Activity Based Costing (ABC)

Activity Based Costing (ABC).

Introduction

Accounting has always been a fundamental part of any business. It seeks to determine the profitability of a business by ensuring that all entries are posted at the right place so as to give a clear idea or picture of the position of the company. Needless to say, there exist various modes of accounting and assigning costs and expenses. These modes have continued evolving, with some accounting methods being relegated to the periphery and some new modes coming up as a reflection of the growth that the field has been experiencing. Nevertheless, one of the most popular methods of accounting is Activity Based Costing (ABC).

ABC refers to a methodology of costing that is mainly used to directly mark overhead costs to costs, thereby assisting managers in making the appropriate decisions pertaining to the product mix, as well as competitive strategies to use. The methodology can drastically alter the way in which managers price their products, determine their product line’s mix, evaluate new technology or identify sourcing components’ location (Narasimhan & Thampy, 2002, pp. 99). The use of this technique has been rising steadily as far as enhancing the accuracy of information pertaining to product cost is concerned (Drury, 2006, pp. 362). Traditional costing methods are known to allocate overhead costs in an arbitrary manner, often on the basis of direct labor hours (Yin, 2009, pp. 48). It is worth noting, however, that direct labor hours are not usually an adequate representation of the percentage indirect resources that certain cost objects may have consumed within a certain period. This, therefore, breeds distortion of product cost. Nevertheless, ABC technique solves this problem by examining the manufacturing system as being made up of activities. The technique allocates the activities’ costs to the cost objects via utilization of cost drivers that embody the use of indirect resources through cost objects, in a more accurate manner that the arbitrary methods used by traditional costing methods.

This system allocates costs to activities on the basis of their utilization of those resources and allocates costs to objects on the basis of their utilization of the activities (Viavio, 2008, pp. 67). The technique has been depicted as a full-absorption method of costing that has gained more use than conventional methods, thanks to its incredible tracing of costs, as well as an accurate assessment of costs (Viavio, 2008, pp. 67). It allows organizations to follow costs that are associated with activities carried out to deliver services or produce products. It is not merely a new set of techniques or rules for allocating overheads to value inventory rather it underlines a way of looking at operating costs, and offers techniques to divide the underlying activities that result in the existence of the costs (Turney, 1996, pp. 33).

This technique of accounting has varied benefits. First, the technique allows for scientific and equitable pricing of products that utilize less activity resources, as well as increase the cost of products that use more of the activity resources of a firm (Popesko, 2010, pp 13). In addition, it assists organizations to offer top-ups or value-added services to the existing products based on the actual costs incurred. Third, the technique is known to get rid of unprofitable items from the line of production, in which case it increases the profitability of an organization without increasing the prices (Drury, 2006, pp. 362). This comes as a valuable option especially during times of recession. On the same note, it allows for the elimination of the cost of running or maintaining non-remunerative activities, something that increases the overall profitability of the organization (Cowton et al, 2008). This technique also allows for the allocation of resources to items that utilize fewer resources or profitable items. In addition, it safeguards compatibility with scorecards of performance management through revealing the contribution of every person to the cost of the products, and, therefore, the profits accruing to every person (Partanen, 2000, pp 134). The technique has been cited as effective in exposing inefficiency and waste thereby productivity. In addition, it allows for the identification, as well as the elimination of non-value adding activities such as duplicate processes and needless inspections.

According to Stratton et al (2009, pp. 31), the technique, however, has been giving significantly less than the desired yields. ABC technique has been abandoned by most companies, which cite the fact that it does not capture the intricacy of their operations (Partanen, 2000, pp 134). In addition, it takes significantly long to implement and is costly to build, as well as maintain (Kulmala, 2002, pp 37). On the same note, other companies have criticized it as impractical as it mainly involved the definition of activities and attempting to make a subjective judgment on the amount of overhead that has been used (Dandago, 2003, pp. 53). This had to be carried out on a regular basis, in which case companies relegated it to the periphery and adopted other techniques. This led to the drop of the technique to the 22nd position from 11th position in a period of seven years (Stratton et al, 2009. Pp. 31).

In spite of the negative reports pertaining to the utility of ABC, there are numerous case studies and reports of companies and organizations that incorporate ABC techniques and even reported satisfaction. These include DB Schenker AB (Austria), AstraZeneca AB (London) NCC Construction AB (Nordic Region), and Indian companies.

