Get help now

ACTIVITYBASED COSTING BEYOND THE SMOKE AND MIRRORS

  • Pages 13
  • Words 3179
  • Views 396
  • dovnload

    Download

    Cite

  • Pages 13
  • Words 3179
  • Views 396
  • Academic anxiety?

    Get original paper in 3 hours and nail the task

    Get your paper price

    124 experts online

    ACTIVITY-BASED COSTING: BEYOND THE SMOKE AND MIRRORS

    The business environment in the 1990s is markedly different from that

    of the past when conventional cost accounting procedures were

    established. Activity-based costing (ABC), pioneered in the late

    1980s, offered a new costing approach consistent with the changed

    environment. However, ABC did not diffuse rapidly into the business

    community. This article demonstrates why adopting ABC is important by

    documenting the potential of ABC in supporting contemporary managerial

    Everything happens faster in business today. Even new management tools

    (some say “fads”) follow a meteoric path. For example, the ink on new

    articles describing activity-based costing (ABC) was hardly dry before

    consulting firms had integrated it into their slick brochures and

    presentations. All they needed was someone to use it. To illustrate,

    Romano identified only 110 installations by August 1990, nearly two

    years after the procedure was developed, with 77 percent of these in

    two major firms [13]. Perhaps this phase, in the process of

    introducing the new procedure, could be called “the period of wild

    over-promise.” However, even by the mid-1990s, ABC has not spread

    widely throughout the industry and “even in large firms, widespread

    success of ABC is not obvious” [16].

    According to Ness and Cucuzza, “thousands of companies have adopted or

    explored the feasibility of adopting ABC. However, (they) estimate

    that no more than ten percent of companies now use activity-based

    management in a significant number of their operations” [11]. A survey

    conducted by the Institute of Management Accountants’ cost management

    group found that only 29 percent of companies used ABC instead of

    traditional systems, but this was an increase from 25 percent in the

    previous year [10]. Among reasons cited for low adoption were employee

    resistance and major organizational changes required with the use of

    ABC [11]. Some trace the source of slow adoption of ABC to technical

    as well as cultural issues [5]. Others feel that ABC would be more

    widespread in industry if it were marketed better by the cost

    As the dust has settled, ABC has turned out to be less a revolutionary

    technique than a useful refinement to proven systems. The costs of

    products and services must be accurate, or management can be misled.

