Activity based costing in manufacturing

Manufacturing organisations in the present day are more intricate compared to the 1960s and earlier. To effectively oversee these organisations, managers need readily available information that is both precise and pertinent. This information is essential for developing and implementing functional strategies, as well as making decisions regarding product variety and production expenses. Despite the adaptations made to production systems to meet the evolving demands of the market, many organisations have not made any changes to their internal management accounting systems and information systems.

Both managers and accountants are not happy with traditional costing systems and have raised concerns about their effectiveness in today’s manufacturing environment. As a result, activity based costing (ABC) has emerged as a viable alternative. This method, developed by Harvard Business School Professors Kaplan and Cooper in the USA, involves listing and measuring the cost of each activity involved in producing and delivering a specific product or service.

The executive summary of a report on ABC published by the Chartered Institute of Management Accountants distinguishes activity based costing (ABC) from conventional costing. According to Innes and Mitchell (1990), ABC treats non-volume related overhead costs differently than conventional costing. Various overheads are associated with specific activities that are somewhat unrelated to the production volume. For instance, the purchasing overhead may be linked to the number of purchase orders. The resources consumed and the resulting overhead cost are determined by the volume of these activities rather than the volume of production.

These activities drive the overhead costs and ABC utilizes such activities for both production costing and process control. Innes and Mitchell (1990) provide a summary of the benefits of activity based costing after conducting a critical review: it offers more precise product line costing, especially when non-volume related overheads are significant and a diverse product line is manufactured. Additionally, it is adaptable enough to analyze costs by cost objectives other than products, such as processes, areas of managerial responsibility, and customers. Moreover, it provides a trustworthy indication of long-run variable product cost, which is particularly relevant for managerial decision-making at a strategic level.

This paper explores the adoption of Activity-Based Costing (ABC) in two organizations and highlights the key factors for successful implementation. ABC provides both financial (period cost driver rates) and non-financial (period cost driver volumes) measures that are relevant for cost management and performance assessment at an operational level. It aids in identifying and understanding cost behavior, leading to improved cost estimation. Additionally, ABC offers a more logical, acceptable, and comprehensive basis for costing work. The implementation of new management philosophies and techniques, such as ABC, is often challenging. The experiences shared by the two companies discussed in this paper serve as valuable lessons for managers considering the adoption of ABC systems.

Both the importance of a new approach to cost management and the attention given to the design and operation of an ABC system have been extensively studied by accounting academics and researchers. However, this paper does not aim to extensively explore these topics. Please refer to the Appendix at the end of this document for a concise overview of the need for a fresh approach and the design and operation of an ABC system.

Extent of ABC systems implementation

Despite its development almost a decade ago, ABC continues to have a low adoption rate as seen in surveys conducted in North America, the United Kingdom, and Australia. A specific survey carried out in 1990 by the British Chartered Institute of Management Accountants (CIMA) ABC Working Group included organizations from the manufacturing and financial services sectors. The findings revealed that merely 6% of the participating firms had commenced implementation, while 9% had declined ABC (Innes and Mitchell, 1991a).

The survey was sent to 720 organizations and received 187 usable responses, resulting in a response rate of 26 percent. Just over half of the respondents had not given serious thought to ABC, while approximately one-third were evaluating it. The Australian Society of CPAs conducted a comprehensive survey on ABC in 1995, involving 213 manufacturing firms across all sectors of Australian manufacturing. This survey was carried out by the University of Technology, Sydney, and referenced by Corrigan (1996) and Wood (1996).

This survey revealed that the majority of surveyed firms, 45%, had never contemplated adopting ABC, despite 88% of them acknowledging familiarity with activity-based costing. Additionally, 29% were still in the contemplation phase, 14% had thought about it and decided against it, and only 12% of the firms surveyed had successfully implemented the approach.

The food, beverage, and tobacco industry had the highest adoption rates of ABC, with 25% of companies in this sector using this method. Among the companies that had adopted ABC, most implemented it within one to two years after deciding to adopt it. The majority of these companies believed that they had successfully achieved five goals.

• more accurate product costing;
• better cost management;
• better cost control;
• better allocation of overheads;
• more accurate cost information.

The survey conducted in Australia revealed that companies that declined to adopt ABC cited two main reasons: the uncertainty surrounding its benefits and the high cost compared to the perceived benefits. Certain companies argued that they already had a successful costing system in place or had other more significant priorities.