DB Schenker

DB Schenker is a leading passengers and Logistics organization based in Vienna Austria. It offers its customers with solutions for logistic services in air, rail and road transport, as well as storage and consulting services ( HYPERLINK “http://www.schenker.at/english/company/history.html” http://www.schenker.at/english/company/history.html). In a 2007 interview with its chief accountant named Jan Saarsoo, it was revealed that the working method of the company mainly revolves around delivering items from one point to another, operations that would not be considered complex. Schenker mainly involves direct costs, which make up the largest part of the company’s total cost as the company rents equipment that is used in carrying out the duties from lumpers. The company makes use of standard cost so as to estimate the amount of expenses that should be incurred in carrying out a certain service (Majid & Sulaiman 2008, pp. 47). Mr. Saarso states that the company’s expenditure mainly results from resource consumption. As much as the traditional methods of cost allocation were serving the company in a satisfactory manner, they were unreliable in decision making decisions. The company applied ABC in the form of a project so as to evaluate the amount of expenses that went in carrying out a certain order. This was done in 2006 as a project rather than a full implementation of the model. The company observed that the model was effective in the provision of information pertaining to the consumption of resources, as well as the expenses that go to the production of an output. In addition, the ABC model has come in handy as a communication tool where the company communicates with employees in clarifying the amount of any service activity would cost to carry out. The company also noted that the ABC model was an effective tool for communicating when negotiating with customers as it gives a clear view of the amount of material, money and time consumed by an activity. On the same note, the company realized that it had been carrying out some activities for free, whereas it was paying for the same activities (Majid & Sulaiman 2008, pp. 47). However, the model presented a number of challenges for the company. For example, the company could not update the model, thanks to its resource and time commitment, as well as its complexity. The company considered the numerical data as challenging to align in the appropriate manner.

AstraZeneca AB (Sweden)

AstraZeneca Company was established through the amalgamation of two large companies that dealt with pharmaceuticals, which were British Zeneca Group and Swedish Astra. The two companies are known for their developments and innovations in the pharmaceutical industry, as well as their science-based cultures and vision ( HYPERLINK “http://www.astrazeneca.com/About-Us” http://www.astrazeneca.com/About-Us). The company produces different products extending from syringe to pastille, the manufacture of which demands machines of varied types. It is worth noting that there are variations in the products of the company from one country to another, which makes the process complex. According to Eva Markstrom, the company’s process manager, direct costs make up the largest percentage or component of the total cost of the company and are only incorporated in the process of manufacture. Other costs considered direct include marketing and energy (Cowton et al, 2008, pp. 27). The company sets the products’ prices in line with the manufacturing costs, thereby making it independent of the prices in the market. ABC makes up the key cost system in Astra Zeneca. The production of a single process involves about 9-10 activities. The fundamental reason for using the ABC model is that it allows every product to bear its own expenses. In essence, the model is mainly used in making decisions pertaining to products including product outsourcing and setting prices of products. In some instances, for example, it is less costly to purchase components of a certain product than to manufacture it, in which case the model supports these decisions thereby assisting the top management in making these decisions (Cowton et al, 2008, pp. 27). Apart from product related decisions, ABC is used in the making of strategic decisions since it offers the management with all-inclusive reports pertaining to the cost of manufacturing medicine of certain types. The company, however, does not use this model to make customer-related decisions such as customer segmentation. Nevertheless, the company uses the model in inventory valuation and comparison of prices between the years.

However, Eva notes that the model is challenging especially considering that it takes a considerable amount of time, and it must be controlled. In some cases, the data must be entered manually in cases where the right data is not obtained. Eva also rues the complexity of calculating the cost of products from the raw materials to finished products, which may take a long time. Nevertheless, the company does not see the model as expensive to maintain.

NCC Construction AB (China)

NCC Construction has distinguished itself as a leading company in property development and construction in the Asia , with emphasis on China. It is mainly involved in the building of commercial and residential properties, public buildings, industrial facilities, civil engineering structures, roads and other categories of infrastructure (Lana & Fei 2007, pp 249). Its operations are considered complex as concerning the volume, number of articles and technical equipment. Different materials are used for different projects, with the company renting certain machines depending on the project. Renting the machines is considered indirect cost, while direct cost is made up of material cost, which makes up about 70%-80% of the entire cost depending on the manner in which the company undertakes the project (Lana & Fei 2007, pp 249). The company has been using ABC system for more than two decades. According to its IT-operator, the model satisfies the company’s need for the accurateness in the process of calculating costs via assigning costs of activities to the cost objects. This helps the company to set its prices appropriately, as well as budget and plan well. However, the company does not depend on ABC entirely for budgeting as there may be changes in the working process. The model is also used in the making of strategic decision as it allows for the estimation of the amount to be charged for every project. This calculation forms the project’s foundation irrespective of any changes in the magnitude of the project. The awareness of the cost and the amount to be spent on a certain project gives the company competitive advantage in the construction industry (Lana & Fei 2007, pp 249). As much as the company finds the model as time consuming, requiring regular maintenance, as well as resources, it does not face problems in maintaining it as the model has been integrated in the data system of the company for a long time.

Indian companies

In a study carried out in 2011 on Indian companies, it was revealed that there existed a high inclination towards implementing ABC model among the respondents. This was especially for companies in the trading and manufacturing organizations. The companies undertook behavioral classification of their costs by categorizing them into variable and fixed costs, with marginal recognition or acknowledgement of semi-variable costs. All the companies had clearly defined direct and indirect costs with overheads being allocated on the basis of predetermined rates. The shift to activity-based costing from the volume based costing was triggered by the over or under allocation of costs (Sharma, & Gupta, 2012, pp. 61). The researchers, in this study, underline the need for a cost management system that would give the true cost of services and products. In addition, the researchers noted that conventional costing methods and ABC models were inefficient in locating constraints, in the manufacturing process that may reduce the throughput. Both systems incorporated inherent limitations that may lead to systemic problems in decision-making pertaining to throughput. As much as ABC comes with a number of constraints, the researchers noted that it assists companies to price their products appropriately. It comes in handy in providing information pertaining to product profitability, thereby enhancing sound decision-making by top management (Sharma, & Gupta, 2012, pp. 61). On the same note, it assists enterprises to enhance their efficiency, as well as reduce costs without compromising on the value for consumers.

