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Activity-Based Costing System Advantages and Disadvantages: SSRN Electronic Journal July 2004
Activity-Based Costing System Advantages and Disadvantages: SSRN Electronic Journal July 2004
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ABSTRACT
In this article one of costing systems, activity-based costing system (ABC), investigated
with differences of traditional systems. ABC aims that to solve problems created by
conventional costing system. ABC has been become widely used by companies in
beginning of 1980s because of usefulness correct product mix decision, controls overheads
and so on. But like the most of cases, new method also has problems, staff resistance,
difficult to implement, timeliness information, unreliable information. Companies have
been becoming hard to solve these problems as implemented Total Quality Management.
Keywords: Activity-Based Costing, Overheads.
ÖZET
Maliyet sistemlerinden biri olan Faaliyete Dayalı Maliyetleme Sistemi geleneksel
sistemden farklılıklarıyla birlikte incelemektedir. Sistem, geleneksel maliyet sistemi ile
ortaya çıkan problemlerin çözümü için çıkarılmıştır. Faaliyete Dayalı Maliyetleme, en
doğru ürün karmasının bulunmasındaki kullanışlığı, genel üretim giderlerinin kontrolü gibi
yararları dolayısıyla işletmeler tarafından 1980’den itibaren kullanılmaya başlanmıştır.
Ama birçok yeni yöntem gibi bu yöntemin de bazı sorunları vardır; personel dirençleri,
uygulama zorluğu, bilgilerin güvenirliği ve bilgilerin elde edilmesinde zaman sınırlılığı
gibi. İşletmeler, Toplam Kalite Yönetiminin uygulanması gibi söz edilen problemlerin
çözümünde zorlanmaktadırlar.
Anahtar Kelimeler: Faaliyete Dayalı Maliyetleme, Genel Üretim Giderleri
INTRODUCTION
Increasing domestic and foreign competition, automation and changing cost structures is
forcing manufacturers to look for a better understanding of their accounting system and to
need real-time information systems. Years ago, typical manufacturers have produced a small
number of products. Labour was the dominant element in cost structure. Nowadays, products
are more numerous and labour are becoming a smaller component of total production costs.
So that companies must take an attention at their traditional and consider a new system.
Product's price consists of costs, which are direct labour, direct materials and overheads.
There is no problem with direct labour and direct materials costs because of their involving
directly to product costs. The problem with overheads is which overheads put in the right
product. Complexity structure of nowadays companies decreases their direct materials and
labour, however their common costs increase instead (Karlöf 1993: 34). A cost management
system's one of objectives is that to identify and eliminated non-value-added costs. As its
name indicates, activity-based costing (ABC - activity-based accounting or activity
accounting) is a system that focuses on activities. Activity-based costing can be a part of a
job-order product-costing system or a process product-costing system.
During 1980s, many managers became dismissed with their costs accounting system
(Horngren and Foster: 151). Some companies began to adopt activity-based costing system
because of dissatisfaction with its existing cost accounting system. There are several reasons
why managers demand it.
First reason is that disadvantages with the method allocates fixed overhead, including
labour, are often arbitrary, not necessarily related and directly associated to production
(Polimeni et al 1991: 567). Using single pools of indirect costs and overhead application
bases such as direct labour hours are no longer considered good enough. In the current
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manufacturing environment, resources are often unrelated to direct labour. Such
misallocations can lead management effort to place the wrong products.
If companies want to maximise their profits they have two options. One option is cutting
costs. Companies focusing on cutting costs are only asking for trouble. For example,
Thornton Equipment Company needed to lower its overhead cost structure, but indeed they
had trouble because of need of overhead costs (Blaxill and Hout 1991; 93). Cutting cost is not
a solution. Another solution is to correct their products prices. This second reason leads to
management toward the ABC.
Another factor in the move toward ABC systems is related to the information
requirements. Cost accounting systems exist to provide information to help executives in
performing their cost management duties. If managers improve and redesign manufacturing
processes, they want their accounting systems to be tailored to the new processes. If the
activities are managed well, costs will fall and the resulting products will be more
competitive. Companies felt that its existing system was oriented too much toward financial
accounting and provided little information in determining product costs, making product mix
decisions, and evaluating plant performance (Polimeni et al 1991: 1119). Developments in
information gathering technology have made practical the gathering and processing of more
detailed information demanded by activity-based costing (Hilton 1994: 209). With these
reasons by companies moving to ABC costs can be better managed and products more
accurately costed (Roohm et. al. 1992: 59).
Some indicators can signal the need for a new costing system (Hilton 1994: 213):
- Some products are reported profitable, although they are priced with market price.
- Some products that have reported high profit margins are not sold by competitors.
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IMPLEMENTING OF ACTIVITY-BASED COSTING SYSTEM
Activity-based costing system follows two stage procedures. The first stage identifies
significant activities and assigns overhead costs to each activity depending on the proportion
of the organisation’s resources it uses. The overhead costs assigned to each activity compose
an activity cost pool (Babad and Balachand 1993: 564). After assigning overhead costs to
activity cost pools in stage one, cost drivers are identified that are appropriate for each cost
pool. Then in stage two, the overhead costs are allocated from each activity cost pool to each
product line in proportion to the amount of the cost driver consumed by the product line.