    Decisions can rarely be better than the information on which they are

    based. ABC allocates costs to the things people are doing in companies

    and assures that these costs are paid by the products that generated

    them. The “corporate socialism” in which some products pay the bills

    of other products is exposed. It is the purpose of this article to

    illustrate how ABC more accurately reveals the true costs of operating

    in the business environment of the mid-1990s and supports managerial

    decision making by providing information consistent with this

    environment. Beyond the smoke and mirrors, ABC can contribute to

    The full cost of a manufactured product or line of products includes

    direct labor, material, variable overhead, and fixed costs. Direct

    labor and material are normally observed and measured by manufacturing

    and maintained as “standards.” The overhead costs are reported by

    responsibility centers, such as departments or plants. The difficult

    decision is what to do about allocating overhead costs to products or

    The typical business uses a two-step system for absorption costing in

    which costs are accumulated in a pool and then allocated to specific

    products based on a single, plant-wide base, such as direct labor

    hours utilized in producing the product [2]. Other allocation bases

    are machine hours or direct labor cost, for example. The wide use of

    direct labor hours as an allocation basis is historical. When cost

    accounting systems were being developed in the mid-1920s, labor was a

    major cost and thus a target of management attention. However, it is

    now apparent that the historical model is oversimplified. Direct labor

    costs that once accounted for 80 percent of all costs, now account for

    no more than eight to 12 percent of all costs in advanced

    manufacturing industries [17]. Indeed, “marketing costs make up more

    than 50 percent of the total costs in many product lines,” not direct

    Activity-based costing, pioneered by Harvard’s Cooper and Kaplan,

    responded to changes in the business environment with a new approach

    that allocated staff and overhead costs to products (or lines or

    territories) based on how the products actually consumed or generated

    the costs [3]. The process is similar to that used by engineering to

    develop a bid or to estimate the cost of a project. ABC identifies

    systematic cause and effect linkages between products and costs,

    before resorting to across-the-board allocations. In ABC, these

    linkages are called cost “drivers,” i.e. costs are driven up or down

    by these factors. Companies are using labor hours, machine hours,

    floor space used, ordersentered, warehousing, size, weight, and sales

    costs as drivers. Refer to Exhibit 1. Costs are first accumulated, as

    has been done traditionally, but are then allocated to the product or

    territory by the appropriate drivers. For example, a product using 30

    percent of warehouse space might get 30 percent of the space costs,

    one using 20 percent of sales effort might receive 20 percent of that

    Changes in the Business Environment

    Operating managers have known for 50 years that the conventional

    costing approach was inaccurate; however, it was close enough. Today,

    because of the multitude of changes in the business environment, the

    errors of conventional costing are systematic and can affect too many

    decisions. These widespread changes have fundamentally altered the

    essential assumptions of conventional cost accounting.

    Direct labor is down dramatically. Not many years ago labor comprised

    25 to 50 percent of a product’s cost. However, since the 1960s, many

    businesses in America have gone through a quiet revolution. For

    example, the textile industry junked 100-year old shuttle looms for

    European air-jet looms, doubling output with half the manpower. In

    steel, the “Nucors” of the U.S. used continuous casting machines to

    yield labor costs of $60/ton compared with traditional “Big Steel’s”

    $130/ton. In short, labor cost now is infrequently the dominant

    driving force it was during the development period of cost accounting.

    Instead, indirect costs have replaced labor as the dominant portion of

    costs for some products [7]. To use labor as the major basis for

    allocating overhead in such cases, as conventional accounting does,

    Overhead costs are higher. Overhead costs are higher due to decisions

    regarding machinery, human resources, and support systems. There has

    been a move to more sophisticated machinery that must be used properly

    by fewer and more skilled workers, supported by expanded auxiliary

    systems. Responsive, flexible machinery is the key to the success of

    many companies. Few can rely on sales of large quantities of

    undifferentiated products. Flexible manufacturing systems (FMS) are

    the models for the advanced application. Machines with a desired range

    of capability and designed for ease of a changeover are integrated for

    efficiency and controlled by computers for maximum responsiveness

    [14]. Millions in capital investment are monitored by one or two

    operators but supported by programmers and technicians. Obviously,

    this affects human resources because a smaller workforce is needed.

    Nevertheless, many companies are seeing their training costs double in

    a single year as resources are poured into the building of employee

    teams. Initiatives in total quality management (TQM) involve heavy

    commitments to personnel. For some companies, the cost is significant

    enough to warrant care in where it is charged. For example, Univar,

    the largest chemical distributor in the U.S., committed $2 million to

    TQM training and implementation [15]. Conventional cost accounting is

    unable to reveal accurately such investments in personnel.

    All these changes have involved investment in support services such as

    engineering, sales, and information systems. Many companies, such as

    Ingersol-Rand’s Compressor Division, believe that sales outside the

    U.S. may soon require ISO 9000 certification. Besides the direct costs

    of the certification visits required, the costs of all the systems

    must be in place throughout the company to support this endeavor.

    Registration for ISO 9000 certification cost one international

    corporation $2,000 to $3,000 per plant; the corporation registered 20

    Inventories are decreased. In the past, inventories have acted as a

    buffer to disconnect manufacturing from the market. Today, competitive

    effectiveness calls for just the opposite. When the market needs it,

    responsiveness is provided with reduced inventory. Again, there are

    cost implications in information systems, such as material

    requirements planning (MRP) and the support of more skilled workers in

    JIT systems. Moreover, today’s smaller inventories require more setups

    and more frequent orders of smaller quantifies [6].

