Activity Based Costing in Management Accounting

6 June 2016

Activity Based Costing or ABC, a subset of Activity Based Management, is “a management reporting system that focused on the costs of the work activities associated with operating the business in lieu of the standard cost centers” (cms.hhs.gov). On the other hand, Activity Base Management “refers to any actions that might be taken based on the ABC information” (Anthony, Hawkins & Merchant 600). Some of these actions might include pricing strategies, supplier selection, customer selection, product mixes, and product designs (Anthony, Hawkins & Merchant 600). This costing tool was developed by Robin Cooper and Robert Kaplan (Kennett, D.

, Durler, M. & Downs, A. 20).The ABC costing method “attempts to provide a better model of the costs of producing products or providing services and delivering them to customers” (Anthony, Hawkins & Merchant 596). This is accomplished through a more in-depth study of the activities involved in “producing products or providing services and delivering them to customers” (Anthony, Hawkins & Merchant 596) and the resources, such as capital and human, utilised by these activities.Because of this inherent characteristic of the ABC model, it is not used for accounting for products and inventories in the books or business organisations rather it is used as an estimating tool. ABC is more than just a simple costing system (Baines 12).

Activity Based Costing in Management Accounting Essay Example

Baines claimed that ABC “forms the heart of a business improvement programmes, but one driven by information on the costs of activities undertaken” (12).A survey in the early 1990s of United Kingdom companies reported that only 6 per cent of the respondents had integrated ABC in their processes (Anthony, Hawkins & Merchant 601). This figure has improved since that survey; however, a similar study in the United Kingdom found out that firms which had implemented ABC have better stock returns than firms which have not (Anthony, Hawkins & Merchant 602). A research done by Kennedy and Affleck-Graves involving a sample of United Kingdom firms showed that “firms adopting activity-based costing techniques outperform matched non-ABC firms by approximately 27 percent over the three years beginning on January 1 of the year in which the ABC techniques are first implemented” (19).Activity Based Costing: Relevance and LimitationsAdapting ABC in an organisation is costly and creates change on how organisation behaves toward financial information. The changes resulting from implementing ABC might also result to disruptions in the production and operation processes of the business organisation. Fortunately, “ABC is not required for external financial reporting, [as such organisations] should implement ABC only if the expected benefits are greater than the expected costs (Kennett, D.

, Durler, M. & Downs, A. 20).RelevanceGeiger suggested three necessary conditions for a successful ABC application and implementation: usefulness, credibility, and affordability (Kennett, D., Durler, M. & Downs, A. 20).

The information provided by ABC should be useful to intended users, credible, and affordable. One of the usefulness of the information provided by ABC is it “directs management’s attention to underlying causes (drivers) of cost and product” (Drury 60). This is important because product costs play a major role in the pricing strategies of businesses.Kennedy and Affleck Graves opined that “[by} more accurately attributing cost to products, services, and customers, ABC can play an important role in providing relevant information for management operating decisions, which, in turn, should impact on profitability and, ultimately, shareholder value” (21).ABC and ABM have a use in the customer relationship management. Information provided by ABC can be used to analyse the profitability of a customer or customer group. “Sweeney and Mays (1997) reference the First Tennessee National Corporation, a regional US bank, where 30 percent of customers were found to be providing 88 percent of the company’s profit, while another 30 percent generated a loss of 7 percent” (Patridge ; Perren 560).

This situation can be corrected through ABC.In improving an organisation’s value chain, ABC can be used to cost and analysed the value of the company’s value added and non-value added activities. “The identification and cost analysis of NVA activities act as a trigger to stimulate their reduction or elimination” (Patridge ; Perren 560). As such, ABC aids management in understanding how all levels of the organisation integrate to create a single chain of value-creation.In business process reengineering or BPR, ABC aids management in measuring before and after costs of processes as a direct result of the BPR initiative of the company (Patridge ; Perren 560). Costing information provided by ABC also supports the strategic and operational decisions regarding product lines, market segments, customer relationships and process improvements (“Activity-based costing management: a growing practice” 17).Another relevance of activity based costing as suggested by Ward and Pattel is that it “provides a sound foundation of future cash flow projections” (Kennedy ; Affleck-Graves 21).

ABC can do this through an improved customer relationship management as a result of the elimination of non-value adding activities identified and accounted by ABC. Ward and Pattel argued that the information provided by activity based costing “leads to investment in value-added activities that support products, services, customers, and market segments, thereby increasing shareholder value” (Kennedy ; Affleck-Graves 21).Activity based costing is also very useful in a company’s budgeting process. With this importance, the use of activity based costing in performance management of a company’s different departments including production and sales goes hand in hand. The use of activity based costing information in budgeting for the company’s future operations give a more realistic view of how much resources the company needs in that future.ABC information lends flexibility to the organization’s budgeting processes. The flexibility stems from the fact that ABC budgets allow for the adjustments of budget data in accordance with actual productions and/ore sales.

Morrow and Connelly said that “in using an activity basis for resource allocation and on going monitoring, the approach can [even] be extended for important activities to help focus on continuous improvement and to ensure that decision making is taken with a better understanding of the cost implications.” (40).The use of activity based costing is not for every organisation. ABC has a lot of underlying assumptions and the violation of any one result to “costing distortions” (Latshaw ; Cortese-Danile 321) which will result to inaccurate product costing method, and then incorrect pricing strategies. Unless an organisation has homogeneous product or service cost drivers, and a well-proportioned cost pool in relation to the activity, ABC will not work for the firm (Latshaw ; Cortese-Danile 31).Activity Based Costing also requires that costs be identified as either variable or fixed. In reality, costs don’t behave in a straight line all the time.

