Advantages & Disadvantages of activity based costing with reference to economic value addition

Table of Contents

Chapter 1: Introduction
1.1 Introduction
1.2 Objective
1.3 Background

Chapter 2: Literature Review
2.1 The Need for Activity Based Costing
2.2 Advantages of an Activity Based Costing System
2.3 Disadvantages of an Activity Based Costing System
2.4 Technical Limitations
2.5 Advantages of Activity Based Costing: Case of CommQuest
2.6 Implementing an Activity Based Costing System

Chapter 3: Research Methodology
3.1 Methodology

Chapter 4: Data and Variables and Findings
4.1 Primary Research: Impressions of ABC in the Industry
4.2 Integrated ABC and Economic Value Added Systems

Chapter 5 Conclusion

Bibliography

Chapter 1 – Introduction

1.1 Introduction

The paper has been formulated in order to determine the basic differences that are present between the activity based costing (ABC) and conventional methods of costing that are used around the world. A large number of companies have converted to the ABC system since as far back as 1980 as the system has shown its usability in the appropriate product mix decision, overheads management etc. (Roztocki 2000) (Reyhanoglu 2004)

The benefits and drawbacks are as follows:

Advantages of an Activity Based Costing System:

- The first and most important advantage is the accuracy in the process of costing with regards to the product line, the end-users of the product, the stock-keeping units employed by the management and the channel and category which streamline the flow of the product from the producer to the end user.
- This system better assists in the process of understanding the concept of overhead costs i.e. the allocation of common business resources as they are used by specific product lines and their relation to specific cost driver.
- The system is easy to understand and interpret is it is accessible, useable and practically implement able across all norms of business set-ups.
- This process uses unitary cost, or marginal cost as the computation base in contrast to the traditional cost accounting methods which employ total cost.
- The system works exceptionally well will quality improvement and up gradation programs e.g. Six Sigma
- This system is particularly helpful in identifying and ear-marking some of the matters business activities which are a burden or stress on the business i.e. wasteful or non value adding services.
- The system also works exceptionally with performance management systems which are employed by most human resource departments in contemporary businesses.
- This process allows companies to implement costing strategies across another diagonal of the firm as business processes, supply chains and value addition channels are ably and optimally analyzed in this process.
- This system mimics the actual business process as the appropriation of common pool resources takes place in the same way as common resources are used in the business.
- This system aids in the process of benchmarking which is an integral part of he quality control system.

Disadvantages of an Activity Based Costing System:

- Data collection process for this system is very time consuming.
- The capital expenditure on the activity based system and its subsequent running costs can be a road block for firms.
- The system is very transparent which some managers would not approve of as they would like to keep some things out of the view of the owners of the company.

1.2 Objective:

The objective to uncover whether ABC system is the best practice in accounting for manufacturing concerns and whether it is able to cater to problems that are faced by industries. In order to achieve this objective, it is necessary first to review the shortcomings of traditional absorption costing and how ABC can help overcome those shortcomings, which can be derived from a conceptual and empirical perspective. Review the shortcomings of traditional absorption costing and how ABC can help overcome those shortcomings, which can be derived from a conceptual and empirical perspective. We will perform a walk-through on the company, which aim at comparing and evaluating the results under the traditional costing method and ABC. Discussion will also be spent in this area, the details of which can be derived from the site visits, management interviews and study of accounting system and cycle. We aim to obtain some raw data inputs for applying the concepts we found previously from literature review.

1.3 Background:

In the People’s Republic of China,the demand for motor vehicles and related products such as tyre has been increasing over the last few years. However, the profit margin in the Tyre Manufacturing Industry is unimpressive.

Traditionally in the United States or in the United Kingdom, all the expenses were allocated to the product based on the volume, such as working hours, machine hours, or number of units produced. ABC was first introduced in the works of John Deere (March and Kaplan, 1987). In this newly distribution system, costs, products and components will be allocated by the use of activities, such as set-up time and the number of load distribution relating to the establishment and material handling. The new system proved that products cost less in the mass production of small batch processing, compared with the results in the traditional absorption costing.

In the concepts of ABC, accountants or managers must separate tracking costs that is required to produce individual units in order to process batch of a product design or maintenance and maintain a manufacturing facility up and running. Robin Cooper and Robert Kaplan have presented their views in the ABC system design and implementation. However, we wish to ascertain if it is a good approach for Tyre Manufacturing Industry. For example, the profitability of Sumitomo Rubber Industry (SRI), a tyre manufacturing company and one of the famous giants in the industry, has been reducing over the past decade. A recent case study concluded that apart from the pricing strategy, SRI should focus and adopt a more positive accounting approach, such as ABC, in order to maintain sales and profitability.

Chapter 2: Review of Literature

2.1 The Need for Activity Based Costing:

Variable overhead includes such elements as supplies, minor parts, and a portion of electricity or other power sources. Fixed overhead includes such elements as supervisory labor, rent, insurance, and a portion of electricity or other power sources.There is no problem with identifying the variable elements (direct materials, direct labor, and variable overhead) with the product. In fact, when we produce another unit, we incur addition variable costs. The problem is in the application of the fixed overhead to the product. By definition, fixed costs do not increase as we produce an additional unit of product. However, financial accounting rules require us to include a portion of that fixed cost in each unit of product. This process is called unitizing fixed costs.