    Product life cycles are shorter. As the pace of technological change

    has quickened, many new product innovations have entered the market.

    These entrants have reduced market shares of established products so

    that product-elimination decisions occur more frequently. Accurate

    costinformation is critical in determining the actual costs of

    frequent product changes and in knowing at what point profits no

    longer justify continuation of a product or line.

    New product development is faster and more frequent. The shortening

    length of product life cycles means that new product development is an

    ongoing process. In the past, this process was largely a function of

    marketing, with its cost relegated to marketing overhead. Today,

    concurrent engineering, simultaneous product development, and venture

    teams mean that costs, prior to manufacturing, are incurred throughout

    the organization. Ultimately, faster new product development can lead

    to lower total costs, but many costs are hidden [4]. This can lead to

    incorrect measures of profitability and incorrect market entry

    Product lines are more complex. Product lines were simpler in the

    past. The Model T came in one color. Now, market segmentation and

    market fragmentation mean different products for different (smaller)

    markets; this means lower sales and profits per product. Under these

    circumstances, accurate costing is essential. There may no longer be

    large volume sales to cover high hidden costs. On the contrary, mass

    customization is fast approaching. More than 200 companies, including

    Westinghouse, Chrysler, and Honeywell, have joined the Agile

    Manufacturing Enterprise Forum, an association seeking to meet the

    need for customized products made as quickly and cheaply as those that

    Order entry is more frequent. As product variety increased, order

    entry frequency did also. More specialized products for diverse

    markets means more customers entering orders for different products,

    more frequently. Furthermore, such customization means that it is more

    difficult to produce large quantities for stock. Also, because the

    cost of holding inventories is prohibitive, more frequent orders are

    entered at the plant in response to JIT buying. Key costs are shifted

    away from manufacturing to marketing subsystems, but they must be

    captured and related to the products and lines that generate them.

    Distribution is expensive. As JIT shifts costs away from storage, it

    shifts them into distribution. This may mean that transportation

    expenses increase or channel costs must go up to compensate dealers

    for holding inventory. These costs must be allocated appropriately if

    prices and profits are to be reflected accurately in management

    Selling is more costly. More customers and customized products mean

    more sales calls and sales expenses. In some industries, the cost of a

    business-to-business sales call now exceeds $300. Such costs across

    product lines can easily eclipse direct labor expense in the factory

    and significantly impact profitability. Many companies are seeking to

    reduce costs by employing telemarketing and direct mail. Others are

    seeking more productivity from sales by using personal computers,

    “virtual” offices, and key account marketing. But these approaches may

    generate marketing costs as they shift them away from direct labor.

    These costs must be recognized in the cost accounting system.

    The changes documented above have had a profound impact on the costs

    of operating a business in the 1990s. Using a conventional cost

    accounting approach in today’s environment may provide distorted

    information to management. This can result in incorrect decisions. The

    use of ABC, on the other hand, provides a way to reflect the

    contemporary business environment in a firm’s accounting system. The

    exhibits below illustrate the physical changes on the plant floor and

    the market changes in the environment, trace these changes in the

    accounting system, and show how the costing approach can dramatically

    alter the apparent profitability of a company’s strategies.

    Two stereotypical products are displayed in Exhibit 2. The

    “traditional” product has high labor cost and a simple manufacturing

    environment. The “contemporary” product, reflecting the mid-1990s

    environment for many companies, has much less labor, lower volume,

    more change/turnover in manufacturing, and increased sales effort. The

    exhibit summarizes these general differences.

    Exhibit 3 takes the product characteristics in Exhibit 2 and shows

    representative activities that these characteristics might entail. For

    example, the traditional product’s higher sales volumes would lead to

    many units sold (23,000) and fewer setups, i.e., longer production

    runs. This is consistent with the business environment of the past.

