Introduction:

Most businesses employ costing systems for a variety of tasks, such as project
scheduling, project selection, product costing, and pricing. In order to evaluate
the cost effects of their short- and long-term planning and control activities,
managers make an effort to understand how costs behave and how cost objects
utilize resources through cost functions. A cost function is a mathematical
illustration of the relationship between changes in the intensity of an activity or
process and the rate at which a cost rises.

In contrast to traditional costing systems, which see cost as a linear function of

volume, more complex costing techniques, such as activity-based costing
(ABC), view cost as a function of variations in activity level.

Previously conducted study on the sophistication of product costing systems

defined sophistication in terms of the methods used to include indirect overhead
cost in product costs.

The three key definitions were: (1) assigning indirect overhead costs to product
costs, (2) include all costs in product costs, and (3) making product costs
understandable to non-accountants. All of the product costing systems were
straightforward when these three categories of sophistication were measured by
the number of cost pools and cost drivers.

Drury and Tayles (2006) mentioned it’s better to use the term complexity to
refer to the method of identifying indirect overhead costs with product costs.
Al-Omiri and Drury (2007) argue that the accuracy of direct costs does not vary
with the sophistication of the cost system. They consider that sophistication is
dependent only on the treatment of indirect costs, which, in turn, affects the
accuracy of product costs.
 Sophistication is defined in different ways. This may mean that prior research is
narrow and incomplete one must question the results of prior research and
consider the need to extend research to examine other types of sophistication in
order to improve the specification of the concept.

This research examines knowledge gaps in management accounting using

cross-sectional field investigations. By doing so, it may be possible to confirm
that include indirect overhead expenses in product costs is the best method to
define sophistication.

In economic terms, the most meaningful cost concept when making decisions in
a multi-product firm is the marginal cost. Given this, then, in general, a more
sophisticated product costing system may be expected to produce more accurate
marginal costs for decision making. This is important because in the context of
decision making, inaccurate marginal costs may lead to incorrect decisions,
such as the production of unprofitable products and the nonproduction of
profitable products (Kaplan 1988; Drury and Tayles 1995, 2000; Kaplan and
Cooper 1998). It should be expected that any increase in sophistication,
however defined, would lead to an increase in satisfaction with accuracy.

The objectives of this paper are to consider, initially, what is meant by the
sophistication of the product costing system. If there are different definitions of
sophistication, then the paper identifies whether the level of sophistication
varies between these definitions.

1- Background

2.1) Defining and Measuring Sophistication:

Drury and Tayles (2005) characterized low degrees of complexity in the context of
product costing as product costing systems having a single plantwide, first-stage
cost pool and a single volume-based, second-stage cost driver. A greater number of
cost pools is predicted to lower the possibility of expenses being averaged across
cost pools and to better represent the usage of cost pool resources by goods in both
of these scenarios. This would imply a greater degree of sophistication.

Similarly, an increase in the number of cost drivers is expected to indicate an

increase in accuracy, because a higher number of cost drivers represent a better
measure of the quantities of resources consumed by individual products by
identifying the appropriate cost driver of each individual cost pool.

Drury and Tayles (2005) further suggested that the degree to which various cost
drivers, such as volume-level, batch-level, and product sustaining cost drivers, are
employed will have an impact on sophistication, with sophistication rising with the
usage of non-volume-level cost drivers. Furthermore, they claimed that the usage
of transaction, length, or intensity cost drivers affects sophistication. Transaction
drivers, which describe the frequency of an activity, are the least sophisticated cost
drivers, according to Drury and Tayles (2005).

Duration drivers are more sophisticated since they reflect the amount of time
required to complete a task. Intensity drivers are the most sophisticated since they
charge directly for the resources consumed when an activity is done. Given all of
that, Drury and Tayles (2005) defined a sophisticated product costing system as
having several cost pools and cost drivers (including volume- and non-volume-
based cost drivers, as well as transaction, length, and intensity cost drivers). In
other terms, an ABC system is a very sophisticated system.
2.2) Cost system complexity:

A fundamental challenge in the design of cost systems is whether the system just
assigns direct costs or also assigns indirect costs to an organization's cost objects
(e.g., goods, services, and processes), and if so, how. Variable cost systems simply
allocate direct costs, whereas absorption cost systems allocate both direct and
indirect costs. Various cost allocation methods have been developed to allocate
indirect costs, with activity-based costing (ABC) being the most recent (at least
among the approaches that are implemented in practice). In general, these
procedures are divided into two steps. In the first step, homogenous resource costs
are collected in cost pools.

These cost pools are functionally (e.g., based on departments) or process (e.g.,
based on activities) oriented, depending on the type of allocation system used. The
costs from the cost pools are assigned to the cost objects in the second stage using
cost allocation bases. Volume-based or hierarchical (e.g., batch-level, product-
sustaining, and facility-related) cost allocation bases are utilized depending on the
allocation technique.

2.3) Cost system complexity and purposes of use:

Cost systems can be used for many different purposes. Major purposes include
stock valuation, product pricing, customer profitability analysis, new product
design, performance measurement and budgeting (e.g., Kaplan & Cooper, 1998).
Kaplan and Cooper (1998) argue that firms essentially need multiple cost systems,
to perform three primary functions: (1) valuation of inventory and measurement of
the cost of goods sold for financial reporting, (2) estimation of the costs of
activities, products, services, and customers, and (3) providing economic feedback
to managers and operators about process efficiency.

2- Literature Review
In developed countries, there have been limited studies that categorize product cost
systems based on characteristics rather than the traditional alternatives of
traditional and activity-based costing (ABC) systems (Abernethy et al., 2001).

The design of cost systems is influenced not only by product diversity but also by
the use of technology to manage diversity. Factors such as product diversity,
degree of customization, size, and corporate sector influence the complexity of cost
system design in UK companies, with financial and service sectors having higher
levels of complexity compared to the manufacturing sector (Drury and Tayles,
2005).

Sophisticated cost systems in UK companies are associated with the importance of

cost information, size, competition intensity, and the financial sector. ABC
adoption is also linked to the use of other management accounting techniques, lean
production, just-in-time, and the service sector (Al-Omiri and Drury, 2007).

Cost system complexity affects the intensity of cost system use and satisfaction,
depending on the purpose of usage, such as product planning or cost management
(Schoute, 2009).

Various studies have explored the impact of cost systems on performance. Some
studies found that the use of ABC is associated with higher return on investment
(ROI), particularly in business units following a differentiation strategy (Frey and
Gordon, 1999; Cagwin and Bouwman, 2002). However, other studies found no
significant relationship between ABC practices and firm performance, as measured
by ROI (Sanford, 2009). Only a few studies have considered cost systems as
mediators between contextual factors and performance (Cagwin and Bouwman,
2002; Sanford, 2009).

Abernethy et al. (2001) view cost system design choices as varying along three
dimensions: number of cost pools (single versus multiple cost pools), nature of cost
pools (responsibility-based versus activity-based cost pools) and nature of cost
allocation bases (volume-based versus hierarchical cost allocation bases).

Al-Omiri and Drury (2007) also identified the issue of the effect of the allocation
of overhead costs to individual cost pools on sophistication. In this case, higher
levels of sophistication are associated with directly assigning overhead costs to
each cost pool or using cause-and-effect drivers to identify overhead costs with
cost pools.

3- Conclusion