Activity-based Costing, manufacturing and the background

Category: Accounting

Activity-based costing is also known as ABC costing is a costing model that organizes activities in an organization and allocates the cost of the each activity resources to all the products and services according to the actual proposition by each. In others word, it is an accounting method that allocates business to collect information about their operating costs. Activity-Based Costing (ABC) has been supported and approved as a basis for making strategic decisions and for improving profit performance (Kaplan and Norton 1992; Turney 1992; Cooper and Kaplan 1991b). Under Activity-based costing (ABC), company will calculate the cost of the resources used in each of these activities. Activity-based costing (ABC) mostly allocates indirect cost, manufacturing overhead and direct cost to the product and services. Those costs will then allocate to particular activities such as planning engineering, or manufacturing, after that, the cost is linked to different product and services. In this way the organization can easily estimate the cost of the products and services for the idea of identifying and eliminating those which are unbeneficial and lowering the prices of those which are overpriced. In such act, organization may also increase their profit by knowing the cost of the product or services with the use of Activity-based costing (ABC). It helps to control the costs at an individual level and on a departmental level in an organization. Supervisors are able to create a data to produce a better budget and raise a greater overall considerate of the expenses that required keeping the company running efficiently. In addition, activity-based costing is able to help the organization or company to find out costs which are unnecessary for the product and services, some costs might not be necessary costs for the product, and so under ABC costing, it will tend to help the organization to eliminate the unnecessary cost. As a result, company or organization may earn a profit. In addition, as Kaplan (1990) predicted, ABC information is now also generally used to evaluate continuous enhancement and to supervise process performance. It helps to fix the price of the products and services as well, by allocate and estimate the cost of the products and services, Activity-based costing (ABC) can fix the price of the products and services.

In recent decades, Activity-based costing (ABC) has been growing important to the cost allocation. This is because this costing is the most effective when organization has used over a long term period rather than short term period. Besides that, manufacturing overhead costs have increased radically in these years. The manufacturing overhead costs can no longer link with the productive direct labour hours and machine hours. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognised when the same broad 'on-cost' percentage is added to all products. In addition, ABC costing become importance is because the mixture of the products and the mixture in customers' demand have grown and some products are produced in large groups, while others are produced in small groups. There is no deny that activity-based costing (ABC) is useful to the organization to set price and allocate cost such direct cost, manufacturing overhead and direct labour cost, but there is some limitations by using this method as well. Activity-based costing is an accounting method that allocates the cost of each activity resources to the products and services, however, some of the overhead costs are difficult to allocate to the products and customers such as the executive's salary. The executive's salary is an overhead cost which is difficult to allocate cost to the products and services, these kind of costs are known as 'business sustaining' which are not allocate to the products and customers, because it is meaningless. As a result, ABC costing has its usefulness as well as limitation.

The remainder of the paper is organized as follows. The next section relates background regarding Activity-based costing (ABC) and some theory in relation to ABC costing and traditional costing. The subsequent section is some example of some company that applies ABC costing. Last will be our conclusion for this paper, summary of the paper.

Background

Activity-based costing was introduced because traditional costing had randomly added expenses in indirect labour cost. Automation has dramatically shifted the balance; reduces the need for labour and increased the capital investment levels.(Gerhard P., 1999) Hence, traditional costing had become incorrect or have mistake for the products and services. This is because the indirect labour cost is not caused by all products. Thus, Activity-based costing had been introduced to overcome the problem.

The ideas of Activity-based costing were recognised in the manufacturing sector of the United States during the 1970s and 1980s. It is based on George Staubus' activity Costing and Input-Output Accounting. Throughout the years, the Consortium for Advance management- International, also known as CAM-I offered a formative role for studying and formalizing the philosophy that have become more formally known as Activity-based Costing. CAM-I had explained Activity-based costing (ABC) as "….the collection of financial and operation performance information tracing the significant activities of the firm to the product costs…" the main point is that the traced to the cost and it is not vice versa. (Joon J and Brian H. K., 1997)

Activity-based costing (ABC) was first introduced in 1987 by Robert Kaplan and Robin Cooper as a chapter in their book Accounting and Management: A Field Study Perspective. Robert Kaplan and Robin Cooper was first focus on the manufacturing industry where when there is an increasing in technology and productivity improvements, it has reduced the relative proportion of the direct costs of labour and materials, but it increased the relative proportion of indirect costs. For example, when there is an increase in technology, such as machines will reduce the labour which is direct labour, it has increased depreciation of the machines which is an indirect material. Besides that, Robert Kaplan and Robin Cooper had explained Activity-based costing as a method to solve the traditional costing management.

