In the past few years we have seen the dramatically growing importance of high
quality information for management decision-making. One of the most important
areas of financial management is that of cost management systems, used for costing
and budgeting. In the face of growing competition due to the rise of globalisation,
companies now need the information about the profitability of a product, customers or
markets, about the costs consumed by differing activities and other areas where costs
play an important role. If a firm is to keep up with its strongest competitors, its
costing system has to implement the ability to react to changes in product and
activities structure and show these changes in their product costing. If the costing
system does not change and the process, activities and product structures do not
conform with the industry dynamics, then the firm's costing system will become
obsolete and incorrect and distorted product costing will be produced. Traditional
costing systems, dating from the 1800s are based on volume-based allocation of
overheard. These systems have lost relevance in a manufacturing environment that
has seen a sharp increase in overhead and a subsequent decline in direct labour. The
traditional costing systems tend to distort product costs and lead to poor strategic
decision-making.
One innovative costing method, Activity-Based costing, has become the accepted
remedy for the limitations of the traditional cost accounting systems. Instead of the
arbitrary allocations which are at the heart of the conventional methods, ABC assigns
costs to products and processes by computations intended to approximate cause-andeffect relationships in the production processes. As Sohal and Chung (1998) explain,
managers and accountants have become dissatisfied with the traditional costing
systems with concerns about their suitability in the modern manufacturing
environment.
As Cooper and Kaplan (1998) state, the traditional system was satisfactory decades
ago when firms only had a narrow range of products, and the most important
production factors were the cost of direct labour and materials which are easily
traceable to the individual products. Overheads were not a big proportion of total
costs (Ballakur 1991). This made it difficult to justify the more sophisticated
allocation methods which are significantly more expensive to implement and operate.
In today’s environment, using traditional methods is not suitable as absorption rates
based on ‘simple’ activity measures is not fully representative of complex
relationships between support activities and outputs ( Allan, 1998, p.161). The cost
structure of products has changed, ‘increasingly enriched with technology and
overhead’ (Ballakur, 1991). Direct labour is now only a small part of costs to
corporations while the costs for overhead functions such as factory support
operations, marketing distribution and engineering have become extremely prominent
for a firm (Cooper and Kaplan, 1988). As Eddy (2004) and Cokins (1998) reported,
companies that use the traditional indirect cost allocations may actually lose money
on certain products and customers by underestimating their costs even if their
accounting systems may be reporting them as profitable. This can have unintended
negative strategic and operational consequences for the firm.
To assign organisational expenses to products the traditional systems use volume
driven allocation bases. However, in today’s environment a lot of resource demand is
not driven by or proportional to the number of units produced or sold, but more so by
the number of batches or production runs that are undertaken. Because of this it is
criticised for not actually measuring the cost of resources used to design products and
to sell and deliver to consumers accurately (Cooper and Kaplan, 1992 p.1). Ballakur
(1991) argues that traditional systems are not found to be an adequate way to manage
costs and shift resources in order to increase revenue. The manager does not get a
clear picture of how much the activities that are done in the organisation cost. The
system only tells how much of these expenses went into each individual resource.
Traditional cost systems in fact often understate profits on the high volume products
whilst overstate the profits for speciality, low volume items when the cost of nonvolume based activities is relevant to the product.
Using an absorption costing system requires a ‘subjective selection of absorption
criteria, allocation criteria and volume assumptions’ (Geri and Romen, 2005). This
can lead to traditional techniques providing misleading information. Cooper and
Kaplan (1998,p.100) found that calculating the actual demand a product makes on
resources of the organisation can be as wrong by as much as 200%. Three case
studies are presented by Innes and Mitchell (1990), which were undertaken on firms
who had implemented and organised ABC systems by CIMA. These found that
gearing traditional costing towards short run decision analysis gives managers of
organisation’s high potential for gathering misleading information (Sohal and Chung,
1998, p.146). Drury (2006) agrees with this high potential possibility as the system
relies heavily on arbitrary allocation bases of indirect costs. It is almost impossible to
end up with accurate product costing figures whilst using the traditional techniques, as
well as being inadequate to provide other information which could be used in
performance management. The absorption costing system was designed to make sure
that all product costs are covered, but not to make sure that these product costs are
accurate (Chadwick and Magin, 1989, p.65). So much so that manufacturing costs that
are not even caused by the individual product are assigned to those products. For
example Willie et al (2006, p. 299) looked at a case where a security guard’s salary
was allocated to all products even though it was not at all affected by the by the
volume of products made and sold in that period.