(Exhibit 1)
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2. Renewable activities are determinated and planned.
ABC has also been extended into activity-based management (ABM) (Kilough 1992:
881; Babad and Balachand 1993: 563) to include other considerations, such as customer
profitability, workforce utilisation, distribution channels, and other management issues. Thus
ABC is the information system that displays the cost and profitability structure of products in
an organisation, while ABM describes the actions to improve quality and reduce costs and
cycle time.
Example of Atlas Electronics Company Plc. produce two types of television, named as
Gezer and Sezer. Product of Gezer has a lower production volume and 50.000 units’ annual
sales. And Sezer has a higher production volume than Gezer, annual sales is 200.000 units.
Gezer system is more multi-functional television and bigger size than Sezer. In this factory,
Advanced Manufacturing System was installed, so that labour costs had been minimised.
Both of products require one hour direct labour for finishing products and company spends
250,000 hours a year. Product Gezer has a high quality and needs more quality control. The
company Product costing is achieved by summing three categories of costs at Exhibit 2. With
this example we will use both costing system, traditional system based on direct labour hour
and activity-based costing system in terms of comparison.
1
The example is mixture of Hilton 1994: 209; Horngren and Foster: 152-4; Hilton 1994: 206-7; Tanış and Tuan
1993: 45-64; Polimeni et al 1991: 567.
2
US Dollar used in the example as a monetary system instead of Turkish Lira because of ease the example. The
company name of in the example does not exist in the reality world.
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Types of TV: Gezer (for upper class) and Sezer (for middle class)
Gezer Sezer Total
Sales of television (per year / units) 50,000 200,000 250,000
Direct materials (per unit / $) 400 200 -
Direct labour (per unit / $) 50 50 -
Overheads (total a year / $) - - 75,000,000
a) Product costs; based on direct labour: Rate of overheads allocation can be formulated
as follow:
Annual Overheads 75,000,000 $
Rate of Overheads Allocation = = = 300 $/ hour
Annual Direct Labour Hour 250,000
Then products costs have shown at the below (exhibit 3):
As seen above with this approach, both products' overheads are equal. Because the
company did not consider factors, effect overheads, and distributed from direct labour hour.
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The first step is to identify the cost drivers. The company after analysed their system,
they have realised that there are six activity areas in the manufacturing facility. Six activities
and their allocation on the products based on application rate at exhibit 4. We can compare
this result with traditional system, based on direct labour hour (exhibit 4).
What has happened at ATLAS ELECTRONICS, INC. plant? The essence of the problem
is that as seen above in terms of overheads, activity-based costing has changed both product
costs comparing with based on direct labour hour because of their hidden completely by the
traditional. As indicated above with low production volume, but high resources allocation
product Gezer’s real unit cost increased by $ 650 with activity-based costing. However
Sezer’s unit cost decreased by $ 162.5 because of low resources allocation. Indeed, Sezer
emerged as an extremely profitable product. The high-volume products basically subsidised
the low-volume line.
Accounting system tended to overcost the intensively competitive high volume product.
It loads too much indirect manufacturing costs on high-volume products and too little on low-
volume products.
Activity-based costing has becoming widely uses because of several advantages. First
over all beginning and visible advantage is more useful in measuring product costs to be
obtained more accurately and making product mix decisions and pricing decisions made so
better factory management (Polimeni et al 1991: 1119). The firm was able to identify the
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relative profitability of the products and understand cost drivers. The companies will meet
helpful to make decision on capital budgeting process. They can evaluate easily on
investment in new technologies.
The pooling of costs by activities or activity areas provides information that may help
managers to better plan and control costs. Information generated by an activity-based costing
system can also encourage companies to redesign products to use more common parts (Blaxill
and Hout 1991; 100). When activity-based costing system is in use, an activity-based flexible
budget may be developed. Such a flexible is more accurate than conventional budgets,
because multiple cost drivers are identified to explain the behaviour of overhead costs.
In addition, ABC provides insight for the analysis of customer profitability, distribution
channels, brands, region, and other areas that directly affect the profitability of a firm.
Because ABC links performance of particular activities on the organisation’s resources
consumed (Babad and Balachand 1993: 564). Also the activity-based costing system creates
opportunities to product designers to make for cost reduction.
The prices competitors set for their products are important factors in making decision
whether a company enter a new market. The estimated long-run cost of a product that will
enable a company to enter or to remain in the market and compete profitably against its
competitors is called the target cost. Japanese consumer-product companies often use target
costs in their pricing strategies (Sakurai 1988 quoted by Hilton 1994: 739; Horngren and
Foster: 416). An activity-based costing system can be particularly helpful as product design
engineers try to achieve a product’s target cost with providing information.
Activity-based costing system generally improves the ability of an analyst to estimate the
cash flows (Hilton 1994: 834). By separating costs into activity pools and identifying a cost
driver into each pool, the analyst can more accurately determine the levels of various costs
that will be incurred.