The very first extension of Activity-based costing into financial institutions such as banking institution was appeared in an article in Journal of Bank Cost and Management Accounting (Volume3, Number 2) by Richard Sapp, David Crawford and Steven Rebishcke in 1990. They stated that financial institutions also have varied products sets which had created opportunities for cross subsides. In addition, in 1991 in the same Journal (Volume 4, Number 1), authors had concluded that Activity-based costing (ABC) can be more accurate in allocating the cost in this environment.

Manufacturing industries and financial institutions have varied products and customers which can cause cross-product and cross customer subsidies, such as banking industry has undergone changes in staffing level and productivity level. Thus, as personnel expenses represent the largest single component of non-interest expenses in financial institutions, these costs should also be qualified more accurately to the products and customer. Therefore, Activity-based costing may even be a more useful tool for doing so.

Activity-based costing was further explained in 1999 by Peter F. Drucker in the book of Management Challenges of 21st Century. Peter F. Drucker had stated that Traditional costing is method to allocate cost to do something, for example to cut a screw thread, whereas for activity-based costing records the cost of not doing, such as the cost of waiting for the needed part. Activity-based costing (ABC) reports the costs that traditional costing does not do.

Traditional Costing Systems versus Activity-Based Costing (ABC)

3.1 Traditional Costing Systems

The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the overhead costs in companies were generally very low compared to today. However, from the 1960s - particularly 1980s - this changed rapidly. For these reasons, and more, traditional cost accounting has been called everything from 'number 1 enemy of production' and questions whether it is 'an asset or a liability' have been raised.

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs . Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.

3.2 Activity-Based Costing (ABC)

Activity-Based Costing (ABC) arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods. Researchers have acknowledged the problems in traditional costing systems. Drucker (1963) is among the earliest ones to point out that indirect costs are caused by transactions but not by output volume. Miller and Vollmann (1985) agree with Drucker's view and echo that the primary drivers for consumption of overhead are transactions:

… in the "hidden factory," where the bulk of manufacturing overhead costs accumulates, the real driving forces come from transactions, not physical products. These transactions involve exchanges of the materials and/or information necessary to move production along but do not directly result in physical products (Miller and Vollmann, 1985, p.144).

Activity-based costing is a system that attempts to accurately trace indirect costs to products by allocating indirect costs to activities and then to products based on their usage of the activities. ABC is optimal when accuracy is very important and when indirect costs comprise a large proportion of total costs compared to direct costs. ABC is commonly used in the manufacturing sector because ABC systems are more accurate than traditional costing systems because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. The leap from traditional costing to activity based costing is difficult.

Comparison between ABC costing and Traditional costing

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Sources : Zhaoxun C., and Liya. W., (2007), " A generic activity-dictionary-based method for produt costing in mass customization", Journal of Manufacturing Technology Management, Vol 18, Issues 6, pp.682

Example of Traditional Costing versus ABC

In this section, let us show some example that compares traditional costing and activity-based costing.

Assume that FireOut Inc manufactures steel cylinders and nozzles for two models of fire extinguishers.

Cylinders

Nozzles

Manufacturing Costs

Traditional Costing

ABC

Traditional Costing

Direct Materials

RM 40

40

30

Direct Labor

12

12

12

Overhead

30

17

30

Total cost per unit

82

69

72

Overstated RM 13 Understated RM 65

4. Activity-Based Costing (ABC)

4.1 Activity Cost Pool

An activity cost pool is the overhead cost attributed to a distinct type of activity (e.g., ordering materials or setting up machines). The activity cost pool is the total cost associated with an activity. Each type of primary cost driver that is traced to an activity cost pool. This can be done by identifying all the costs of an activity in terms of costs can be directly charged to each cost pool. If some resources are shared by several activities, then some measure of apportionment will be necessary. The basis of apportionment should reflect as closely as possible the extent to which each activity consumes the shared resource. The best estimation of apportionment rate does not affect the accuracy (Keegan and Eiler, 1994).