Turney (2008) explains how interest in ABC was increased by emerging evidence of
the financial benefits, along with improvements in technology, such as the use of
Internet, ‘Business Intelligence systems’ to report ABC information, new ABC
methods and software. This was along with the increased opportunity cost of having
inaccurate product costing and information processing costs no longer being too high,
and acting as a barrier to entry (Holzer and Norreklit, 1991). There was a change in
the manufacturing environment that traditional systems could not keep pace with;
product life cycles were continually shortening and the direct labour component as a
percentage of total overhead was rapidly declining (Ballakur, 1991). Having been
designed decades ago, traditional techniques were now very much out of touch.
Organisations began to be more complicated, with indirect and overhead costs
growing at a speedier rate than sales or services. This ‘displaced the costs of the frontline worker’ (Cokins, 1998). ABC has reduced the ambiguity which surrounds cost
estimation. This makes it a very valuable tool when using it to support strategic
decision-making.
ABC costing systems solve the problems found with the outdated traditional
techniques. It corrects these limitations by identifying all the activities and the costs
that go into producing and distributing a product, performing a service or a process.
ABC improves upon the traditional approach by using a two-stage allocation
procedure and multiple cost drivers. In the first stage, significant activities are
identified and overhead costs are assigned to each activity in proportion to the
resources used. The focus on resource consumption means that this new costing
system will support strategic decisions of the firm (Cooper 1990 as cited in Geri and
Romen, 2005). Cost drivers are then identified for each of these cost pools. This
allows the links between the activities and the resource demands that these activities
make in order to give managers a clear view of the way revenues are generated and
resources consumed. In stage two, the overhead is allocated from the cost pull to the
final outputs, or cost objects, in proportion to the amount of the cost driver consumed.
These many cost drivers, unlike the method in traditional systems where overheads
are pooled by departments, are representative of diverse factors of cost drivers more
accurately when products are costed. (Willie et al, 1996, p.299). In traditional costing
systems, the only costs that can be traced directly back to the product are direct labour
and material (Akyol et al, 2005). In ABC, with multiple cost drivers, this is not the
case; activities can be categorised as either value-adding or non-value-adding
activities, with those that do not add anything able to be eliminated. Cooper et al
(1992) recognised that some firms found it beneficial to the firm to rank all activities
used in the ABC system according to the value they give to the customer. There
could, however be negative implications to this in that a full blown analysis would
have to be done to rank these, which would be costly to the firm.
ABC aids decision-making by becoming a key management tool for planning; it
calculates the difference between the demand and the supply for the product which
allows expected future spending on resources to be predicted. ABC greatly reduces
any uncertainty by making the cost accounting system of firms interactive (Feldman
and March, 1981). In their three case studies, Innes and Mitchell (1990) recognised
potential benefits of the implementation of ABC in a relatively short period of time.
These included more accurate product line costs, which were extremely beneficial for
firms with cost sensitive prices and where promotion strategies and decisions on the
range and mix of the products need to be made regularly (Sohal and Chung, 1998, p.