    The traditional product is labor intensive, five hours versus one hour

    for the contemporary product, and material intensive, $15 versus

    $13.50. On theother hand, the contemporary product requires more

    setups, 18 versus nine, and engineering changes, 12 versus seven. The

    contemporary product’s increased selling effort requires more sales

    The total costs of some departments providing the services are also

    shown in Exhibit 3. These costs, reflecting the different business

    conditions of the mid-1990s, are documented to develop a realistic

    model of the two types of operating environments. Total costs for the

    period are $4,015,000. This information will be used later in

    comparing conventional cost accounting with ABC to show the potential

    The information in Exhibit 3 is used to generate the costs of each

    product and the total costs under both the conventional method and the

    ABC method of allocating costs. Refer to Exhibits 4 and 5. In Exhibit

    4, labor and material are derived from actual costs as usual. The

    contemporary product has much less direct labor, $12 compared with

    $60, and uses less material, $13.50 versus $15.00. Using the

    conventional (non-ABC) costing method, overhead costs are allocated by

    labor according to the formula shown in Exhibit 4, $68.83 to the

    traditional product but only $13.77 to the contemporary product. This

    yields a total traditional product cost of $143.83 per unit versus

    $39.27 for the contemporary product.

    The development of costs using ABC is shown in Exhibit 5. Direct

    material and labor are the same as they were in Exhibit 4. Using ABC,

    overhead costs were distributed across products by the drivers, as

    explained in Exhibit 5. In other words, rather than simply allocating

    costs based on direct labor, costs were allocated by the unique

    drivers identified in Exhibit 3. For example, the receiving department

    cost $61,000 and received 950 shipments, as shown in Exhibit 3.

    Therefore, each receipt of materials cost $64.21. The traditional

    product required 350 material receipts generating receiving costs of

    $22,474. Since 23,000 units of traditional product were sold, each

    unit sold generated $0.98 in receiving costs. Other overhead costs

    were allocated similarly to distribute total product costs of

    $4,015,000; each unit of the traditional product cost $105.18. The per

    unit cost of the contemporary product was $88.65. These costs are

    quite different from those of the conventional method in Exhibit 4.

    The dramatic impact on apparent profitability due to this change in

    cost allocation is shown in Exhibits 6 and 7 on page 30. Using

    conventional cost accounting methods with labor-based allocations, the

    traditional product’s higher labor accumulated excessive overhead

    costs, such as engineering or sales, that it did not generate. Instead

    of losing more than $548,000 as shown in Exhibit 6, the traditional

    product would have generated net profits in excess of $340,000 as

    shown in Exhibit 7. On the other hand, the contemporary product was

    undercharged for costs it incurred, generating an apparent net profit

    of more than $1 million, shown in Exhibit 6. However, when costs were

    charged to the products as they actually occurred using ABC, the

    picture was quite different as shown in Exhibit 7. The contemporary

    product’s $1 million profit shrank to about $204,000. Thus, ABC

    avoided a potentially erroneous decision to drop the traditional

    product and seek more business for the contemporary product.

    Exhibit 8 on page 30 summarizes these results. The traditional product

    shows a significant decrease in costs using ABC rather than historic

    costing. The contemporary product, which required more support and

    service (changes, setup, sales calls, and orders), saw costs per unit

    increase to reflect these expenses. In this situation, ABC exposed the

    charges inherent in the 1990s business environment whereas historic

    The business environment of the 1990s is vastly different from that of

    the 1920s when conventional cost accounting procedures were

    established. The primary difference is the decline of labor costs and

    the increase in overhead generated by shorter product-life cycles,

    product-line complexities, expensive new technology, and the other

    realities of today’s business environment. As a result, the

    information necessary to make good decisions regarding products and

    markets can be obscured by conventional costing procedures.

