Importance of cost accounting systems (intro?)
Nowadays, global competition forced manufacturing organisations to become more
flexible, integrated and highly automated to increase productivity at reduced costs.
Impossible to sustain competitiveness without accurate cost calculation mechanism
(Ozbayrak et al 2004 as cited in Akyol et al 2005)
Though cost accounting systems do not usually rank high in organisational hierarchies,
the information they generate plays a major role in the decision making process and has
crucial influence on organisational performance: sometimes used to determine product
prices and product mix, to decide on outsourcing or off-shoring activities, investments
etc. (Geri and Romen 2005)
Mismatch between perceived importance of cost systems and their impact on
organisational value (Geri and Romen 2005)
Goal of any cost management system is to provide relevant and timely information to
management – supports better management of corporate resources in production or
provision of services, improves competitiveness in terms of cost/ quality and
profitability. Is a planning and control management system (Berliner and Brimson 1988)
(Babad and Balachandran, 1993 p. 563)
What else to do other than ABC (conclusion?)
- As a further work, Balanced Score Card (BSC) implementations can be performed. The
existence of the ABC database is an advantage for BSC applications since its financial
phase recommends an ABC implementation. Kaizen applications and BSC can give the
firm great advantages in the short and long run under the scope of ABC. (Akyol et al
2005)
Only by combining extensive knowledge of revenue drivers with traditional analysis of
cost drivers can the full benefit of quality-related ABC concepts be realized (Ittner 1999)
ABC been extended to ABM, therefore ABC is the information system that reveals the
cost and profitability structure of products and services in the organisation, while ABM
describes the actions taken to improve quality and lower costs and cycle time, once
information about activities costs is known. (Babad and Balachandran p.563)
-
Don't abandon ABC – after all it has helped many companies identify important cost and
profit enhancement opportunities through the repricing of unprofitable customer
relationships, process improvements on the shop floor, lower cost product designs and
rationalised product variety. (Kaplan and Robertson, 2004 p. 132-133)
-
Potential for ABC on a larger scale = huge opportunity for companies. (Kaplan and
Robertson, 2004 p.133)
-
Simplification now possible in time-driven ABC where mangers directly estimate the
resource demands imposed by each transaction, product or customer. (Kaplan and
Robertson, 2004 p. 133)
-
More accurate cost driver rates by allowing unit times to be estimated even for complex,
special transactions. (Kaplan and Robertson, 2004 p.133)
-
Easily update time-driven AC models – simply estimate the unit time required for each new
activity, and easily update cost driver rates. Updating ABC on events rather than on the
calendar, is a much more accurate reflection of current conditions. (Kaplan and Robertson
2004 p. 134)
-
Can accommodate the complexity of real world operations. (Kaplan and Robertson 2004
p.134)
-
Time-driven ABC – facilitated an open trusting relationship between supplier and competitor
(differentiates from other competition) (Kaplan and Robertson, 2004 p.136)
-
Transparent, scalable methodology that is easy to implement and update. Draws on existing
databases to incorporate specific features for particular orders, processes, suppliers and
customers. No longer expensive, complex implementation.(Kaplan and Robertson, 2004
p.138)
-
Provides managers with meaningful cost and profitability information quickly and
inexpensively. (Kaplan and Robertson, 2004 p.138)
Facts
ABC adoption rates 18% in UK in 2000 (Innes et al 2000) – cost reduction most widely used
application. (p. 368) (Drury 2006) (Innes et al)
In 1995 Australian Society of CPAs initiated a major survey on ABC amongst ABC manufacturers.
Conducted by the University of Technology, Sydney involved 213 firms. (Corrigan, 1996; Wood,
1996) – 12% of firms had adopted it – they believed they had achieved five goals: more accurate
product costing, better cost management, best cost control, better allocation of overheads and
more accurate cost information. (Sohal and Chung, 1998 p. 139)
Corrigan (1996) undertook a similar survey as above in the USA by the Institute of Management
Accountant – much higer level of implementation amongst American firms: 41% already using it,
and 33% believe they should be (Sohal and Chung, 1998 p. 139)
-
The Gartner Group estimated that between 20 and 50% of global 1000 firms have
adopted ABC (Turney, 2008 p.7)
Firms still use traditional costing
Despite the praise heaped on it by academics and management consultants, in practice,
most firms still use traditional accounting systems, even though their faults are well
known. (Garg et al 2003 and Innes et al 2000)
Most firms that tried ABC ultimately decided to abandon it, but regarded
favourably,(Cooper and Kaplan 1991 as cited in Geri and Romen 2005)
because ABC involved thorough analysis of processes and costs and Drew attention to
neglected aspects of organisational activites, which resulted in improvements. However
once managers internalised these lessons, they no longer require complex cost data to
make improvements, and used non-financial measurements instead. (Geri and Romen
2005)
It suggested that many firms have not implemented an ABC system because most of the
benefits are found in the cost driver analysis. Organization would prefer to take actions
to reduce the effects of the drivers instead of using them to allocate indirect cost.
(Gosselin 1997)
Cobb et al. (1992), suggest that the major problem experienced with ABC relate to the
lack of adequate internal resources, particular staff time and computer resource (Cobb
et al 1992 as cited in Malmi 1997)
45% of 1995 Australian Society of CPAs survey had never even considered adopting it
(eventhough 88% of those surveyed had heard of it) and 14% had thought about it and declined
it – this was because of uncertainty of benefits and the hig cost relative to perceived benefits, or
they had more important priorities (Sohal and Chung, 1998 p.139)