ABC allocates overhead in a two-stage process. The first stage allocates overhead costs to activity cost pool. Example of overhead cost pools are ordering materials, setting up machines, assembling products, inspecting products. The second stage assigns the overhead allocated to the activity cost pools to products, using cost drivers. The cost drivers measure the number of individual activity undertaken or performed to produce products or provide services. Examples are number of purchase orders, number of setups, labor hours, or number of inspections. (Jerry J. W., Paul D.K., Donald E. K. 2008)

The four steps involves in ABC costing

abccosting.jpg

Sources: Jerry J. W., Paul D.K., Donald E. K. (2008), "Managerial Accounting: Tools for Business Decision Making", 4th edition. pp. 147-175

ABC involves the following four steps:

Activity Cost Pools

Estimated Overhead

Setting up machines

Machining

Inspecting

RM 300,000

500,000

100,000

Total

RM 900,000

Step 1: Identify and classify the major activities involved in the manufacture of specific products, and allocate manufacturing overhead costs to the appropriate cost pools.

Sources: Jerry J. W., Paul D.K., Donald E. K. (2008), "Managerial Accounting: Tools for Business Decision Making", 4th edition. pp. 147-175

Step 2: Identify the cost driver that has a strong correlation to the costs accumulated in the cost pool.

Activity Cost Pools

Cost Drivers

Expected Use of Cost Drivers per Activity

Setting up machines

Machining

Inspecting

Number of setups

Machine hours

Number of inspections

1,500 setups

50,000 machine hours

2,000 inspections

Sources: Jerry J. W., Paul D.K., Donald E. K. (2008), "Managerial Accounting: Tools for Business Decision Making", 4th edition. pp. 147-175

Step 3: Compute the overhead rate for each cost driver.

Activity Cost Pools

Estimated Overhead

(RM)

Expected Use of Cost Drivers per Activity

Activity-Based Overhead Rates

Setting up machines

300,000

1,500 setups

RM 200 per setup

Machining

500,000

50,000 machine hours

RM 10 per machine hour

Inspecting

100,000

2,000 inspections

RM 50 per inspection

Total

900,000

Sources: Jerry J. W., Paul D.K., Donald E. K. (2008), "Managerial Accounting: Tools for Business Decision Making", 4th edition. pp. 147-175

Step 4: Assign manufacturing overhead costs for each cost pool to products, using the overhead rates (cost per driver).

Activity Cost Pools

Cost Drivers

Expected Use of Cost Drivers per Activity

Expected Use of Cost Drivers per Products

The Boot

Setting up machines

Machining

Inspecting

Number of setups

Machine hours

Number of inspections

1,500 setups

50,000 machine hours

2,000 inspections

500

30,000

500

Sources: Jerry J. W., Paul D.K., Donald E. K. (2008), "Managerial Accounting: Tools for Business Decision Making", 4th edition. pp. 147-175

4.2 Classification of Activity Levels

It is not possible to identify all the cost drivers at the same level. In the traditional costing system cost behavior has classified a cost as either variable or fixed. For a company's manufacturing costs usual use variable cost such as direct labor. (John C. 2000) But in the ABC system cost drivers are identified at the following four levels.

Hierarchy of activities levels

Four Levels

Explanation

Types of Activities

Examples of Cost Drivers

Unit-Level Activities

These are related to activities that are performed such that only one unit of a batch is affected by the activity. (Gunasekaran, A.1999)

Machine-related

Drilling, cutting, milling, trimming, pressing

Labor-related

Assembling, painting, sanding, sewing

Machine hours

Direct labor hours or cost

Batch-Level Activities

Batch level drivers will include the type of activities that will facilitate the manufacture of a batch of the same type of product.

(Gunasekaran, A. 1999)

Equipment setups

Purchase ordering

Inspection

Material handling

Number of setups or setup time

Number of purchase orders

Number of inspections or inspection time

Number of material moves

Product-Level Activities

These drivers relate to the activities that need to be performed to continue a product in manufacture. The cost of these activities must therefore be divided into the total number of the product that will be made.

(Gunasekaran, A. 1999)

Product design

Engineering changes

Number of product designs

Number of changes

Facility-Level Activities

Costs of some facility level activities are very difficult to apportion to individual product accurately. These will be traced to the product in some manner such as the total facility sustaining costs for a period apportioned to a product with the help of the percentage of the used driver.

(Gunasekaran, A. 1999)

Plant management salaries

Plant depreciation

Property taxes

Utilities

Number of employees managed

Square footage

Square footage

Square footage

4.3 Decision on the implementation of an ABC

Decisions concerning the implementation of ABC system are discussed with the help of a conceptual model. According to Cooper and Kaplan (1991), before one can start designing an ABC system, six major decisions should be made and they are:

Should the system be integrated with the existing cost system or should it be a standalone system?

Should a formal design be approved before implementation?