There are costs called mixed costs which display the characteristics of both fixed and variable costs. In practice separating the variable and fixed component of a mixed cost might not be straightforward, but rather subjective which defeats the purpose of ABC.Because of the difficulty in implementing ABC, a company can opt instead not to allocate its overhead costs into its products or services. This method utilises variable costing which only considers the costs directly attributable in the making of the product or in delivering the service (Drury 63). Many companies who had implemented ABC had failed to realise the benefits promised. This is so because many of these companies failed to “understand the impact (even shock)” (Buys ; Green 37) implementing activity based costing brings.Activity Based Costing: TrendsActivity Based Costing which is very popular product or service costing method in the private sector has started to gain grown in government offices.

The City of Indianapolis in the United States has implemented ABC to provide several needs of the city government. These needs are accurate information about the cost to provide city services, measuring productivity, measuring the quality of service delivery, and measuring the efficiency of service delivery. In implementing ABC, the city expects to benefit from the costing method through an improved management, significant improvement in service and cost savings, and delivered a dollar’s worth of service for each dollar of investment (Simpson & Williams 26). This trend is observed in other areas in the United States and the rest of the world.In a survey done in the United States, United Kingdom, and Canada, which was participated in by several chief administrative officers of various municipalities, aimed to “understand the use of contemporary management techniques by municipal governments, their effectiveness, and future expectations” (Kidwell, Ho, Blake, Wraith, et al 63). The contemporary management techniques included in the research study are activity based costing, activity based management, benchmarking, process reengineering, total quality management, and balanced scorecard. The result of the survey revealed that only 3.

3 per cent of the 105 respondents from the United Kingdom considers activity based costing as ‘very effective’ in municipal government, and 80 per cent of them said that it is ‘moderately effective’ (Kidwell, Ho, Blake, Wraith, et al 64-65).Activity Based Costing is increasingly being used in the health care system. Health care providers need calculate the costs of providing health care to each patient in all departments. Costs are collected for “each in-patient day, out-patient visit, each test and procedure performed and each drug prescribed (Beck, Beecham, Mandalia, Griffith, Walters, Boulton & Miller 311). Costing health care will help the hospital better manage its resources and the government to better manage the country’s health care system.Another ensuing trend in the use of activity base costing is its use in the service industry. Take the banking sector for example.

Contrary to what, Peter Drucker, the management guru said on the non existence of cost information of service industries (Max 23) there is a growing need and demand for the service industry to properly manage the costs that go into service delivery. Truly business enterprises were created to extend the wealth of its owners, as such there is a need to manage the costs associated in providing the business enterprises’ products and services to their customers.Logically, the more control a business organization exercises on its costs, then the more it can contain those costs to their desirable levels. As costs are contain, profit of the organization is maximized, which will result to a better wealth creation for the business owners. The banking sector had “traditionally used average costs as part of [its] profitability analysis” (Max 24). But as the banking sector become more complex in terms of the financial products and services they provide to their clients, the cost structures of these products and services become increasingly more complex. “As a result [of this complexity], average costs have never been more inappropriate” (Max 25).

Today banks have identified several ways to leverage cost and profitability information. These new and unique methods are activity based pricing, linkage between activity based costing information and performance management scorecards and processes, information on the profitability of discrete customer relationships, and information on a process view of costs (Max 26).ConclusionsNumerous research studies done on the bottom line impact of activity based costing have shown that companies who use ABC performs better than those who don’t. It is therefore important for a business organisation planning to implement ABC to assess and plan on how to proceed with the project. CMA suggested nine generic steps that a company can follow: 1) identify and assess ABC needs, 2) training requirement, 3) define the project scope, 4) identify activities and drivers, 5) create a cost and operational flow diagram or schematic, 6) collect data, 7) build a software model, validate and reconcile, 8) interpret results and prepare management reports, and 9) integrate data collection and reporting (“Activity-based costing management: a growing practice” 17).In an increasingly competitive and global marketplace, an organisation needs to gain, develop and sustain its competitive advantage in order to survive. One way for it to gain, develop and sustain competitive advantages is through activity based costing.

ABC aids companies in improving business processes particularly those processes identified in the production of products and delivery of services to customers. It also helps companies to streamline their value and supply chains by identifying and costing non-value adding activities and links.Lastly, management and their organisations must keep in mind that “[activity] based costing is not (another) cure all” (Baines 13). It has its own limitations. It doesn’t stand alone. It must work and integrated with the other processes of a business organisation for that firm to realise the optimal value of activity based costing and activity based management.References“Activity-based costing management: a growing practice.

” CMA 67.2 (Mar. 1993): 17.Anthony, R., Hawkins, D. and Merchant, K. Accounting Text & Cases.

11th ed. Boston, Massachussets: McGraw-Hill, 2003.Baines, A.”Activity-based costing.” Work Study 41.2 (Mar/Apr 1992): 12-13.Beck, E.

, Beecham, J., Mandalia, S., Griffith, R., Walters, M., Boulton, M. & Miller, D. “What is the cost of getting the price wrong?” Journal of Public Health Medicine 21.

3 (Sept. 1999): 311-317.Buys, P. & Green, K. “Costing Techniques – Activity based Costing.” Accountancy SA (Nov. 2006): 36-37.

cms.hhs.gov. “Activity Based Costing.” www.cms.hhs.

gov. http://www.cms.hhs.gov/ActivityBasedCosting/02_ActivityBasedCosting.asp (18 Mar. 2007).

Drury, C. “Product Costs: Activity-Based Costing.” Management Accounting 67.8 (Sept. 1989): 60-64.Kennedy, T. & Affleck-Graves, J.

“The Impact of Activity-Based Costing Techniques on Firm Performance.” Journal of Management Accounting Research 13 (2001): 19- 45.

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