpatient clinic.

For instance, Demeree et al. (2009) implemented TD-ABC at an outpatient clinic. They have gathered data through direct observations and interviews with department heads and outpatient clinic managers. To register different time consumptions for relevant activities a stopwatch was utilized. This process was repeated 3 months later to ensure that consistent results were obtained. This data gathering method was recorded as a success.

Other authors point out that TD-ABC brings conceptual shortcomings connected to the use of time estimates (Cardinaels & Labro, 2007). Gosselin (2007, p.649) concluded that TD-ABC is the most recent development in the field of activity-based costing methods, but “does not solve the conceptual problems inherent to ABC”.



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