Who should take ownership of the final system?

How precise should the system be?

Should the system report historical or future costs?

Should the initial design be complex or simple?

After having answered these important questions one can start with designing the appropriate ABC system for its demanded purposes.( Gunasekaran, A., Marri, H.B., and Yusuf, Y.Y. 1999)

Sources : Gunasekaran, A., Marri, H.B., and Yusuf, Y.Y. (1999), "Application of activity-based costing: some case experiences", Managerial Auditing Journal, 14/6, pp.286-293.

~> Condition favoring the use of ABC

In the last 20 years, there are many other financial and marketing factors that have played an increasingly important role in justifying the implementation of ABC systems (Tsai, 1996):

Measurement costs

During the last decades the introduction of more advanced information technology has become cheaper and easier to carry out the necessary calculations to arrive at the desired product costs. Therefore, implementation of ABC systems has become easier.

Increasing costs of error

As a result of the recessions which the world encountered in the last two decades, it has become increasingly important to have a profound knowledge of the right production costs. This together with the falling labor base and the more expensive investment programs gives a synergetic effect. Making wrong decisions based on wrong product figures can lead to very serious consequences.

~> Factor against the implementation of ABC

The decision on the implementation of an ABC system should well be considered because the change not only needs resources in the form of man hours and capital (in buying the necessary equipment), but also the involvement of employees. Besides that, the difficulties of implementation ABC are lost production, congestion on the factory floor and lack of involvement. If cost drivers are used to measure the performance of employees in developing a reward system, then the consequence is that manager and especially the employees will focus too much on the cost drivers.

4.4 Advantages and limitation of ABC

~> Benefits of ABC

The primary benefits of ABC are more accurate product costing. Here's why:

Performance measurement

The information provided by ABC on cost drivers and cost driver rates shows that they are potentially powerful influences on the behavior of staff and they are used as performance measures (Kingcott, 1991).

Different cost object.

The ABC methodology can be applied to cost objects other than the product. One recent development has centre on the identification of costs associated with the serving of individual customers (John and Mitchell, 1991). This allows customer profitability to be analyzed and so provides management with a market-oriented view of how profit has been earned.

Budgeting

ABC also provides information relevant to both the setting and using of overhead budgets. The availability of cost driver volumes provides, often for the first time, a measure of the work of each activity (Shank and Govindarajan, 1993).

ABC leads to better management decisions

More accurate product costing should contribute to setting selling prices that can help achieve desired product profitability levels. In addition, more accurate cost data could be helpful in deciding whether to make or buy a product part or component, and sometimes even whether to eliminate a product.

Activity-based costing does not change the amount of overhead costs. What it does is allocate those overhead cost in a more accurate manner. Furthermore, if the score-keeping is more realistic and more accurate, managers should be able to better understand cost behavior and overall profitability.

~> Limitations of ABC

Although ABC systems often provide better product cost data than traditional volume-based systems, there are limitations:

ABC can be expensive to use.

The increased cost of identifying multiple activities and applying numerous cost drivers discourages many companies from using ABC. Activity-based costing systems are more complex than traditional costing systems-sometimes significantly more complex.

Some arbitrary allocations continue.

Even through more overhead costs can be assigned directly to products through ABC's multiple activity cost pools, certain overhead costs remain to be allocated by means of some arbitrary volume-based cost driver such as labor or machine hours.

4.5 Company that apply ABC

Since we had talk all the theory for ABC costing above, now let present some virtual company that implement ABC system in their company.

Milkcom is the biggest producer of milk cream in Belgium. Inco group founded Milkcom in 1963. It has produces 6,700 suppliers and 900 workers in its production facilities with an annual turnover of $4 billion. The companies produces 770 million litres of milk annually and produce 60 million litres of pasteurized milk, 300 ton of milk powder daily and 1 million pieces of ice-cream. In order to remain competitive, Milkcom try to obtain ISO 9002 certificate and develop ABC system with Vlerick school. Management able to trace their production much better after the information system had been implemented. Milkcom can handle each production line and each type of product, a bill of material and get the signals if there is any change occurs during the production process. Milkcom is one of the company who success after implement ABC system. Although Milkcom had spend 3 million for development and implement ABC system, it has been worth it according to the management. In the hypercompetitive market, it is important to know the exactly of product cost. This helps to continuously alter the product-mix based on the performance of each product. (Gunasekaran, A., Marri, H.B., and Yusuf, Y.Y. 1999)

