Abstract
The recent years have witnessed the evolution of the accounting discipline from simple accounting techniques to the present advanced accounting systems which have simplified accounting while at the same time increased efficiency in handling huge volumes of accounting information. Cost accounting, and in particular cost allocation systems have evolved tremendously over the past few decades, from the traditional costing methods to the most preferred cost allocation method, activity based costing. This paper explores the emergence of ABC system, while comparing traditional costing systems with ABC. The benefits of using ABC system, its evaluation and implementation will be explored. Activity Based Management (ABM) which came up as a result of ABC system will also be explored in detail.
Activity based costing was a huge departure from the traditional cost allocation systems, which was developed in the mid 80’s by Cooper and Kaplan, researchers from Harvard Business School(Johnson and Kaplan,1987).Cooper and Kaplan initially called it transaction costing but the name was later changed to Activity Based Costing (ABC).
The development of this system is associated with the Harvard network, which was led by Coopers and Kaplan, and the CAM International, a group of firms that were concerned about improvement of cost management systems in their organizations and included large USA manufacturing firms and big professional accounting firms such the then Cooper and Kaplan, which is today popularly known as PriceWaterHouse Coopers (PWC).
These scholars described conventional cost allocation systems as obsolete and ineffective to adequately handle the continuously complex cost accounting environment. Such conventional methods and systems prevented organizations from enhancing their level of profitability and efficiency in service delivery, thus reducing the competitiveness of American firms. Traditional costing systems were also critiqued for their inability to provide managers with sufficient information (Jones and Dugdale, 2002).
Activity Based Costing was thus seen as revolutionary, a cost management system that if appropriately implemented would assist American firms to improve their profitability and competitiveness. Since the 80’s, ABC has received considerable attention from all accounting scholars and enthusiasts and has over the years, increased in popularity and attracted quite a huge following after consistently changing its features and core concepts in response to criticisms from its opponents.
Up to the late 1980’s, ABC was majorly applied for product costing (Jones and Dugdale, 2002),but from the 1990s up to today, ABC has been used to provide critical information to managers on costs through the identification of activities and thus enabling managers to manage activities in their organizations, a term now popularly known as activity based management (ABM).ABM is a term used to refer to the activities undertaken by management on the basis of the foundations of ABC study to improve the efficiency of activities and eventually increase profitability of their firms(Johnson, 1992; Jones and Dugdale, 2002).
Features of activity based costing and traditional costing systems.
ABC by definition is a system of cost allocation that attempts to accurately trace indirect costs to products by allocating overheads to activities and then to products based on their usage of such an activity. It has been found to be optimally useful when accuracy is key, and also when indirect costs comprise of large proportions of total costs compared to the direct costs especially in manufacturing concerns.
There are several key features of activity based costing that distinguish it from traditional costing systems.
Allocation of both manufacturing and non manufacturing costs to products-Unlike the traditional costing systems, activity based costing by its nature allocates non- manufacturing costs commonly known as overheads to products. Using several techniques as explained below, ABC costing can Identify particular cost overheads in a cost pool and allocate it to all the consumers of that cost and thus enabling an accurate determination of consumption for each product which is then allocated to that cost unit(Jones and Dugdale, 2002)..
A number of overhead cost pools are used and each is allocated to products and other costing objects using a unique measure of activity, commonly known as the cost allocation base. A cost allocation base is what determines the cost to be allocated. For instance in a manufacturing concern, the manufacturing base may be number of units, batches, floor usage etc. This enables an accurate allocation of costs for each cost unit.
Traditional costing systems differ from activity based costing in accuracy and complexity of the methods. Traditional methods are usually more simplistic and less accurate than the revolutionary ABC method, and will typically assign overhead costs to products on the basis of an arbitrary average rate thus giving a misleading cost.
Traditional costing systems usually apply indirect costs to products based on a set of predetermined overhead absorption rates. It treats overhead costs as a single pool of indirect costs. It’s most effective when the overhead costs are low compared to the direct costs.
Implementation of activity based costing.