Harper and et. al. have conducted a project to test the feasibility of applying this method
to purchasing (Roohm et. al. 1992: 59). The test showed that ABC works well when used to
analyse a purchasing department, and the information it provides management with accurate
cost data.
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(TQC) that often goes together with JIT. Variable manufacturing costs would be lower, due to
saving in direct labour. General factory overhead costs would increase, due to implementing a
new production equipment (Hilton 1994: 210 and 343). But with this type of problem would
be decreased by ABC.
ABC uncovers problems with poor quality, poor design, and neglected markets. Kilough
doubts that ABC provides this capability (Kilough 1992: 881). Besides, a similar example has
been used to suggest advantages of JIT and TQM. But when implementing these new systems
some problems have been raised.
According to Blaxill and Haut some companies miss the point; overhead is not only
about cost more fundamentally, it’s about process (Blaxill and Hout 1991; 93). One of the
obstacles to adopting ABC is that it requires a building management’s thinking (Roohm et. al.
1992: 62).
Educating employees at all levels about implementing ABC may be the most difficult
task of all. Measurement has to be tied to the ABC numbers. And the daily decision-making
process often must be significantly altered, too (Ness and Cucuzza 1995: 130). Both Chrysler
and Safety-Kleen mounted major programs to educate employees at all levels. Both began
with one plant as a pilot plant.
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Most companies understand how big a job gathering the information needed to set up an
ABC system is after implementing it (Ness and Cucuzza 1995: 135). One reason is that ABC
is much more detailed and complex than standard cost accounting. Traditional systems come
together many costs into a few heterogeneous overhead pools. Under ABC, each of those
pools are often broken into activities, and it may take hundreds of inquires to identify and
gather the information on them. Similarly, an ABC system uses many more statistical
measures than a traditional system. Also activity-based costing system using multiple cost
drivers and overhead rates is more complicated and more costly to use (Hilton 1994: 99).
As Kaplan (1989: 1-3 quoted by Polimeni et al 1991: 1116) indicated that all cost
accounting systems are the problem of timeliness of information. Activity-based costing
could not have solved this problem. A manager might need on a daily or hourly basis.
However, many systems provide information, on a monthly basis. Indeed, there is often a gap
between the time information is reported and the time period that is shown in a report. Also
questionable is important of the quality of the information. Another problem is collecting data
that is so time-consuming, especially in the beginning, what kind of information is that
required to set up an ABC system and where to find it takes a while.
To solve these problems Howell and Soucy recommend that firms adopt multiple cost
accounting systems (Howell and Soucy: 48 quoted by Polimeni et al 1991: 1121). But using
multiple cost accounting system is costly and may lead managers to confuse results. Instead
of them new accounting system should be introduced, for example Time-Based Costing.
Another approach to solve the problem, which is not solve it. That means not to use
complicate systems because of competition leads companies to determine their products price
by market as Japanese companies do.
CONCLUSION
Global competition requires that companies continually improve and innovate. New
products must be developed and introduced to replace those that become obsolete. New
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processes must continually be developed to make production more efficient. But companies
realised that product mix was wrong priced because of old fashion accounting systems.
With these problems, activity-based costing has been implemented in the business with
leading writers Robin Cooper, Robert S. Kaplan, M. Thomas Johnson. The flexibility,
planning and behavioural considerations, that are afforded by ABC make it a significant
improvement over the traditional approaches. ABC has emerged as a tremendously useful
guide to management action that can translate directly into higher profits.
But ABC has also problems such as difficult implementing, costly, staff resistance,
timeless and difficult gathering information and questionable gathered information.
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REFERENCES
Blaxill, Mark F. and Thomas M. Hout, “The Fallacy of The Overhead Quick Fix”, Harvard
Business Review, July-August 1991, Vol. 69, Iss. 4.
Hilton, Ronal W., Managerial Accounting, Second Edition, McGraw-Hill, Inc., New York,
1994.
Kilough, Larry N., “Book Reviews: Peter B. B., Common Cents: The ABC Performance
Breakthrough (Hills-bono, OR: Cost Technology, 1991)”, The Accounting Review, Vol.
55, Iss. 4, October 1992.
Ness, Joseph A. and Thomas G. Cucuzza, “Tapping the potential of ABC”, Harvard
Business Review, Vol. 73, Iss. 4, July-August 1995.
Polimeni, Ralph S. and et al., Cost Accounting, Third Edition, McGraw-Hill, Inc., Singapore,
1991.
Roohm, Harper A. and et. al., “Yes, ABC Works With Purchasing, Too”, Journal of
Accountancy, November 1992.
Tanış, Veysi Naci and Tuan, A. Kadir; “Yönetim Muhasebesinde Yeni Bir Yaklaşım: Faaliyet
Esasına Dayalı Maliyetleme”, Çukurova Üniversitesi İktisadi ve İdari Bilimler
Fakültesi Dergisi, Vol. 4, Iss. 1, 1993.
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