According to Corrigan (1996), a survey conducted by the Institute of Management Accountants in the USA exhibited a significantly higher level of implementation in American firms. The survey revealed that 41% of the American respondents already adopted ABC as their cost management system, while 33% believed that they should be utilizing activity based costing systems.

Another Australian survey was conducted by Chenhall and Langfield-Smith (1996) to assess the adoption of traditional and contemporary management accounting practices by large firms. The survey also looked into the benefits obtained from these practices, future intentions to prioritize certain management accounting practices, and the correlation between benefits gained from specific practices and the successful implementation of management innovations like TQM, JIT, team work, and supplier partnerships.

Out of the 140 manufacturing firms selected from the 1994 Business Review Weekly list of Australia’s top 200 companies, a survey was mailed which resulted in 78 usable responses. Amongst the 42 management accounting practices listed in the Chenhall and Langfield-Smith survey, activity based costing was ranked as the 24th most adopted practice. This indicates a low adoption rate for this method within the past three years. When it comes to the relative benefits received from each practice, ABC was ranked 38th. However, it ranked slightly higher at 29th in terms of future emphasis to be given to each item.

In terms of the association of management accounting practices with the effective application of management innovations, a study conducted by Chenhall and Langfield-Smith in 1996 showed that activity based costing (ABC) provided relatively higher benefits for the high benefit groups in all of the management innovations, although still in the low to moderate benefit categories. The survey results indicated a preference for traditional management accounting techniques that emphasize financial information. Respondents also highlighted ABC as an area where there would be greater future emphasis, along with strategic planning, product profitability analysis, and benchmarking.

Previously, we have implemented ABC.

Cobb et al. (1992) utilized the findings from the 1990 CIMA survey mentioned earlier to examine the issues and challenges associated with ABC. They conducted telephone interviews with 30 out of the 62 participants who had initially shown interest in ABC and had identified potential implementation problems. Additionally, they visited 12 companies that had implemented ABC, including two that had initially adopted but later rejected it. The purpose of this project was to specifically investigate the problems and concerns faced when adopting ABC. Out of the 30 companies interviewed via phone, 20 were still considering adopting ABC after one year.

The group identified five main problems: the extensive work required to install an ABC system, especially for small companies, which was acknowledged by 15 out of the 20 companies; competing uses of resources that took precedence over ABC; lack of appropriate accounting staff resources for implementing an ABC system; insufficient computer resources; and difficulty in selecting suitable cost drivers.

The sensitivity of making significant changes and innovations to the management accounting system was recognized in this group of 20 companies. This acknowledgment was based on a combination of factors:

• the perceived importance of the management accounting system;
• the difficulty of accepting that it has been wrong;
• management accountant’s lack of innovative experience;
• or simply continuing doubts about the value of ABC.

Three out of the 30 companies that were interviewed via phone had initially thought about using ABC (Activity Based Costing) but eventually decided against it. They identified data collection challenges, competing priorities, and the time commitment required for accountants as significant obstacles. The expenses associated with implementing and maintaining an ABC system were believed to outweigh the advantages it would bring. This perspective was shared by two small companies that had actually implemented ABC before ultimately abandoning it (Cobb et al., 1992).

During the first year of implementing an ABC system, the most common problems were identified as the amount of time spent on ABC and the retraining needed by accountants and computer staff. In total, there were 17 companies in this group, with seven being interviewed by telephone and ten being visited by the research team. Furthermore, like any other major organizational change project, ABC also necessitates a change to the organizational structure, which remained an ongoing problem for the companies in this group.

During the initial stage of implementation, many companies faced various challenges including the selection of activities and cost drivers, uncertainties surrounding the use of ABC for stock valuation in external financial reporting, and the alignment of cost drivers with specific product lines (Cobb et al., 1992).

The Chartered Institute of Management Accountants in the United Kingdom conducted case study research to explore the potential of ABC. They prepared three case studies, two of which focused on manufacturers (High-Tech Electronics and Traditional Engineering) that had implemented ABC for one year, while the third case studied a retail distribution company that had two years of experience with ABC. These case studies can be found in Innes and Mitchell (1990).

The deficiencies of the cost information produced by the conventional costing systems used were demonstrated in the three case studies. Accountants and managers in the three companies recognized these deficiencies and saw ABC as a way to overcome many of the disadvantages associated with the conventional costing system.