Cobb et al (1992) followed up on a survey done by CIMA in 1990 to find out the problems
they percieved or experienced with ABC. Telephone interviews with 30 of the 62 firms who
were considering ABC and they also visited 12 companies who had implemented ABC and 2
of which had then rejected it. The aim was investigate problems and issues involved in
adopting ABC. 20 of the 30 were still considering implicating it. The main issues were:
amount of work installing an ABC system, particularly for small companies (15 out of 20
companies), competing uses of resources which were given a higer priority than ABC,
suitable accounting staff resources ( a lot is needed) to install ABC system, computer
resources and the difficulty of selecting suitable cost drivers. The two who had rejected ABC
said data collection was difficult and the time involved for the accountants, the cost of
implementing and running an ABC system was considered to far exceed the benefits which
would be generated. Great retraining needed of both accountant and computer staff. (Sohal
and Chung, 1998 p.140)
Traditional costing firms less competitive
Over time, TCMS based manufacturing firms have become less competitive unless the
top management has relied on operational performance measures (such as interval,
defects, etc.) in addition to cost (Ballakur 1991)
Both systems adopt two-stage allocation process
ABC – assign overheads to each major activity, then trace to individual products
Traditional – allocate overheads to production departments, then trace to individual
products p.277 (Drury 1994)
Traditional cost accounting – advantages
Mandatory GAAP principle for external financial repoting (need to use absorption
method) (Geri and Romen 2005)
Integrating financial and managerial accounting systems ensue better costing control
(Geri and Romen 2005)
Does not underestimate the importance of fixed costs (p. 225) (Drury 2006)
Avoids fictitious losses being reported (fixed overheads deferred and included in the
closing inventory valuation, and recorded as an expense only in the period that goods
are sold. Logical profit calculation). (p. 225) (Drury 2006)
Justify absorption: Fixed overheads are essential for production. (p.225) (Drury 2006)
Absorbs overhead to determine a “full” cost per unit, especially for sell price is to be
based on cost .p.122(Alan 1998)
-Designed primarily to provide unit product costs for external reporting purposes P.298
(Willie et al 2006)
-Aims to properly value stocks and COGS for external financial reports. P.298 (Willie et al
2006)
 Traditional costing system: Maintains one big overhead pool with a single activity
rate. The single activity is easy for data gathering, storing and processing (Babad
and Balachandran, 1993 p. 564)
 Decades ago when companies had a narrow range of products, cost of direct
labour and materials were the most important production factors this system
was satisfactory as can be traced easily to individual products. Distortions from
allocating factory and corporate overhead by burden rates on direct labour were
minor and expense of collecting and processing data made it hard to justify more
sophisticated allocation of direct costs. (Cooper and Kaplan 1988 p.96)
Traditional cost accounting – disadvantages
General
-
Can be as wrong as 200% using traditional techniques of the actual demand
a product makes on organisational resources. (Cooper and Kaplan 1988 p.
100)
-
Should not treat selling, general and admin expenses to just period expenses ( these exceed
more than 20% of total revenues). This is known as 'below the gross margin line' treatment.
Should be charges allocated to products. (Cooper and Kaplan 1988 p.100)
-
Can lead to a 'death spiral': a downturn in forecast demand creates idle
capacity, the cost system reports higher costs which leads to management
raising prices and less demand and still higher capacity costs. (Cooper and
Kaplan 1988 p.102)
Case study:
Cost savings were able to achieve within manufacturing plant through its programme of
“continuous improvement”, but under absorption rate this were lost within the overall
recovery rates and not reflect through into specific products. (Bhimani and Pigott 1992)
focus on responsibility accounting and accurate tracing of costs to cost centers -such
reporting fails to provide the accurate, timely, operational, process focused , teambased measurements needed to drive continuous improvement and learning p.41(JEAN
BOOK)
-
Had unintended negative strategic and operational consequences (T urney, 2008 p. 3)
-
EG. Tektronix – allocated manufacturing overhead to products based on direct labour, which
encouraged engineers to design products that required less labour to manufacture. This
design directive increased the complexity of the product and the number unique parts in
each product. It also increased the cost of purchasing, receiving and stocking thousands of
different parts, thereby reducing profitability and ultimately competitiveness. (Turney, 2008
p.3)
focus on the performance of isolated and unlinked tasks machines and individuals, and
concentrate on controlling costs to preset standards, not making continuous
improvements in quality, cycle times, and actual costs. (JEAN BOOK)
-
Measuring and managing the operating expenses of most organisational
resources as fixed in the short run does not give much insight as to why the
resources were acquired, what the resources are currently being used for, and
the level of resources that will likely be required in the future. Cooper and
Kaplan, 1992, p. 2
-
Volume variances used in traditional systems reported only in aggregate financial terms
as does not identify the quantity of overhead resources supplied or used. (p.3) Cooper
and Kaplan 1992
-
Calculated with a denominator volume based on budgeted production, rather than
practical capacity. (p.3) Cooper and Kaplan 1992
-
Allocating overhead with a denominator volume is useful only for inventory valuation,
not to provide relevant information for management. (p.3) Cooper and Kaplan 1992
-
Assumes that factory expenses are used by products in proportion to the overhead
allocation base (proportional to volumes of units produced). (p.4) Cooper and Kaplan,
1992
-
Uses allocation bases that do not represent the demands for support
resources by activities, the volume variance for a period can be zero even
while substantial shortages or surpluses of capacity exist for many
individual activities. Cooper and Kaplan, 1992 p. 4
Unsuitable cost structure
-
Traditional systems: Volume driven allocation bases e.g. Direct labour
dollars, machine hours etc. to assign organisational expenses to individual
products and customers. But many of resource demand of products are
not proportional to the volume of units produced or sold, therefore it
doesn't measure accurately the cost of resources used to design and
produce products and to deliver and sell to customers. (p.1)Cooper and
Kaplan 1992
Created when most products were labor intensive to manufacture and overhead was
not a big proportion of total cost. (Ballakur 1991)
not appropriate where product cost structures have shifted from labor-dominated to
overhead-dominated costs. (Ballakur 1991)
The consideration of choice of volume measure, the case use a machine hour absorption
rate rather than machine hour, this may be true or untrue? Depend on machine
intensive or labour-intensive. p.135-136(Alan 1998)
-
Today, direct labour is a small fraction of corporate costs while expense covering factory
support operations, marketing distribution, engineering and other overhead functions have
exploded. Simplistic approaches no longer justifiable. Accurate product cost information is
crucial to competitive success with global competition and new production technologies.
(Cooper and Kaplan 1988 p. 96)
-
Traditional accounting treats costs as variable only if they change with Short term
fluctuations. Many important cost categories don't vary with short term changes in
output, but with changes over a period of years with customers etc..These costs of
complexity must be assigned to products. (Cooper and Kaplan 1988 p. 97)
No complete picture of costs
The manager does not get a picture of the cost of the activities being done by the
organization. Instead, they are told how much of the expenses went into each resource
category (i.e., people's salary and wages, supplies, etc.) Therefore, traditional cost
systems not adequate to manage expenses and shift resources to enhance revenue.
(Ballakur 1991)
Volume related costs & non volume related costs
Traditional costing assumes that indirect costs are fixed and irrelevant for decision
making (p. 348) (Drury 2006)
Non-volume related costs should not be allocated to the product unit level (Lucas
1997b)
Many product related costs are not driven by the number of units produced per se, but
by the number of batches/production runs undertaken (Lucas 1997b)
Expenses which do not relate to individual products, but to particular customers e.g.
order processing and distribution costs (Lucas 1997b)
general overheads which do not relate to any particular product or customer, such as
the chief executive's salary (Lucas 1997b)
no need (or justification) for any allocation downwards from a higher level, of nonvolume related costs to the product unit level (Lucas 1997b)
based on the received wisdom that non-volume related costs should not be allocated to
the product unit level.
The costs “did not reflect reality” since the accounting system allocated costs purely on
the basis of production scale without any consideration of non-volume factors. (Bhimani
and Pigott 1992)
Failed to account for difference in resource consumption, the net result was that
products were seen to either over of under-absorb overheads and the costs reported.
(Bhimani and Pigott 1992)
Many overhead costs will bear little relationship to volume of output, so absorption cost