Hong Kong Certified Aircraft Engineers Ltd (HKCAE) is a solely repair and maintenance work for airport ground service equipment in Hong Kong. It founded in 1961. There are 600 employees in the company. Besides solely on airport ground service, HKCAE also produces steelworks engineering and other heavy industrial product which are different business characteristics and the nature of their main activities are dissimilar. Under the current accounting system (traditional costing system), indirect costs are allocated to each project at a rate of the proportionate amount of work receipts of the project. By using the traditional costing system, it does not provide any guidelines to difference valuable and non-valuable activities. Hence, HKCAE decide to implement ABC system. After apply ABC costing, HKCAE had centralize all the clerks into a clerical work pool to improve efficiency is the organization's attempt to utilize the reservoir of knowledge by introducing the new working procedure to reinvent its business. In addition, it able them to difference added value and non-added value and reduce duplicate work. (Chan. M.F.S., Keung K.F. and Chung W.W.C., 2000)

Super Bakery, Inc. is a nationwide supplier of mineral-, vitamin-, and protein-enriched doughnuts and others baked goods to the institutional food market, primarily school systems. It created in 1990 by former Pittsburgh Steelers' running back Franco Harris. By using traditional costing system, Super Bakery had achieves their goal and their sales have grown at an average annual rate of approximately 20%. Management suspected a wide variation in the cost of serving customers in different parts of the country. Yet by using traditional costing methods were spreading costs over the entire customer base. Each customer's order appeared to cost the same amount to complete. Therefore, Super Bakery had changes their system to ABC system. It would more accurately assign the costs of each order and profit margin on each sale. (Tom R.V.D. and Bruce L.D., 1996)

WAGDA, a company locates on Belgium, with 1,000 employees that produce highly specialized steel products used to prepare components for textile machines. A program of integral quality system was set up in the year 1980. It can reduce the repair costs of facilities that include various machine tools and equipments. They had implement ABC system for its budget to support the program. The cost system enables the engineers to have detailed information about the costs of different repair services of machines in about 90 departments in the company. With ABC system, the department has been able to reduce 2 percent of downtime machines. Besides, the ABC system also enabled the department to find the critical areas and helped them in their decisions related to the various investment programs such as new maintenance technologies and systems to improve them. (Chan. M.F.S., Keung K.F. and Chung W.W.C., 2000)

On the above, there are 4 companies that had adopted ABC and success in the end. ABC is not 100% suitable for all the company or division. Below have an example of Hewlett-Packard company, which faced problem when implement ABC system.

Hewlett-Packard (HP) is considered one of the best-managed and most innovative companies in the world. It have the ability to adapt to global competitive challenges through technical innovation and continual reassessment of its management and control mechanisms. Most application of activity-based costing by HP has been successful. In 1988, HP decides to implement ABC system in Colorado Springs Division, so that can provide a better product costing and inventory valuation. Compare with other division of HP, Colorado Spring division was a larger division that had a high mix, low volume product line. Management decided to implement ABC in this division in order to get better cost information on which to base product pricing decisions. After implement ABC system, it help the division understand its manufacturing processes, overhead consumption, and manufacturing efficiency, but it did not help them with their inventory valuation method. Due to high heterogeneous product mix and high fixed cost. (Steven P.L., Larry M.W. and Tim M.L., 1997)

Conclusion

Traditional costing not longer provides an accurate product cost because of manufacturing is moving away from measuring labour efficiency and moving toward more material-focused systems.(Gerhard P.,1999), Hence, traditional costing had replaced by activity-based costing.

In this paper, we had fully discussed activity-based costing apply in manufacturing. This has been help with some virtual company that had implement ABC system. ABC systems trace more exactly the real costs to the products than any other volume-based cost systems. Therefore, more accurate overhead cost allocations lead to fewer distortions (Cooper and Kaplan, 1991). However, a trade-off should occur between the economic benefits of an ABC and the costs of implementing it. For some industries ABC systems are useful and for others not as it can be seen from case experiences. When implementing an ABC system, a change in the management structure should occur in order to facilitate the application of ABC. The management should adapt an activity-based management system using the provided information by the ABC system and achieving their primary target that is making profits.

As long as there is a strong partnership between different departments, ABC can be a great communication tool. It can drive empowerment if everyone understands their role. In order to improve gross margins, you need to know well for cost structure of the organization and the key of cost drivers. However, there is pro and con for activity-based costing. Sometime, it is difficult to allocate some of the overhead cost to the products and customers as well especially in service firms. This is because a larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services provided by the company.