In conclusion, ABC has been extremely popular as a method of costing in many companies. However, its popularity has been reducing thanks to some limitations especially pertaining to complexity, time consumption, and the need for regular maintenance (Karolefski, 2004, pp 18). However, as the research on companies from different companies shows, it is still extremely relevant in making decisions among the top management, especially thanks to its provision of product profitability and customer profitability (Rajaramn, 2000, pp. 575). In addition, the technique allows for scientific and equitable pricing of products that utilize less activity resources, as well as increase the cost of products that use more of the activity resources of a firm. In addition, it assists organizations to offer top-ups or value-added services to the existing products based on the actual costs incurred (Geri & Ronen, 2005, pp. 139). Moreover, the technique is known to get rid of unprofitable items from the line of production, in which case it increases the profitability of an organization without increasing the prices (Thyssen, 2005, pp 252). This comes as a valuable option especially during times of recession. On the same note, it allows for the elimination of the cost of running or maintaining non-remunerative activities, something that increases the overall profitability of the organization (Ozbayrak et al, 2004, 57).

References

Sharma, G.L 7 P.K. Gupta, P.K, 2012, Activity Based Costing : Strategic Implications for Indian Companies. LBS Journal of Management & Research, pp 58-63

DB Schenker AB webpage, 20th December 2012 from HYPERLINK “http://www.schenker.at/english/company/history.html” http://www.schenker.at/english/company/history.html

AstraZeneca AB webpage, 20th December 2012 from HYPERLINK “http://www.astrazeneca.com/About-Us” http://www.astrazeneca.com/About-Us

Yin, R. K. (2009). Case study research: Design and methods (4th ed.). Thousand Oaks, CA: Sage, pp. 47- 57

Viavio, J. 2008. Qualitative Management Accounting Research: Rationale, Pitfalls and Potential. Qualitative Research in Accounting & Management, 5 (1), pp. 64-86.

Thyssen, Jesper, Israelsen, Poul & Jørgensen, Brian, 2005.”Activity-based costing as a method for assessing the economics of modularization – A case study and beyond”, Elsevier, pp.252.

Turney, P. (1996): “Activity-based costing the performance breakthrough”, CLA, London. Pp.33

Stratton, W. O., D. Desroches, R. A. Lawson and T. Hatch. (2009). “Activity-based costing: Is it still relevant?” Management Accounting Quarterly, Vol.10, No. 3, pp.31-40.

Popesko, B. (2010), Utilization of Activity-Based Costing System in Manufacturing Industries – Methodology, Benefits and Limitations. International Review of Business Research Papers, Vol.6, No.1, pp. 1-17.

Partanen, V.; Järvenpää, M. & Tuomela, T. (2000): “Wisapaper: the role of management accounting in managing customer relationships”, in Cases in Management Accounting. Current practices in European companies, Prentice Hall, London 126-146.

Karolefski, J, 2004. “Time Is Money: How Much Are Your Customers Costing You?” Food Logistics, 15 June, pp.18.

Majid, J.A. & M. Sulaiman (2008), Implementation of activity-based costing in Malaysia: A case study of two companies, Asian Review of Accounting ,vol. 16(1): p. 39-55.

Lana, Y.J.L. & P. Fei (2007), The implementation of activity-based costing in China: an innovation action research approach, The British Accounting Review, vol.39 (3): p. 249.

Dandago, K, I, (2003), Advanced Accountancy: Theory and Practice, Adonis&Abbey Publishng Limited, London. 45- 67

M. Ozbayrak, M.Akgtin, and A.K. Ttirker(2004), “Activity-based Cost Estimation in a Push/Pull Advanced Manufacturing System,” International Journal of Production Economics, Vol. 87, pp. 49-65.

Geri, N., and Ronen, B. (2005). “Relevance lost: The Rise and Fall of Activity-based Costing”. Human Systems Management, 24(2), 133-144.

Rajaramn N. (2000), “Activity Based Costing & Its Implementation Aspects”, The Management Accountant, ICWAI, Calcutta, July:575-581.

Narasimhan, M. S. & Thampy, A. (2002), “Activity Based Costing in Banking Service: A Case Study of a Large Indian Private Sector Bank”, Prajnan, 31(2):95-110.

Kulmala, H.I., Paranko. J., Uusi-Rauva. E, (2002),The role of cost management in network relationships, Int. J. Production Economics 79 (1), pp.33-43

Drury, C., 2006, Cost and Management Accounting, 6th edition, Thomson Learning, London. pp. 362-363.

Cowton, C. J., Brierley, J, A. and Drury, C, 2008, Investigating activity-based costing in manufacturing industry. Cyprus International Journal of Management, 13 (1). pp. 21-33.