Activity Based Costing, Balanced Scorecard and Economic Value Added
The operating or overheard expenses of an enterprise are generated by its activities to perform its business and/or manufacturing processes successfully. As its name implies, Activity-Based Costing, relates the costs facing the enterprise to its various activities. By so doing, this system of costing provides pretty accurate information about costs in addition to the origin of the costs (Cooper, 1988). According to Liberatore & Miller (1998):
One of the first areas in which ABC [Activity-Based Costing] gained prominence was product costing for manufacturing operations. Traditional manufacturing cost systems typically allocated costs to products using only a few standard cost bases: labor hours, machine hours and/or material dollars consumed. However, as more firms began to view manufacturing operations as a series of linked activities, it was increasingly recognized that these limited traditional bases did not accurately depict the true costs of production. Firms began to expand the number of cost bases or drivers to include such activities as the number of setups and changeovers, the number of receipts and shipments, the number of orders, and so on. Thus, many conventional volume-based costing systems gradually evolved toward ABC.
Undoubtedly, by keeping an accurate account of its costs in relation to its activities, the firm is in a position to manage the quality of its processes and improve them. Implementing the management system known as balanced scorecard, on the other hand, enables the firm to clarify its vision as well as strategy before translating them into action (Arveson, 1998). Whereas conventional systems of financial reporting may only provide help in understanding the firm’s past performance, the balanced scorecard is able to reveal a vision of the firm’s future as well. In order to do so, this system of performance measurement considers financial measures in addition to business process, customer, and learning measures. The financial measures may include the operating income of the firm as well as the economic value added. The customer measures include market share in addition to customer satisfaction and retention. The business process measures could include costs as well as quality; while the learning measures generally include employee satisfaction and retention among other measures (“The Balanced Scorecard,” 2007).
A firm that relies on an accurate vision of its future with references to measures of its performance has the opportunity to improve its present performance so as to experience a more profitable future. Thus, the balanced scorecard management system and activity-based costing may both help the firm to manage and improve the quality of its work process. Yet, both systems are vastly different seeing that cost is only considered one of the measures in the balanced scorecard, whereas the activity-based costing system is solely reliant on cost data. While the cost data generated by an activity-based costing system may help the management to develop better strategic objectives, the balanced scorecard is specifically known to help in the clarification of strategy, communication of strategic objectives, planning strategic initiatives as well as aligning them, in addition to strategic learning and feedback (“The Balanced Scorecard”).
Economic Value Added, also known as economic profit, is another helpful tool in quality management. This performance metric may help the firm to evaluate its financial performance (“EVA,” 2007). The measure is “based on the residual wealth” of the firm, “calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis) (“Economic Value Added,” 2007).” Hence, economic value added turns out to be a measure that the firm could use to efficiently manage its capital (Roztocki & Needy, 1998). The firm that manages its capital with economic value added as a performance metric may improve its performance.
As mentioned previously, activity-based costing helps the firm to manage its costs rather effectively. The balanced scorecard management system would neither focus on the costs nor the capital of the firm. Rather, the management system of balanced scorecard provides the firm with an overview of its performance. Thus, the balanced scorecard management system happens to be the most comprehensive of all. If a firm is inefficiently managing its capital and costs, the balanced scorecard would be able to reveal this information.
But, if the organization is unable to satisfy and/or retain its customers or employees, the activity-based costing system would only reveal increasing costs of activities involving customers or employees instead of presenting a clear picture of the problems at hand. The economic value added would not make it easy for the organization to appreciate the true problems facing it either. Because the balanced scorecard system quantifies a lot of the information that is qualitative in nature, and also relies on a variety of measures, it is a better tool for evaluating performance. Moreover, this system of evaluating present performance takes strategic objectives into account for the firm to improve its processes. Even though activity-based costing and economic value added may both help in improving the firm’s performance, the balanced scorecard system is implemented on the premise that quality management and improvement are necessities.
Using the activity-based costing system or economic value added, the company would not necessarily establish strategic objectives. Rather, these methods require the company to make an extra effort to evaluate its performance in the light of its vision, whenever the company considers such an evaluation necessary. Seeing that the evaluation of strategic objectives is essential in quality management, the balanced scorecard does not consider this evaluation as an extra effort outside the system.
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