141). These accurate product line costs mean that all future costs will be predicted on
the accurate historic costs which reduces greatly the potential for misleading
information. With this more accurate information, managers can more clearly see cost
variability and clearly see ways in which they can reduce the demands the activities
make on the organisation's resources. This may lead to increase profits, from the
ability to lower costs or increase throughput ( Cooper and Kaplan, 1991)
Activity-Based Costing systems, following a great success, began to be appreciated as
a strong tool for profit analysis (Turney, 2008, p.1). This would be due to the fact that
ABC techniques could disclose hidden costs and sources of profitability that are not
easily visible. ABC allows firms to focus on the profitable markets and customers
only, getting rid of any unprofitable products, activities the firm is doing that does not
add value and finally lower costs of the production process by altering products. It
also allows management to partake in pricing strategies and reprice products if need
be. Ittner (1999) confirms this view by stating that it can be a 'powerful means of
quantifying the financial impact of poor quality'; this allows the firm to be much more
specific and target the individual activities and processes that are causing the lag, to
either improve them or get rid of them completely. ABC allows a stronger
differentiation of prices among products, customers and the market as a whole.
(Cooper, 1988, Kaplan and Atkinson, 1998 and Goebel 1998 as cited in Eddy et al,
2004)
ABC is by no means just a cost accounting tool. Turney (2008) describes it as ' the
emerging foundation of performance management'. Sohal and Chung (1998, p. 143)
found in the two case studies they carried out that ABC delivers many benefits to the
firm. It gives the company a greater position competitively in the market; this is done
by the more accurate information available on costing and pricing. This cost
accounting technique also creates suitable benchmarks, which allows managers of a
firm to make comparisons in relation to imported competitive goods. Other ways in
which benefits are delivered to the firm is that it allows to outsource current in-house
inefficient products, better weighting analysis which allows more competitive capital
investment, and development of performance measurements which validates annual
expenses in annual budgets. The fact that is provides a strong reliable inclination of
what long run variable costs will be is a strong strategic tool for the managers of the
firm.
Despite the many advantages of ABC systems, it is not without its faults. As Piper
and Walley (1991) correctly stated, 'ABC creates a more complicated costing system,
but not necessarily an accurate or useful one'. One area in which many theorists argue
the strength of ABC is that in decision-making. Even though it aids in this, it cannot
solely be relied upon to be an adequate measure on its own. Geri and Romen (2005)
have argued that when the volume of production alters ABC is unable to predict
profits and thus cannot be relied upon as a sole tool for decision-making. Turney
(2008, p.5) also agrees with the statement; in that with ABC you could not reliably
measure what the short term impact of decisions would be on operating costs, along
with inventory and throughput. Because of this we could argue that even though ABC
has its advantages in providing accurate product costs, additional information is
needed for analysis which requires extra effort and expense. One way in that ABC
does not improve on the traditional techniques is that of arbitrary cost allocation. Both
are based on these subjective allocation methods. The only difference between the
two really is the number of allocation or cost drivers. The fact that they are both
subjective methods means that both methods may cause for misleading decisionmaking.
Another negative aspect of ABC is that of the relationship between the activities and
resource consumption. Not only is it difficult to link the cost drivers to the individual
product in the initial implementation of the system, it also regards the relationship
between the resource consumption and activities as 'linear, absolute and certain' (Geri
and Romen, 2005). This leads us to the conclusion that if there are an increase in the
number of activities there will be an increase in the costs and visa versa. We know for
a fact, however, that there are many discontinuities in costs, meaning we should not
rely on ABC.
The Gartner Group estimated that only between 20% to 50% of global one thousand
firms have adopted ABC (Turney, 2008, p.7) One of the main reasons for this is the
cost of implementing and maintaining the activity-based costing system. It requires
change to the organisational structure as a whole. Babad and Balachandran (1993,
p.565) recognise that looking at the activities in extremely intricate detail is not only
costly to collect, store and process, but allows for error to be found in the data in the
collection, reporting and estimation of sources, which allows for inconsistencies
between different cost drivers for different systems and allows errors in pricing and
costing of the products. The more complex analysis described that is required for
ABC could mean that the costs outweigh the benefits if the costs for gathering and
updating information is too high.