can result not only in inaccurate unit costs but also possibly in incorrect decisions by
management. p.152(Alan 1998)
traditional cost systems frequently understate profits on high-volume products and
overstate profits on specialty items (Geri and Romen 2005)
Using only volume based cost drivers to assign non volume related overhead costs can
result in the reporting of distorted product costs. (p. 351) (Drury 2006)
-place too much reliance on unit-level allocation bases such as direct labour and
machine hours, which results in over-costing high volume products and under-costing
low-volume products. P.325(Willie et al 2006)
Always use volume-related allocation base. Some product costs are unrelated to
physical volume (support activities eg material handling & procurement). P.274(Drury
1994)
-Assumes products consume all resources in proportion to their production volumes.
Some product costs are unrelated to physical volume P.274(Drury 1994) -Result in
distorted product costs whenever the costs of some product-related activities are
unrelated to volume. P.279(Drury 1994)
cost system report distorted product cost when cost of non-volume related activities is
significant -> low-volume products tend to be undercosted and high-volume products
overcosted  Traditional system ignore differences in relative consumption of
overhead resources. (Drury 1994, p.274-279)
Absorption rates based on “simple” activity measures such as direct labour or machine
hours may be unrepresentative of complex relationships between support activities and
outputs (Alan 1998, p.161)
Relationship between overhead costs and individual products
rarely reflects the true cause and effect relationship between indirect and overhead
costs and individual products, services, channels or customers. (Cokins 1998)
-no single volume based allocation method could fairly trace indirect costs into the rich
variation of products, service lines and customers. (Cokins 1998)
Arbitrarily allocation of costs (both traditional and ABC)
-non-product related costs will be arbitrarily apportioned, thus resulting in
product/revenue segment costs which are non-decision relevant (Lucas 1997a)
The use of absorption costing requires subjective selection of absorption criteria,
allocation criteria, and volume assumptions (Geri and Romen 2005)
Misleading information
-
Innes and Mitchell (1990): inaccurate product line costs – incorporate product line costs
inaccuracies, fixed/variable segmentation based only on production volume – limited as
cost estimation based primarily on volume changes, high potential for misleading
information, geared to short-run decision analysis (Sohal and Chung, 1998 p. 146)
Companies that use traditional indirect-cost allocations may actually lose money on
certain products and customers, even though their accounting systems report them as
profitable (Cokins 1998)
When such cost allocations overestimate (underestimate) costs for a particular market
segment, firms’ cost systems may report accounting losses (profits) for markets that
actually are profitable (unprofitable). (Eddy 2004)
as pricing and quotation practices usually rely on the same flawed cost, the errors are
perpetuated. (Cokins 1998)
too many of the costs are lumped together in some categories(Cokins 1998)
the average rates selected for many costs tend to be excessively broad(Cokins 1998)
often irrelevant factors are used to allocate indirect costs. e.g product inspection
costs(Cokins 1998)
Traditional costing can produce biased cost estimates in heterogeneous markets
(Cooper and Kaplan 1998 as cited in Eddy 2004)
“the standard costing system was inadequate both in terms of predicting accurate
product costs and also in providing other information which could be incorporated into
a management information package”. ((Bhimani and Pigott 1992)
Misleading information for decision making: rely on arbitrary allocations of indirect
costs, rely extensively on volume based allocations – can over cost high volume
products and under cost low volume products (p. 369) (Drury 2006)
Nearly impossible to end up with a reliable profit of loss with an absorption costing
system, they were designed to ensure that all cost were covered, but were not designed
to give accurate product cost. p.65(Chadwick and Magin 1989)
The division of administration, selling and distribution costs between product/job is an
extremely difficult task (indirect costs). p.70(Chadwick and Magin 1989)
-treat many factory expenses as fixed or period expenses. [These period expenses are
either ignored entirely, as in direct costing systems, or allocated using the same cost
drivers (materials weight, labour hours, machining hours) used to assign variable
expenses to individual products] (JEAN BOOK)
-Idle capacity – predetermined overhead rates computed by dividing budgeted
overhead costs by a measure of budgeted activity such as direct labour hours. This
practice results in applying unused capacity to products p.300(Willie et al 2006)
-ALL manufacturing costs assigned to products, even manufacturing costs that are not
caused by the products. Eg security guard’s wage allocated to all product even though
his wage is totally unaffected by which products are made or not made during a period.
P. 299(Willie et al 2006)
because of large variety of activities encompassed in overhead, and when company has
a range of products that differ in volume, batch size or complexity of production,
overhead will not be correctly assigned, because traditional approach rely on volume as
the factor in allocating overhead cost to products, and assumes overhead is directly
proportional to allocation base. P.300(Willie et al 2006)
- Tradional costing system: Maintains one big overhead pool with a single activity rate.
The single activity is easy for data gathering, storing and processing (Babad and
Balachandran, 1993 p. 564)
Rise of ABC (kind of disadvantage to traditional
cost)
Traditional costing was acceptable, ABC not so viable
ABC was considered as an expensive management project that only large organizations
with extensive resources could undertake (Cokins 1998)
-When cost systems were developed in the 1800s, data relating to direct labour were
redily available and convenient to use, and managers believed there was high positive
correlation between direct labour hours and overhead costs. p.299 (Willie et al 2006)
Traditional costing methods were created when most products were labor intensive to
manufacture and overhead was not a big proportion of total cost. (Ballakur 1991)
Fine when first designed as companies manufactured a narrow range of products and
direct labour and materials were the dominant factory costs. (p. 351) (Drury 2006)
-
Managers and accountants have become dissatisfied with conventional costing
systems and have expressed concerns about their suitability in the modern
manufacturing environment. (Sohal and Chung, 1998 p.137)
How ABC emerged in the late 1980s:
 back then, most companies manufacture narrow range of products (Drury 1994,
p.274)
 direct labour and materials were dominant factory costs(Drury 1994, p.274)
 overhead costs relatively small, distortions from overhead allocation not
significant(Drury 1994, p.274)
 Information processing costs were high(Drury 1994, p.274)
Change of organizations and industries
-
Increase in interest of ABC was fuelled by new evidence of financial
benefits, emergence of a new generation of enterprise ABC methods and
software, and the use of the Internet and Business Intelligence systems to
report current ABC information to decision makers. (Turney 2008 p.7)
The trigger for ABC was the increasing Japanese competition experienced by
Western companies, particularly those in electronics and and automotive
verticals. (Turney, 2008 p.3 )
-realisation of inaccurate costing information due to the rapid changes in the cost
structures during 1980s, direct labour based allocation costing was no longer sufficient
(Cokins 1998)
Cost structure of products have changed dramatically. Increasingly enriched with
technology and overhead, making traditional costing systems unsuitable & no longer be
acceptable in calculating product costs. (Ballakur 1991)
Product life cycles continue to shorten, while the direct labor component continues to
shrink as the percentage of overhead increases. The traditional cost management
system has shortcomings in keeping pace with this changing manufacturing
environment (Ballakur 1991)
-on economy wide basis, direct labour and overhead costs have been moving in
opposite directions for a long time. Direct labour cost decreasing, overhead costs
increasing, advancement of technology, p.299(Willie et al 2006)
-nowadays in many companies, direct labour may no longer be highly correlated with
overhead costs p.299(Willie et al 2006)
-organisations became more complicated, indirect and overhead costs grew at a faster
rate than sales or services and displaced the costs of the front-line worker. (Cokins
1998)
-expanded service lines and diversification of products as well as the customers and
increase in channels (Cokins 1998)
-increase in competition has forced all organizations to focus not just on their top line ~
sales or budget funding, but also their middle line- their costs. (Cokins 1998)
-unprofitable products have to be eliminated. (Cokins 1998)
-Traditional product costing systems were designed decades ago, now out of date (Drury
1994, p.274)
Nowadays - ABC more viable
decrease in the price of personal computer, more accounting data could be stored and
processed. (Cokins 1998)
with the proliferation of computers for data gathering and computing plus the
recognition that most data for decision making need not be accurate to several decimal
places, any organization can implement ABC. (Cokins 1998)
Information processing costs no longer a barrier (p. 351) (Drury 2006)
Information processing costs no longer a barrier to introducing more sophisticated
systems (Drury 1994)
