Accounting has always been a fundamental part of any business. It seeks to determine the profitability of a trade by ensuring that all entries are posted at the right place to give a clear idea or picture of the position of the company. 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 forms 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).
What is Activity Based Costing
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 about the product mix, as well as competitive strategies to use. The methodology can drastically alter how managers price their products, determine their product line’s mix, evaluate new technology, or identify sourcing components’ locations (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 particular cost objects may have consumed within a certain period. This, therefore, breeds distortion of the product cost. Nevertheless, the ABC technique solves this problem by examining the manufacturing system as being made up of activities. The method allocates the activities’ fees to the cost objects via utilization of cost drivers that embody the use of indirect resources through cost objects, in a more accurate manner than the arbitrary methods used by traditional costing methods.
This system allocates costs to activities based on their utilization of those resources and assigns costs to objects based on 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 expenses 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 strategies to divide the underlying activities that result in the existence of the costs (Turney, 1996, pp. 33).
Advantages of Activity Based Costing
This technique of accounting has varied benefits. First, the method allows for scientific and equitable pricing of products that utilize fewer activity resources, as well as increase the cost of products that use more of the activity resources of a firm (Popesko, 2010, pp 13). Besides, it assists organizations in offering 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. Also, 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. Also, it allows for the identification, as well as the elimination of non-value adding activities such as duplicate processes and needless inspections.
Disadvantages of Activity Based Costing
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). Also, it takes significantly longer 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 regularly, in which case companies relegated it to the periphery and adopted other techniques. This led to the drop of the method to the 22nd position from 11th position in seven years (Stratton et al., 2009. Pp. 31).
Activity Based Costing Case Studies
Despite the adverse reports about 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 is a leading passenger 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 (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 the standard price to estimate the number of expenses that should be incurred in carrying out a particular 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 competently serving the company, they were unreliable in decision-making decisions. The company applied ABC in the form of a project to evaluate the number of expenses that went in carrying out a particular 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 about the consumption of resources, as well as the expenses that go to the production of an output. Also, 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 several 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 numerical data as challenging to align correctly.
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 (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 results 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 critical 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 expenses. In essence, the model is mainly used in making decisions about products, including product outsourcing and setting prices of products. In some instances, for example, it is less costly to purchase components of a particular 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 choices since it offers the management with all-inclusive reports about 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 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 the direct payment is made up of material cost, which makes up about 70%-80% of the total price depending on how the company undertakes the project (Lana & Fei 2007, pp 249). The company has been using the 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 particular project gives the company a 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 into the data system of the company for a long time.
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 mainly for companies in the trading and manufacturing organizations. The companies undertook the behavioural classification of their costs by categorizing them into variable and fixed costs, with marginal recognition or acknowledgment of semi-variable expenses. All the companies had clearly defined direct and indirect costs, with overheads being allocated based on 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. Also, 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 about throughput. As much as ABC comes with several constraints, the researchers noted that it assists companies to price their products appropriately. It comes in handy in providing information about product profitability, thereby enhancing sound decision-making by top management (Sharma, & Gupta, 2012, pp. 61). On the same note, it assists enterprises to improve 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 about 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, mainly thanks to its provision of product profitability and customer profitability (Rajaramn, 2000, pp. 575). Also, the technique allows for scientific and equitable pricing of products that utilize fewer activity resources, as well as increase the cost of products that use more of the activity resources of a firm. Also, it assists organizations in offering 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).
- 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
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- AstraZeneca AB webpage, 20th December 2012 from http://www.astrazeneca.com/About-Us
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