This is a dumb and stupid rule. The unitization of fixed costs treats these costs as variable even though they are fixed. Thus, when we make decisions concerning products when fixed costs have been unitized, we are assuming that total fixed costs will change as the activity level changes and, in fact, those costs do not change. This makes contribution margin computations invalid - and we have already emphasized the importance of contribution margin to the decision making process.

Now, let's look at how traditional fixed overhead is added to the product. In the slide presentation below, the variable costs (direct materials, direct labor, and variable overhead) have already been assigned to the product. The costs incurred refer only to the fixed costs that must be allocated to the product. Note the three steps. In the first step, we must decide which costs are to be allocated and to which product. This is the definition of the cost pool. Next the fixed

In summary, ABC modifies traditional product costing by assigning costs to activities instead of cost pools. There is a careful analysis of the process to define the appropriate activities and then a cost driver (allocation method) is selected to allocate these costs to the product. Now, consider the impact of this change. By defining these fixed costs within activities, the behavior of the cost has been redefined. Costs that were previously defined as fixed now are actually treated as variable. In fact, the previous classification of fixed was inappropriate and the costs are now properly treated as variable costs. This is the primary (but frequently unrecognized) value of ABC inventory valuation.

In this illustration we have the same costs and products as in the traditional illustration. In step 1, we identify three activities for which costs can be segregated - the ordering, cutting, and painting activities. In step 2, we identify that portion of the previous cost pool costs that are associated with each of these activities. In step 3, we develop individual cost drivers for each activity and assign the costs based on the activity incurred by each product. The result is that a significant portion of the costs are now allocated to the products on the basis of the activities generated by those products.

2.2 Advantages of an Activity Based Costing System:

- The first and most important advantage is the accuracy in the process of costing with regards to the product line, the end-users of the product, the stock-keeping units employed by the management and the channel and category which streamline the flow of the product from the producer to the end user.
- This system better assists in the process of understanding the concept of overhead costs i.e. the allocation of common business resources as they are used by specific product lines and their relation to specific cost driver.
- This process uses unitary cost, or marginal cost as the computation base in contrast to the traditional cost accounting methods which employ total cost.
- The system works exceptionally well will quality improvement and up gradation programs e.g. Six Sigma
- This system is particularly helpful in identifying and ear-marking some of the matters business activities which are a burden or stress on the business i.e. wasteful or non value adding services.
- This system mimics the actual business process as the appropriation of common pool resources takes place in the same way as common resources are used in the business.
- This system aids in the process of benchmarking which is an integral part of he quality control system.

2.3 Disadvantages of an Activity Based Costing System:

- Data collection process for this system is very time consuming.
- The capital expenditure on the activity based system and its subsequent running costs can be a road block for firms.
- The system is very transparent which some managers would not approve of as they would like to keep some things out of the view of the owners of the company.

2.4 Technical Limitations

The major technical limitation that will be faced is testing the hypothesis in the real world. Testing the hypothesis whether ABC is a more appropriate accounting solution is certainly possible on paper but its desirable effects in the real world cannot be properly gauged unless it is directly implemented by companies operating in the world today and the analysis is conducted in a kinetic time mechanism. This is a major stumbling block for most organizations who are remain transfixed to their current accounting mechanism and don’t want to change over to this new system, which despite its obvious benefits, seems to come a great switching or even multi-homing cost.

2.5 Advantages of Activity Based Costing: The Case of CommQuest Limited

CommQuest Limited is a fully incorporated marketing and digital communications group with leading positions in the mobile and digital segments. CommQuest provides a wide variety of marketing and communication choices for its diverse and impressive portfolio of clients such as Telstra, News Limited, NEC, Ford, Medibank and ANZ. [Google Finance, 2008]

An Activity-based costing system follows two steps. The first step identifies major activities and appropriates overhead costs to each activity depending on the proportion of the resources that are employed in that activity. After the assigning of overhead costs is complete, identification of cost drivers relevant each cost pool ensues. Then in step two, division of overhead costs from each cost pool to each product line in proportion to the cost driver consumed by the product line. [Reyhanoglu, 2004]

Now, as we move onto our own case, we have decided to specifically target the cost head of consulting fees during the period of 2005 to 2007.

Here, we will look at perhaps the most important aspect of activity based costing: the ascertainment of cost drivers. When we look at the cost head of consulting fees, it is clear to note that this cost is not restricted to a section of the organization. Suffice to say, every organization contributes towards the accumulation of this expenditure. Therefore, the most pertinent cost driver that can be employed in this condition is to trace the whereabouts of cost with regards to the department or area of their inception in this organization. So, in principle, the organization is basically being demarcated into smaller units each of whom provide different services to the customer, and each of whom in collaboration form CommQuest Limited. From here on, the cost of consulting are attributed to each section of the organization from where it arises and is duly noted likewise in the operating statement.

It is not abundantly clear whether the mechanism of costing that is employed by CommQuest Limited is activity based costing but the structure of their operating statements certainly seem to make the job of an activity based accountant easy as the statement is created for the entire organization as well as the operating units of the company. Therefore, the financial statements take a sort of a grid-like structure whereby costs associated to a single area head e.g. depreciation, is also displayed in entirety with regards to the firm’s activities and also broken down in line with the smaller sections that are doing business as well.

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