Holzer and Norreklit (1991) increased opportunity cost of having poor cost information,
and the decreased cost of operating more sophisticated cost systems, incrased the
demand for more accurate product costs. (p. 351) (Drury 2006)
"Traditional" labor based cost management systems were designed for an era of
manufacturing characterized by long product life cycles, high levels of direct labor, and
low levels of technology and overhead (Ballakur 1991)
Change in environment – traditional costing unsuitable (Royce 2010)
What is ABC
Purpose of ABC
-Kaplan suggests that ABC is primarily an attention-directing device rather than a
decision-making one, i.e. ABC cost analysis directs attention to problematic
products/revenue segments and a special study is then undertaken, based on
incremental cost analysis, in order to make the final decision (Kaplan 1990 as cited in
Lucas 1997a)
General
Most of the large consulting firms started to use ABC practices in the late 80's,
early 90's, and the first commercially available software for ABC was introduced
in 1990. (Turney, 2008 p.4)
-
ABC implementations expanded into insurance, healthcare, banking,
energy etc. These industries faced increasing competition during the 90's
and benefited from information about the cost of services, activities, and
customers. (Turney, 2008 p.7)
- ABC developed in the USA by Harvard Business School Professors Cooper
and Kaplan (Sohal and Chung, 1998 p. 137)
-can be defined as a methodology that measures the cost and performance of activites,
resources and cost objects. (Akyol et al 2005)
-Can be considered as alternative paradigm to traditional cost-based accounting
systems. (Akyol et al 2005)
- ABC assigns costs to activities using multiple cost drivers, then allocates costs to
products based on each product’s use of these activities (Akyol et al 2005)
-ABC assumes that activities cause costs, and products create the demands for activities.
A link is made between activities and products by assigning costs of activities to
products based on an individual product’s consumption or demand for each activity.
(Drury 1994 P.275)
-ABC systems are models of resource consumption, not spending. It recognises that in
the longer term, changes in the consumption of resources are eventually followed by
the corresponding changes in the spending on the resources. To predict future spending
trends, ABC systems estimate the quantity of resources consumed by each product.
P.281 (Drury 1994)
-
ABC an integral component of a new generation of business performance management
solutions – profitability management, performance management, financial
management, sustainability and human capital management. (Turney, 2008 p.8)
-
ABC is an integrated family of analytical costing methods. A single ABC model can
support historical cost measurement, predictive cost measurement, resource planning,
capacity planning, performance management etc. (Turney, 2008 p.12)
-
Bursting of the ABC bubble 1991-1995: media over-enthusiasm, confusion over the
method itself, limits to the method and supporting systems, difficulties of sustainability,
and some well publicised failures (Turney, 2008 p.5)
- ABC method models the usage of the organization resources by the activities
performed and links the cost of these activities to outputs, such as products, customers,
and services (Ben-Arieh and Qian 2003)
Emphasises that products or cost objects consume activites, and in turn activities
consume resources, instead of products directly consuming resources (The traiditonal
mind-set) (Ballakur 1991)
Treats technology and overhead as direct product cost and allocate expenses of
activities based on multiple cost drivers (Ballakur 1991)
ABC reduced the uncertainty inherent in cost estimation, can be conceived as valuable,
when hused to support strategic decision-making. (Malmi 1997)
In an executive summary to a report on ABC published by CIMA, Innes and Mitchel (1990)
differentiated ABC from traditional costing by stating that it differs: in its treatment of non-
volume related overhead costs. Many significant overheads are related to specific
activities which are relatively independent of production volume. It is the volume of
such activities (not the volume of production) which consumer resources and therefore
determine overhead cost. These activities drive the overhead cost and ABC uses such
activities for both production costing and process control. (Sohal and Chung, 1998 p.
137)
ABC – advantages
General
-
Buoyed by early success, ABC emerged as a powerful profit analysis tool.
These successes stemmed from ABC's ability to reveal the hidden
sources of profitability and embedded cost, and to serve as a catalyst for
decisions to improve profitability. (Turney, 2008 p.1)
-
Today, the emerging foundation of performance management. (Turney, 2008 p.1)
-
Help to see the impact of decisions (Turney, 2008 p.3)
-
ABC can yield important insights into profitability. This is because ABC eliminated the
product cross subsidies inherent in traditional cost accounting, revealed the source of
loss that were responsible for the decline in profitability and acted as a catalyst for
decisions affecting profitability. (Turney, 2008 p.4)
-
Helps develop companies develop a new focus on profitable markets and customers,
prune unprofitable products, redesign products to remove cost, and eliminate nonvalue added activities (Turney 2008 p.4)
-
Value of ABC is its ability to drive change (Turney, 2008 p.4)
To reduce uncertainty, top management made cost accounting interactive by adopting
ABC. The ABC initiative by the top management signaled the importance of “reliable”
assessment of axle profitability to the factory management. But perhaps more
importantly, it served a surveillance function by searching for surprises or, assuring that
there are none (Feldman and March 1981) (p.469) (Malmi 1997)
Can be adopted for both product costing and cost management. (p. 367) (Drury 2006)
-Not only calculates accurate product costs but also a mechanism for managing costs.
P.282(Drury 1994)
- ABC system focuses management’s attention on the underlying causes of costs. Costs
are managed in the long term by controlling the activities that drive them. By managing
the cost drivers, costs will be managed in the long term. P.282-283(Drury 1994)
-Designed to provide managers with cost information for strategic and other decisions
tht potentially affect capacity and therefore ‘fixed’ costs. P.298(Willie et al 2006)
-ABC achieves improved accuracy in estimation of costs by using multiple cost drivers to
trace the cost of activities to the products associated with the resources consumed by
those activities. (Babad and Balachandran, 1993 p.563)
-ABC has recently emerged as a superior method for obtaining more accurate product
costs and thus better factory management (Babad and Balachandran, 1993 p. 564)
-
Provides insights for the analysis of customer profitability distribution channels,
vendors, brands, regions and other areas that directly affect the profitabilty of a firm.
(Babad and Balachandran, 1993 p. 564)
-
Use of all activities in minute detail may be more accurate but... (Babad and
Balachandran, 1993 p.565)
-
Innes and Mitchell (1990) claimed (based on a case study of 3 firms) that an
organisation can achieve a range of benefits reasonably quickly from the design
and implementation of ABC. Improved product line cost would be invaluable for
organisations where price may be cost sensitive and where product promotion
strategies and product range/ mix decisions need to be made frequently. An
improved visibility of overhead cost enhances the process control of costs by
linking costs to the series of activities (cost pools) which cause them. (Sohal and
Chung, 1998, p.141)
-
Case study of two firms. ABC delivered many benefits: more accurate
information on costs and pricing and hence competitive positioning of the
company in the market place, identification of appropriate benchmarks which
can be used against imported competitive products, enable companies to
outsource many products which were inefficiently managed in house, more
appropriate capital investment decisions able to be made as a result of better
weighting being determined, many problem areas identified where costs were
excessive, performance measurements developed which are used to identify
improvement initiatives and a validation for annual budgets for specific
expenses. (Sohal and Chung, 1998, p. 143)
-
- Innes and Mitchell (1990): Provides more accurate product line costing
particularly where non-volume related overheads are significant and a diverse
product line is manufactured, is flexible enough to analyse cost by cost
objectives other than products such as processes, area of managerial
responsibility and customers, provides a reliable indication of long run variable
product cost which is particularly relevant to managerial decision-making at
strategic level, provides meaningful financial (period cost driver rates) and non
financial (period cost driver volumes) measures which are relevant for cost
management and performance assessment at an operational level, aids
identifcation and understanding of cost behaviour and thus has the potential to
improve cost estimation, provides a more logical, acceptable and comprehensive
basis for costing work. (Sohal and Chung, 1998 p. 138)
-
Innes and Mitchell (1990): accurate product line costs –future costs based on
accurate past costs – low potential for misleading information, product cost
information is geared to LR strategic analysis, cost segmentation relates all costs
to determinants – volume driven costs and activity (various) driven – future costs
based on projected changes in a whole range of cost determinants, non financial
cost driver based performance in analysis aids process control in SR and LR.
(Sohal and Chung, 1998 p. 146)
-
Companies don't have to commit their entire accounting systems to ABC to use it