As explained above, ABC allocates costs on the basis of multiple cost pools each of which has an appropriate cost driver, which leads to more accurate costing and improved manager’s control over overheads. Its most effective when the firm in question has a large number of heterogeneous products and services mix and in cases where overhead costs form a huge part of the total cost and also in areas where a manufacturing concern in PPE intensive..
With this background information in mind, we shall explore the major steps in the implementation of Activity Based Costing which include:
Clarifying the major drive, purpose or need for allocation, while defining why the reason to allocate these costs exists and the expected benefits of doing so.
Identifying support and any other operating departmental cost pools for allocation
Clearly selecting an allocation base otherwise called a cost driver for each department cost pools on a cost and effect relationship between the support and operational departments.
Choose and apply a method of cost allocation. Most commonly used methods are the direct methods which allocates costs directly from the support departments to the operating departments that uses its services. For instance, the personnel department may allocate its costs depending on the number of employees in each department. The step down allocation method considers the fact that support departments use other support departments and the reciprocal method uses ratios to allocate costs.
An evaluation of activity based costing
The advantages associated with ABC are;
ABC results to a more accurate costing of products and services. This in essence enables the firm to recoup a lot of costs and improve on its profitability.
Besides the apparent complexity of the system, ABC is specifically simple to understand even by non accountants and is easily implemented resulting to tremendous gains(Jones and Dugdale, 2002)..
ABC is known to use unit costs instead of total costs. This essentially means that a manager is able to have a clear understanding of how mush each unit of product in the organization costs regardless of the number of product lines in the company.
ABC clearly makes visible any wastages non value added activities or losses resulting from inefficiencies in any department. This enables management to effectively reduce such wastages and losses and this translates to profitability.
ABC supports performance management and also enables the implementation of the balanced score cards in an organization. With the ability to note all the inefficient areas or people in an organization, management can easily improve performance management in their organizations.
The shortcomings are;
Implementation of an ABC system is a costly affair to any business and requires substantial resources; it’s also quite expensive to maintain an ABC system once implemented.
ABC data can easily be misinterpreted and must carefully be handled when making decisions. since costs in ABC are only potentially relevant, managers must be careful to identify only costs that are relevant to a particular decision before jumping in into conclusions since some costs are quite irrelevant in a particular context (Johnson and Kaplan,1987)
Reports generated by this system do not conform to GAAPS thus any organizations using ABC must have two systems; one for internal use and another for external reports.
It provides no understanding about how key business processes affect costs a shortcoming that is overcome by the emergence of Activity Based Management.
The emergence of activity based management and its usefulness.
Activity based management, as explained from the onset is a term that came up as a result of the study of activity based costing by managers. It’s used to refer to the activities undertaken by management on the basis of the foundations of ABC study to improve the efficiency of activities and processes and eventually increase profitability of their firms.
The history of activity based management dates back to the 90’s with the increased adoption of activity based costing as a financial management tool. Managers use ABM to manage activities and processes in the organization so as to increase profitability and create value for the customers and shareholders of the entity.
ABM is not to be looked at as a replacement of sales and stock valuation in the financial statements. It’s a new level of information system combining operational and financial information in such a way that both can assist the managers in making improved decisions. This means that ABM must take into account the operational processes of the firm and the cost of resources as presented in the financial statements (Johnson, 1992; Jones and Dugdale, 2002).. These must then be combined in such a way that it captures the costs in the financial system and also the integrity of the system and also reflects how the operational processes consume resources and costs.
Conclusion
Accounting has evolved over the years from simple book keeping procedures to more complex systems that are able to handle large information and also provide useful information for management decision making. The introduction of ABC and its subsequent adoption by many firms has been a phenomenal development in the accounting Discipline, which has led to massive cost savings for firms all over the world (Kaplan,1984).ABM, that came up as a result of the development of ABC has also found its place in modern management by providing useful information that has enabled the creation of value to all the stakeholders of an entity.
References
Cooper R, and Kaplan. R.S. (1988). Measure Costs Right: Make the Right Decisions. Harvard Business Review, September-October, pp. 96-103
Jones,C.and Dugdale,D.(2002) The Bandwagon and the juggernaut of modernity.Accounting organizations and systems.Harvard Business School
Kaplan, R.S.(1984).The evolution of management accounting. The Accounting Review, July, pp. 390-418
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