The implementation of ABC in the three companies enhanced the credibility, perceived utility, and comprehension of the cost information by management. Innes and Mitchell found similarities among the three companies in their approach to implementing ABC. These include forming a small team, led by a senior accountant, to design and implement the system. Additionally, they involved all relevant managers in the organization for consultation, allowing them to contribute to the system’s design and ensure feasibility. Furthermore, they simplified the system by reducing the number of cost pools and drivers, enabling a timely implementation.

In their research, Innes and Mitchell found that implementing ABC can lead to a variety of benefits for organizations relatively quickly. Two of the companies observed a significant change in their product line costs, while all three experienced an increase in the visibility of overhead costs. This increased visibility of overhead costs is particularly valuable for organizations that are price-sensitive and frequently make decisions regarding product promotion strategies and product range/mix. By linking costs to the activities (cost pools) that cause them, an improved visibility of overhead costs enhances the process control of costs (Innes and Mitchell, 1990).

Additionally, one of the companies utilized cost driver rates to facilitate a thorough cost comparison between its manufacturing plants, which aided management in making informed decisions regarding the placement of certain processing work. Moreover, designers are able to enhance the design of new products or modifications to existing products by gaining a deeper comprehension of the product characteristics that contribute to overhead costs.

The three case studies showcased several issues in implementing ABC. The primary concern was the significant upfront expenses involved in designing the ABC system, which required substantial time from management and accountants. Two companies found the identification of cost drivers and their connection to product lines to be costly, while one of these companies believed that the abundance of information produced by the ABC system would necessitate increased accounting staff.

Innes and Mitchell (1991) also discuss a in-depth case study of the implementation of ABC at Cummins Engine Company’s Daventry (UK) plant. The case study highlights the importance of organisation-wide consultation, acceptance, and board-level support during the implementation process. These factors were considered major contributors to the success of the implementation. The ABC system provided new information that helped make managerial decisions resulting in cost reductions across various areas. This review underscores the need for managers to gain a better understanding of the adoption processes and identify critical implementation factors.

The authors conducted a study on the adoption of ABC in two different companies in order to contribute to the existing body of literature on this topic. These companies were selected because the authors knew they had successfully implemented ABC. The authors obtained permission from each company to document their experiences with ABC and conducted interviews with staff members who had overseen the implementation process.

The authors developed a structured interview questionnaire to collect data. The subsequent section includes two case studies on ABC implementation, highlighting the benefits and problems associated with it. The final section comprises the key factors for a successful ABC implementation.

Case study one: MelCo

The following information pertains to a company known as “MelCo.” MelCo is located in Melbourne and specializes in the production of engineering components. As the sole manufacturer of these products in Australia, MelCo has encountered significant competition from international rivals. MelCo operates as a subsidiary within a larger conglomerate and currently sustains a workforce of slightly over 100 individuals.

Six members of staff work in the accounting department at MelCo, including a financial controller who was hired with the purpose of implementing Activity-Based Costing (ABC) into the company. In his previous position at a Melbourne-based automotive component manufacturer, the financial controller’s efforts to introduce ABC were unsuccessful due to the skepticism of top management regarding the benefits of this costing method. In contrast, MelCo is the first company within the group to successfully adopt ABC. Previously, the company used a traditional costing system, in which overhead costs were allocated to products based on the amount of labor hours utilized.

The company had a diverse product range and served a large customer base using a wide array of processes and methods. These ranged from advanced and automated processes to more manual ones. The company fulfilled orders for customized items in small quantities, which required a high level of flexibility and responsiveness. To meet these demands, MelCo had made significant investments in new manufacturing technologies, including a robotics welding cell, five years ago.

The cost structure of MelCo’s manufactured products has dramatically changed, with labor costs now accounting for a smaller proportion than before. Despite the savings from the technology upgrade, the customers were not benefiting from lower prices, leading to a noticeable disadvantage in prices in the marketplace. Although many buyers wanted to switch to overseas suppliers, they still chose to stick with MelCo. While the company’s overall profit margins were increasing, it was gradually losing customers to overseas suppliers.

The company was unaware of the factors that contributed to the increase in profit margins. Senior management realized that the current accounting system was insufficient and prevented informed decision-making on matters such as pricing due to a lack of information. The idea of implementing ABC came from senior executives in the group, although they themselves had no firsthand experience with the system or its development and implementation. They acknowledged that ABC would solve the issues faced by MelCo. Consequently, a financial controller was appointed exclusively to carry out the implementation of ABC at MelCo.