( Cooper and Kaplan, 1988 p. 97)
-
ABC can act as a tool of corporate strategy. (Cooper and Kaplan, 1988 p.
97)
-
More sophisticated approach to attributing factory overheads, corporate
overhead and other organisational resources, first to activities and then to
the products that create demand for these indirect resources. (Cooper and
Kaplan. 1988 p.100)
-
ABC can show that specialised products assembled from high volume
components will have low productivity costs even if shipping volume is not
high. (Cooper and Kaplan, 1988 p.100)
-
All organisational costs, not just factory overheads or marketing expenses
are traced to the activities for which these resources are used, and then to
the divisions, channels and product lines that use them. (Cooper and
Kaplan, 1988 p.101)
-
Directly links the cost of performing organisational activities to the products and
customers for which these activities are performed (p.1) Cooper and Kaplan 1992
-
ABC resource usage cost information can be used by managers to monitor and predict
the changes in demands for activities as a function of changes in output volume and
mix, process changes and improvements, introduction of new technology, and changes
in product and process design. (p.2) Cooper and Kaplan 1992
-
Measuring the costs of resources supplied indicates to managers the level of current
spending (or more generally, expenses) and the capacity to perform activities that this
spending has provided. (p.3) Cooper and Kaplan 1992
-
Measuring the cost of resources used by individual outputs provides information for
managerial actions. (p.3) Cooper and Kaplan 1992
-
Reports both the quantity (number of purchase orders not written) and the cost of
unused capacity (p. 3) Cooper and Kaplan, 1992
-
Always practical capacity of activity supplied, not anticipated volume. (p.3) Cooper and
Kaplan, 1992
-
Separate activity cost drivers for each activity. Not devices to allocate costs. Represent
demand outputs made on each activity. Some unit related, many are batch, order
related, product and customer sustaining. (p.4)Cooper and Kaplan 1992
-
Helps companies improve profitability by repricing products, services or customers so
that the revenues (resources) received exceed the costs of resources used to produce
products for individual customers – pricing strategies (Cooper and Kaplan 1992, p.8)
-
can help managers reduce resource usage while holding revenues constant: - reducing
number of times activities are performed – Increase the efficiency with which activities
performed (TQM and JIT) (Cooper and Kaplan, 1992 P.10)
-
Managers adjust their product and customer mixes, introduce new products, phase out
mature products, improve operating processes and introduce new technology – the
change in the demand for activities performed by indirect and support resources is
estimated with ABC model. (Cooper and Kaplan, 1992 p.11)
-
ABC systems contain two important insights:
-
Activities performed by many resources are not demanded in proportion to the total
volume of units produced (or sold). The demands arise from the diversity and
complexity of the product and customer mix.
-
ABC systems not a model of how expenses or spending vary in the ST.
Estimate the costs of resources used to perform activities for various
outputs. Model how activity usage varies with the demands made for
these activities. (Cooper and Kaplan 1992 p. 12)
Aid in decision making- General
- Serves to direct managers' attention to where more detailed analysis will likely
yield the highest pay off. (Cooper and Kaplan 1992 p.9)
-
ABC a central tool for management planning and budgeting: differences
between the demand for and the supply of resources can then be
translated into expected changes in future spendings on resources.
(Cooper and Kaplan, 1992 p.11)
a way to translate general ledger data into a format that helps managers make
decisions. (Cokins 1998)
-a clear picture of the total cost of a process comes into view when the individual costs
are added up. (Cokins 1998)
-distinguish the cost of servicing different customers(Cokins 1998)
- How a product is produced, how much time is needed to perform an activity and finally
how much money is absorbed by performing tasks are answered by the help of ABC
studies. (Akyol et al 2005)
ABC can help managers modify existing product mix (Cooper and Kaplan 1991)
ABC can help managers anticipate effects of planned changes (Cooper and Kaplan 1991)
Promotes designers to consider factory activity costs in their designs (Ballakur 1991)
ABC can be used to analyse many aspects of company operations – also can compare
profits that various customers, product lines, brands, or regions generate. – analyse
company operations in multiple levels and angles (Cooper and Kaplan 1991)
More relevant information for managerial decision making ((Bhimani and Pigott 1992)
-
Helps make mangers make better decisions about product design, pricing,
marketing, and mix, and encourages continual operation improvements (Cooper
and Kaplan 1988 p.103)
ABC solves traditional cost management problems
-a practical solution for problems associated with traditional cost management (Cokins
1998)
corrects for the limitations of traditional costing by identifying all the work activities and
their costs that go into manufacturing a product, delivering a service or performing a
process (Cokins 1998)
ABC applicable to areas outside the scope of cost accounting- administration, sales,
marketing, R&D, supply chain and logistics. (Turney, 2008 p.6)
Aid in decision making – clearer picture of costs
-Emphasis the need to obtain better understanding of behaviour of overhgead costs,
and thus ascertains what causes overhead costs and how they relate to products. P.275
(Drury 1994)
-ABC recognises that in the long run, most manufacturing costs are not fixed, and it
seeks to understand the forces that cause overhead costs to change over time
p.275(Drury 1994)
More useful and state of the start definition of product costs (Ballakur 1991)
ABC reports should be able to pinpoint the contribution of each activity so as to locate
the causes of product cost changes at any period of time. (Ballakur 1991)
Assists product managers and manufacturing managers in determining the state of the
art product costs (Ballakur 1991)
ABC permits managers to understand the source of cost variability and reveal actions
they can take to reduce demands on their org resources. Then increase throughput or
reduce spending to convert savings into increased profits. (Cooper and Kaplan 1991)
ABC reveals the links between performing activities and the demands those activities
make on org resources -> give managers a clear picture of how revenues are generated
and resources are consumed (Cooper and Kaplan 1991)
cause-and-effect relationship is a superior way of determining relevant costs. (p. 369)
(Drury 2006)
Enhanced product cost accuracy (Bhimani and Pigott 1992)
More accurately assigns costs to cost objects such as products, customers and locations.
(p. 365) (Drury 2006)
More comprehensive cost data for performance evaluation (Bhimani and Pigott 1992)
Greater potential for sensitivity analysis (Bhimani and Pigott 1992)
Cost driver analysis had permitted certain manufacturing improvements to be financially
captured and represented in economic terms. (Bhimani and Pigott 1992)
ABC provided factory managers with a tool for justifying desired changes in terms which
could understood be by levels of management outside the factory. (Bhimani and Pigott
1992)
Use both volume based and non volume based cost drivers (p. 351) (Drury 2006)
Allocates overheads on a cause-and-effect basis and more accurately measures the
relatively high level of overhead resources consumed by the product. (p. 354) (Drury
2006)
Recognises that many indirect costs vary in proprtion to changes other than volume,
costs more accurately traced (p. 369) (Drury 2006)
Greater number of cost centres (p. 349) (Drury 2006)
Assigns overheads to each major activity rather than departments (p. 349) (Drury 2006)
Assign activity costs to cost objects on the basis of cost driver usage. (p. 349) (Drury
2006)
ABC can therefore more accurately measure the resources consumed by the cost
objects (p. 349) (Drury 2006)
-With ABC systems, many activity based cost pools (cost centres) are established,
whereas with traditional systems, overheads tend to be pooled by departments. This
can result in extensive reapportionments of service department costs to ensure that all
overheads are allocated to production departments. P.279(Drury 1994)
-could use its cost assignments to track down underlying economic events. (JEAN BOOK)
-setup costs are assigned based on setups performed for individual products. Product
support costs can be traced back to work performed to maintain products. (JEAN BOOK)
-ABC system recognises differences in relative input consumption, and traces the
appropriate amount of input to each product. p.279(Drury 1994)
-Non-manufacturing costs may also be assigned to products, whereas in traditional cost
accounting, non-manufacturing costs are treated as period expenses (many of these
non-manufacturing costs also part of costs of producing) p.299(Willie et al 2006)
-A cost is assigned to a product only if there is good reason to believe that the cost
would be affected by decisions concerning the product. P.299(Willie et al 2006)
-ABC reflects diverse factors that drive cost more accurately when costing products.
P.300(Willie et al 2006)
-products are charged for the costs of capacity they use, no idle capacity charged to
products. p.300(Willie et al 2006) (traditional have this problem)
-ABC links performance of particular activities (frequency) with the demands these make on
theorganisation's resources, the revenues from products or services can be directly matched
with costs as resources consumed ( Cooper and Kaplan 1992) (Babad and Balachandran, 1993
p.564)