    Activity-based costing, a natural progression of the technology of

    information systems, can more realistically model the cost structure

    Surprisingly however, ABC has spread very slowly in the industry. This

    means that important strategic decisions are being based on incomplete

    (inaccurate) information. The examples used in this article show how

    profoundly the information used for decision making can be influenced.

    The purpose of the examples is not to suggest that contemporary

    products are less profitable than traditional ones. Even if that were

    true, management does not have the option of producing only

    traditional products. The market dictates which products are required,

    and the market of the 1990s is different. Instead, the examples are

    used to draw attention to how these differences in the market need to

    The pioneers of the ABC concept wrote that activity-based costing “is

    designed to provide more accurate information about production and

    support activities and product costs so that management can focus its

    attention on the products and processes with the most leverage for

    increasing profits. It helps managers make better decisions about

    product design, pricing, marketing, and mix and encourages continual

    operating improvements” [31:103]. The purpose of this article was to

    show that there is more to ABC than smoke and mirrors. ABC can make a

    genuine contribution to improving decision making.

    1. Brausch, J.M. “Selling ABC: New Cost Systems Can Flounder if They

    Are Not Marketed.” Management Accounting, February 1992, pp. 42-46.

    2. Collins, F. and M.L. Werner. “Improving Performance with Cost

    Drivers.” Journal of Accountancy, June 1990, pp. 131-134.

    3. Cooper, R. and R.S. Kaplan. “Measure Costs Right: Make the Right

    Decisions.” Harvard Business Review, September/October 1988, pp.

    4. Crawford, C.M. “The Hidden Costs of Accelerated Product

    Development.” Journal of Product Innovation Management, September

    5. Geishecker, M.L. “New Technologies Support ABC.” Management

    6. Heizer, J. and B. Render. Production and Operations Management.

    7. Kelly, K. “A Bean-Counter’s Best Friend.” Business Week, October

    8. Lewis, R.J. “Activity-Based Costing for Marketing.” Management

    Accounting, November 1991, pp. 33-38.

    9. Lofgren, G.Q. “Quality System Registration: A Guide to Q90/ISO 9000

    Series Registration.” Quality Progress, May 1991, p. 37.

    10. “More Companies Turn to ABC.”Journal of Accountancy, July 1994, p.

    11. Ness, J.A. and T.G. Cucuzza. “Tapping the Full Potential of ABC.”

    Harvard Business Review, July/August 1995, pp. 130-131.

    12. Port, O. “Custom-Made, Direct from the Plant.” Business Week,

    13. Romano, P.L. “Trends in Management Accounting.” Management

    14. Roth, A.V., C. Gaimon, and L. Krazewski. “Optimal Acquisition of

    FMS Technology Subject to Technological Process.” Decision Sciences,

    Vol. 22, No. 2, Spring 1991, pp. 308-334.

    15. Schonberger, R.J. and E.M. Knod Jr. Operations Management:

    Continuous Improvement. Richard D. Irwin, 1994, p. 44.

    16. Selto, F.H. and D.W. Jasinski. “ABC and High Technology: A Story

    with a Moral.” Management Accounting, March 1996, pp. 37-40.

    17. Smith, R.B. “Competitiveness in the ’90s.” Management Accounting,September 1989, pp. 24-29.

    This essay was written by a fellow student. You may use it as a guide or sample for writing your own paper, but remember to cite it correctly. Don’t submit it as your own as it will be considered plagiarism.

    Need a custom essay sample written specially to meet your requirements?

    Choose skilled expert on your subject and get original paper with free plagiarism report

    Order custom paper Without paying upfront

    ACTIVITYBASED COSTING BEYOND THE SMOKE AND MIRRORS. (2018, Jun 21). Retrieved from https://graduateway.com/activitybased-costing-beyond-the-smoke-and-mirrors/

    Hi, my name is Amy 👋

    In case you can't find a relevant example, our professional writers are ready to help you write a unique paper. Just talk to our smart assistant Amy and she'll connect you with the best match.

    Get help with your paper