The financial controller at MelCo formed a project team to develop and implement ABC. The team included the controller, an engineer, and a cost/systems accountant. They spent three months holding informal discussions with other employees. The engineer and controller dedicated full-time hours to the project, while the accountant spent about two-thirds of their time on it.

The team spent a significant amount of time agreeing on the cost drivers and established 25 cost pools for the entire company. Among the cost drivers identified were:

• frequency of set-ups for the new machines, this included programming the NC machines;
• number of manufacturing orders – this was driving many activities from the original quoting stage to dispatch of the finished products;
• number of purchase order lines – this was driving the workload in the purchasing department;
• number of store issues to the production departments – this was driving the workload in the stores;
• number of inspections made – sampling inspection was carried out in many areas; area allocation to processes and machines;
• service personnel costs.

The project team had no trouble assigning cost drivers to activities because many of the cost drivers were shared among multiple cost pools. MelCo used a PC-based system built by their financial controller, primarily using in-house spreadsheets. They only spent $1,000 on software, but put in a significant amount of effort customizing it for the company’s specific needs. Collecting and inputting data was also a time-consuming task.

The ABC system was first tested on a sample of 40-50 products that represented the full range of products made by the company. The number of products analyzed reduced to 25 once their similarity was confirmed. Although the old costing system is still utilized for stock valuation, variance analysis, and labor efficiencies, the ABC system can produce accurate costs and prices, automatically generate performance measures and product profitability, and offer various information for management decision-making. The data and models derived from the ABC system are being used to prepare the budget for the current year.

Management expectations of the ABC system

The general manager at MelCo was initially supportive and acknowledged the potential of the ABC system. However, he underestimated the time and effort needed for its setup. Just one month into the implementation, the general manager requested results. The financial controller politely informed him that achieving this was not feasible with the current allocated resources. If the general manager desired a prompt implementation, allocating additional resources would be necessary.

The general manager felt pressure from head office to demonstrate results from the ABC system. To verify the claims of the financial controller, the general manager conducted his own investigations and determined that the allotted resources made the required timeframe achievable. Despite this, no additional resources were given, and the implementation continued according to the financial controller’s original plan.

Issues encountered during the implementation process

Lack of resources was an ongoing issue during implementation, especially when the general manager expected quick results. Due to a lack of available in-house skills, a significant amount of education and training had to be done. The financial controller primarily handled this informally, as needed, while also providing formal education to senior management to familiarize them with ABC and its implementation in the company.

The training of the cost/systems accountant was ongoing throughout the project planning and implementation stages. As part of the communication and data gathering exercise, the financial controller had to deal with the unions on the shop-floor. Several union officials were interviewed to determine how they spent their time during the day. In many cases, there was reluctance on the part of the union officials to answer questions and they indirectly resisted the implementation of the ABC system. They were somewhat wary of why ABC was being implemented, particularly its implications for their jobs. They were informed that this was simply a costing exercise. In general, they recognized the usefulness of the system for the long-term survival of the company.

The ABC system results

According to the financial controller at MelCo, the implementation of the ABC system has resulted in numerous advantages. These benefits encompass:

• more accurate information on costs and pricing and hence competitive positioning of the company in the marketplace;
• identification of appropriate benchmarks which can be used against imported competitive products;
• better information has enabled the company to outsource many products which were inefficiently manufactured in-house;
• more appropriate capital investment decisions being made as a result of better weighting being determined on various aspects of this exercise;
• many problem areas identified where costs were excessive.

Despite the fact that it required 12 months of work, the advantages of implementation far exceed the drawbacks. The main benefit is having significantly more precise and applicable information that can be efficiently utilized by management. ABC is a tool provided for management to aid in commercial decision-making. This is the current status of the ABC system.

The lack of adequate resources for the ABC system is still an issue at MelCo. This could become a significant problem soon due to recent changes in senior management. The previous general manager, who introduced the ABC system at MelCo, has recently left and been replaced by a new general manager who is unfamiliar with the ABC system and does not fully recognize its advantages.

The new general manager may not allocate the necessary resources for further development and operation of the ABC system. However, the group’s top management acknowledges the significant potential of ABC. The financial controller views the ABC system as a valuable tool for the group’s growth and complete implementation across other companies. With experience in implementing two ABC systems in different companies, the financial controller considers activity-based costing as an essential and logical system that addresses the challenges faced by manufacturers. The system provides reliable information of superior quality, enabling informed decision-making.