Designed to improve the accuracy of product cost using high level cost pools and cost
drivers (Turney, 2008 p. 4)

Provides more accurate information about production and support activities and
product costs so that management can focus its attention on the products and
processes with the most leverage for increased profits. (Cooper and Kaplan 1988 p.103)
Aid in decision making- directs attention to problems
-Kaplan suggests that ABC is primarily an attention-directing device rather than a
decision-making one, i.e. ABC cost analysis directs attention to problematic
products/revenue segments and a special study is then undertaken, based on
incremental cost analysis, in order to make the final decision (Kaplan 1990 as cited in
Lucas 1997a)
Intended to support strategic decisions as Cooper claimed its purpose is to focus
management attention on resource consumption. (Cooper 1990 as cited in Geri and
Romen 2005)
to help managers make better strategic decisions on products and processes and to
influence product design activities (Cooper 1990 as cited in Geri and Romen 2005)
ABC reveals the cost of complexity arising from the range of products and variations by
allocating all costs to the products or services that consume them. ABC implementation
leads to a better understanding of the cost drivers that generate these costs, thereby
focusing management attention on the way resources are consumed by activities and
supporting effective management of these activities. (Cooper 1990 as cited in Geri and
Romen 2005)
Aids manufacturing support managers in identifying and supporting critical process
needs (Ballakur 1991)
ABC helps managers understand precisely where to take actions that will drive profits.
(Cooper and Kaplan 1991)
help managers focus their attention on improving activities that will have
biggest impact. (Cooper and Kaplan 1991)
ABC analysis can be used to direct process improvements (Cooper and Kaplan 1991)
ABC concepts provide a powerful means for quantifying the financial impact of poor
quality, enabling the firm to more effectively target specific activities for improvement
or elimination. (Ittner 1999)
- ABC system focuses management’s attention on the underlying causes of costs. Costs
are managed in the long term by controlling the activities that drive them. By managing
the cost drivers, costs will be managed in the long term. P.282-283(Drury 1994)
ABC facilitates activity-based-management, can be used to identify areas that would
benefit from process improvements, focuses on managing activities as a way of
eliminating waste and reducing delays and defects. P.311(Willie et al 2006)
Aid in decision making- pricing decisions
ABC have a value enhancing effect on pricing decisions and profit performance as ABC
allows better price differentiation among products, customers and markets (Cooper
1988, Kaplan and Atkinson 1988, and Goebel 1998 as cited in Eddy et al 2004)
Aid in decision making- identify non value adding activities
-In traditional cost accounting systems, direct materials and labor are the only costs that
can be traced directly to the product. By using the ABC system, activities can be
classified as value-added and non-value-added activities. In order to improve the
performance of the system, non-value-added can be eliminated. (Akyol et al 2005)
Aids in identifying and eliminating "nonvalue added" activities (Ballakur 1991)
Aids in changing cost cutting behavior (Ballakur 1991)
A full ABC system can provide valuable information on non-value-added activities and
their drivers. Cooper et.al (1992), for example, reported that some firms find it useful to
rank all activities in their ABC system based on their value to customer. (Cooper et al
1992 as cited in Ittner 1999) One limitation to this approach is the need to conduct a
full-blown activity-based costing analysis to identify and rank each activity. (Ittner 1999)
ABC – disadvantages
General
ABC creates a more complicated costing system, but not necessarily an accurate or
useful one (Piper and Walley 1991as cited in Geri and Romen 2005)
Even though should generate most accurate product costs, the cost of implementing
and operating an ABC system is significantly more expensive then traditional. (p. 363)
(Drury 2006)
Difficult to justify more sophisticated overhead allocation methods when companies
manufactured a narrow range of products (p. 351) (Drury 2006)
Implementation problems (Friedman and Lyne 1995, 1999 – longitudinal case studies):
amount of work in setting up the system and data collection, difficulties in identifying
activities and selecting cost drivers, lack of resources and inadequate computer
software. (p. 368) (Drury 2006)
It might be that more complex analysis required by ABC could impose additional costs
for information-gathering and updating such that the associated benefit is outweighed.
p.164(Alan 1998)
-ABC does not conform to generally accepted accounting principles (GAAP). Product cost
for external reports must include all manufacturing costs and only manufacturing costs,
ABC exclude some manufacturing costs and include some non-manufacturing costs.
Possible to adjust ABC data at the end of period to conform to GAAP but requires more
work. P.324(Willie et al 2006)
-auditors likely to be uncomfortable with allocations based on subjective data, which is
easily manipulated by management. (P.324 Willie et al 2006)
-use many estimates(JEAN BOOK)
 Use of all activities in minute detail is enormously costly to collect, store and
process. Furthermore, errors of data collection, reporting and estimation of
sources, and possible inconsistencies between different cost drivers that are
generated by different systems can also create errors in product and process
costing. (Babad and Balachandran, 1993 p. 565)

Can be problems using ABC system for monthly performance management eg. Hewlett
Packard QTD case ( Robin Cooper and Kiran Verma HBS case no. 9-191-067.) The two
functions of performance monitoring and processing cost information soon came into
conflict when production volume dropped. This led to monthly volume variances
because operating expenses could not be reduced proportionally to the decline in
volume. Higher cost driver rates were calculated based on the lower production
volumes, so the accounts would 'clear' each period without large volume variances. This
change however negated the primary purpose of the ABC – unused capacity expenses
now loaded onto cost driver rates, system no longer provided product designers with
accurate information on the expenses of activities performed to manufacture their
product. (p.7) Cooper and Kaplan 1992

Critics ask why we need ABC system? Why not just calculate the changes in spending
that would occur for any decision like outsourcing and make a decision based on that
analysis? What purpose is served by building, maintaining and interpreting a generated
ABC model? (p.9) Cooper and Kaplan 1992

- Cost drivers are chosen for planning and control – if too many drivers are chosen,
planning and controlling the production cost for each would be neither effective or
efficient. (Babad and Balachandran, 1993 p. 565)

Requires change to organisational structure (Sohal and Chung, 1998 p.141)

Uncertainty of using ABC for stock valuation for external financial reporting (Sohal and
Chung, 1998 p.141)

Difficult to link cost drivers to individual product lines (in initial stages of implementation)
(Sohal and Chung, 1998 p. 141)

High set up costs associated with the intitial set up (additional staff)(Sohal and
Chung, 1998 p.141)

ABC inconsistent with the principles of continuous improvement and TQM. (Turney, 2008
p.5)

Lacked customer focus, was not process orientated, did not enhance organisational learning
and was top down in approach (did not involve employees) (Turney, 2008 p.5)

Inconsistent with Theory of constraint (Turney, 2008 p.5)

Could not reliably measure the ST impact of decisions on operating cost, inventory and
throughput ( Turney, 2008 p.5)

Aids in decision making – but not adequate for decision making
When the production volumes change, ABC cannot predict profits, therefore it is not
adequate for decision-making. (Geri and Romen 2005)
ABC is to improve the quality of planning and decision-making; an ABC unit cost is
therefore of little value (Lucas 1997b)
Kaplan and Cooper argue that if higher-level, non-volume related costs such as batch
level costs etc are allocated to the product unit level the resultant unit cost will be
largely meaningless (Kaplan and Cooper 1990 as cited in Lucas 1997b)
-Despite the advantages of providing accurate costs, it requires additional effort and
expense in obtaining the information needed for the analysis (Lewis 1995)
Arbitrarily allocation of costs (both traditional and ABC)
ABC is based on subjective arbitrary cost allocations. The main difference between
traditional absorption costing and ABC is the number of allocation bases, or cost drivers
(Geri and Romen 2005)
allocation of all kind is arbitrary, and the use of any method based on full allocation
(traditional cost accounting or ABC) may cause a misleading decision-making process.
(Geri and Romen 2005)
Relationship between activities and resource consumption
ABC regards the relation between activities and resource consumption as linear,
absolute and certain. This means that additional activities result in additional costs, and
reduced activity levels imply cost reductions. However, in reality, there are
discontinuities of costs. (Geri and Romen 2005)
ABC ignores constraints & no differentiation between bottleneck and
excess capacity
ABC ignores constraints and does not differentiate a bottleneck from resources with
excess capacity. If a firm has an internal capacity constraint, i.e., the demand for its
products is greater than its production capacity, the firm should determine the optimal
product mix according to each product’s contribution per unit of the limited resource.
The “costs” of the various products are not relevant for the product mix decision (Geri
and Romen 2005)
ABC processes
-once ABC is set up to determine true costs, cost estimating is a natural next step. It
begins with forecasts of a products’ output; then, by adding the various cost driver rates
for that activity, the total projected costs can be determined. (Cokins 1998)
Cooper (1989): 'The art of designing an ABC system can be viewed as making two seperate but
interrelated decisions about the number of cost drivers needed and which cost drivers to use.
These decisions are interrelated because the type of cost drivers selected changes the number
of drivers required to achieve a desired level of accuracy.' (Babad and Balachandran, 1993 p.
564)
- Ideally, to derive true costs, first consider every activity of the company, where all activities are
mutually exclusive and collectively exhaustive, then identifies the unique cost driver associated
with each activity to develop a per activity cost. Finally the cost of all activities consumed by a
product or process are multiplied by their frequency and are accumulated. Known as the 'bill of
activities' (Babad and Balachandran, 1993 p. 564)
Implementation issues to consider
1) implementing is huge project – need project champion to drive from the top (Ballakur
1991)
2) project team need to involve engineering, accounting and information systems for
initial design and coordinate various issues that come up during implementation
(Ballakur 1991)
3) picking the correct cost driver (Ballakur 1991)
-accurately reflect cost of activities
-cost of measurement must be low (ideally data currently tracked using existing
systems)
-cost drivers must encourage management desired behavior.
Eg is excess investment is problem, then cost driver for material planning activity should
mesure and aid in reduction of excess orders, while minimising shortages
4) educate all managers on the new system – essential that they be involved at key
steps so they understand what is being done and what has changed. Company need
expertise to drive this change. (Ballakur 1991)
In the case study, factory management initiated a production control system to be built
together with a centrally initiated ABC system. The new ABC system without production
control support, seemed to offer relatively little to resolve the concerns which the local
management had in their day-to-day operation of the factory, but for such system, local
support can easily become a critical issue. (p.465-467) (Malmi 1997)
Optimal for organisations with intensive competition, non volume related indirect costs
that are a high proportion of total indirect costs, diverse range of products all
consuming organisational resources in significant different proportions (high product
diversity). (p. 364) (Drury 2006)
Kaplan and Cooper (1998) – service companies are ideal candidates for ABC as most
costs are indirect. (Kaplan and Cooper 1998 as cited in Drury 2006, p.364)
-Difficult to make changes in accounting system – cost accounting systems in large
companies usually embedded in complex computer programs that have been modified
in0house over the course of many years. Extremely difficult to make changes in such
computer programs without causing numerous bugs. P.324(Willie et al 2006)
-every cost assignment to an activity, or a product, service or customer, should be
transparent and traceable, via cause-and-effect relationships, to the demand for
resources by the cost object p.99-p.100(JEAN BOOK)
- Therefore, on a cost-benefit basis a balance must be sought between accuracy benefits
and costs of data collection, storage and processing. (Babad and Balachandran, 1993
p.565)
 For an optimal balance must find the optimal number of cost drivers that
discriminates and captures most of the incurred costs, and identify a priority
order that specifies which low priority and relatively insignificant activities will be
combines to save costs without sacrificing much accuracy. (Babad and
Balachandran, 1993 p.565)#
 Many of the problems and difficulties associated with introducing ABC are
related to managerial aspects rather than technical aspects of the ABC. (Sohal
and Chung, 1998 P. 145)

Managers need to understand better the processes involved in adopting ABC and
recognise the factors that are critical to implementation. (Sohal and Chung, 1998 p.141)

Key ingredients for successful implementation of ABC: total commitment from top
management, clear, simple and realistic objectives, objectives regularly reviewed and
revised as market place and organisation change, multi-disciplinary project team to
introduce and implelement ABC system – all with similar values and attitudes, education
and training of all the people in the organisation to understand the complexity of the
project and its impact on the organisation, adequate resource allocation to the ABC
project (time for data gathering and analysis), time allowed to gain confideance with the
new system, on going feedback to top management and low level employees on the
progress on the ABC project (Sohal and Chung, 1998 p. 145)
 Potential reasons for failure of implementation of ABC: employee resistance,
sceptism – in particular where education/training has not been great or where
other major organisational changes are occuring at the same time, ABC project
seen as accounting project by other functional managers, underestimating the
cost of data gathering, shortage of appropriate resources in particular
people.(Sohal and Chung, 1998 p.145)
-
Cost of implementation and reduction in the effort required to maintain ABC
system: by web based surveys, time based algorithms to measure complexity,
and the use of ETL technology to integrate ABC with data sources. (Turney, 2008
P. 8)
Ways to utilise ABC
Case study:
The decision to adopt the ABC system was also taken with a view to meeting a number
of objectives other than simply to ensure greater accuracy in product costing. For
instance, by utilizing measures of activities which factory managers could identify with
and by demonstrating how they related to standard costs; intend to overcome the
barrier of product costs being the domain of the accountants by involving all the factory
management. (Bhimani and Pigott 1992)
In many case, factory manager viewed the ABC resulting costs as confirming their
suspicions about the “real” cost of product, and were able to comment on reasons for
their magnitude based on operational factors, such as for instance, the use of special
high cost machinery or the large number of raw material inputs required by a product
cost was undercosted by the conventional system relative to ABC. (Bhimani and Pigott
1992)
Can be used for a range of cost management activities (cost reduction, performance
management etc..) (p. 365) (Drury 2006)
-Also used as an element of activity based management – an approach to management
that focuses on activities. P.298(Willie et al 2006)
-most companies confine ABC efforts to special studies for management, and no
attempt to integrate abc into formal cost accounting systems. (P.324 Willie et al 2006)
-
Attributable Costs
This concept is from (n4) SHILLINGLAW, G.: The concept of attributable cost, Journal of
Accounting Research, Spring 1963, pp. 73-85.
So need to cite original author Shillinglaw (Lucas 1997a is also citing him)
The concept of Attributable cost
-an estimate of how costs will be affected by a decision to expand or contract a
particular segment or aspect of the business, assuming that enough time is allowed to
permit a change in capacity -would, on average, be avoided if the revenue segment
were to be discontinued (Lucas 1997a)
Attributability
-a criterion adopted by Shillinglaw in deciding which short-term fixed costs should be
apportioned to revenue segments (Lucas 1997a)
To identify Attributable Costs (Lucas 1997a)
-Shillinglaw classifies fixed costs into four categories. He distinguishes between costs
which are traceable and those which are common/shared. He also distinguishes
between costs which are divisible and those which are indivisible.
-Traceability: traceable costs are specific to the revenue segment under consideration,
whereas common costs are shared by other/all segments.
-Divisibility: a fixed cost is divisible if significant shifts in the volume of activity will
require increases or permit decreases in the total amount of that cost. Thus, if a factory
has eight storemen, their wages would be a divisible cost; if it has only one, then this
would be an indivisible cost. Other examples of indivisible fixed costs are likely to be
factory rent, rates and the general manager's salary)
- A divisible fixed cost is variable with respect to volume if the volume increment is large
enough and the time horizon long enough
Is on ABC cost the Attributable cost? (Lucas 1997a)
-An ABC cost can be considered the attributable cost of producing a product or serving a
revenue segment if two conditions are fulfilled
-it excludes apportioned, indivisible, common fixed costs
-it is based on the 'normal' cost of activities
NORMAL activity cost (Lucas 1997a)
-Regular cost of providing support activity resources
- When demand for support activities is less than the capacity supplied, actual cost per
unit of activity will be higher than normal activity cost.
-in the short term, the support activity constitutes a fixed cost.
-The actual cost per unit of activity is also likely to be higher than normal activity cost
when demand exceeds the amount of resource supplied
- cost premium may be incurred in the form of overtime payments, subcontracting
-normal cost would equal to the actual cost when the demand for the activity equal
exactly to the capacity made available by the resources committed to the activity
Random
Calculation of a unit-level operating margin for individual products (Lucas 1997b)
-First, by subtracting the unit-level costs from sales revenue.
-From this unit-level margin can be subtracted batch-related and product-sustaining expenses to
arrive at a product-level margin.
-Margin can then be calculated for each product in the range and from this can be deducted any
customer related expenses to determine the profitability of a particular sales order.
-give managers better insights into the nature of their costs and thus facilitate better informed
decisions when bidding for jobs or deciding which orders to accept
-Notes: can also be applied in determining the profitability of a product over a period of time--not
by calculating a full unit cost to compare with the selling price, but by identifying the demands the
product puts on service and support activities
-may be revealed that low volume products are unprofitable because of the disproportionate
demands placed on batch level activities--a machine set-up is necessary whether one unit or
one thousand units are being manufactured
Implication of Kaplan's analysis (Lucas 1997b)
-the non-volume related costs included in any decision analysis are not short-term incremental
costs, but proxies for long-run incremental cost-based typically on existing average activity costs
-the total cost of machine setups is divided by the number of set-ups performed to arrive at
average cost per set-up.
-This is then used as an estimate of the long-term incremental cost that will arise by performing
machine set-ups
The Zimmerman approach (Lucas 1997b)
-suggested that there are certain service/support costs which are fixed with respect to short-run
changes in production volume, but which are related, in the longer term, to the level of primary
inputs (e.g. labour)
Argument for Zimmerman approach (Lucas 1997b)
-Zimmerman argues that these opportunity costs and consequent long-term incremental actual
costs should be taken into account by individual managers when deploying labour resources.
Such costs are hard to observe/measure, but allocating current average cost can serve to proxy
them.
Zimmerman merely introduces a category of long-run volume related costs which are effectively
ignored in Kaplan and Cooper's analysis
The Japanese approach (Lucas 1997b)
-advanced manufacturing technology (AMT) strategy
-production overhead--including non-volume related costs (i.e. batch level, product-sustaining
level costs etc) are allocated using labour hours
-Japanese companies tend to use estimated product costs produced outside the management
accounting system and based on managers' past experience or intuition. It appears that the
primary purpose of management accounting in Japan is to influence behavior rather than to
provide accurate product costs
Cost-driver = an event associated with an activity, that results in the consumption of the firm's
resources. (Babad and Balachandran, 1993 p. 563)
-
Government agencies and the military used ABC to help ameliorate budget pressures
(Turney, 2008 p.7)
-
Possible strategy: Make unprofitable customer turn into profitable customer: if
unprofitable line,: price increase, minimum order size, eliminate more
complex product and replace with product produced in efficient, high
volumes or outsource. (Kaplan and Robertson, 2004 p. 136)
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Strategic Options once got more reliable cost information: (Cooper and Kaplan 1988
pp.102 – 103):
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Dropping unprofitable products
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Raising prices (drastically if low vol low price elasticities products). Acceptable if
company now supplying fewer money losing items.
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For high volume products – price core product more competitively
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Redesign products to use more common parts
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change how managers evaluate new process technologies.
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