A look into the Activity Based Accounting

Essay

By Joseph Cesar Fourth Year

Advance Diploma in Hospitality Management

Management Accounting Module

Commissioned by Miss Marie Harnett (Lecturer)

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 In the financial operations of every organization, substantial amount of wastes are

generated resulting from transactions and/or projects. It is very difficult to identify these wastes

if careful analysis of the various costs involve is not done. Variable costs are very easy to

identify as they are directly proportionate to cost objects. However, costs affiliated with

overheads are indirectly affiliated to products, thus invincible. These indirect costs should be

recovered so that they can be added to the total costs of products/services, making the prices

realistic and profitable. Jones (2008, 394) reflected that; “all products/service must be priced so

as to fully recover all the costs incurred in making and rendering them respectively.” Therefore

both direct and indirect costs that are affiliated to products must be recovered and absorbed in

their prices. The basis of cost absorption is “the process of recording, classifying, allocating the

costs, and then absorbing these costs into individual product/service” Jones (2008, 394). During

the past, when manufacturing organizations were the dominating industry, this process was

introduced to recover costs and it assumed that overhead costs were relatively small because

products were made intensively using machines and direct labour, thus overheads were absorbed

using those measures. Eventually, manufacturing industry became less active by the rise of

service and/or knowledge-based industries. The latter uses very little direct labour and

machines, therefore they became irrelevant. “New methods of allocating cost were necessary.

The stimulus to find these new methods led to the development of activity-based costing (ABC)

which seeks to establish activities as a basis for allocating overheads” Jones (2008, 407).

In this essay, the development of ABC as a management accounting technique and its

utilisation are detailed. Its advantages and disadvantages are also discussed. An example of the

method’s introduction into a hospitality organisation is examined.

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 The traditional cost accounting method focuses only on measuring units of particular

products assuming that each unit consume resources such as the number of direct labour hours,

machine hours or material costs consumed in making the product. “The ABC system focus on

the activities performed to produce products. Costs are traced from activities to products based

on each product’s consumption of the activities performed” Cooper, (1990a), cited in Jong No

and Kleiner (1997, 68). They further states that ABC acknowledges that products and services

use up activities rather than direct use of resources. This is based on the activities that a product

drawn up. An activity is a particular operation in the production cycle and/or the entire material

acquisition process. Activities use resources such as support labour, power, set-up, material

handling and supervision. What causes activities to happen is called cost driver. ABC uses cost

drivers to locate costs. Examples of cost drivers are set-up hours, set-ups, parts, purchase orders,

inspections, maintenance hours and machine hours, etc. The key factors of ABC are activities

and their cost drivers.

ABC is defined as “the collection of financial and operation performance tracing the

significant activities of the firm-to-product cost” Jong No & Kleiner (1997a, 68). ABC has been

around since the mid-eighties. It was initiated in that time by two associate professors of control

at the Harvard University, and developed to help financial management understand and control

indirect costs. Turney (2008, 1) wrote that ABC emerged in response to competitive pressures

that exposed inaccuracies and distortions in the earlier cost accounting analysis.

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 There are five steps in the design of an ABC system with the objective of getting more

benefits possible at the lowest total cost. The first step is to group all actions into activities as a

whole. Jong No & Kleiner (1997, 70) mention that it is economically unfeasible to use a

different cost driver for each action because of the vast number of actions. A driver is then use

to locate the costs of activities to products.

The second step is how to report the cost of activities. The resources that each activity

consumes can be reported separately or collectively with other activities in its group. For

example as used by Jong No & Kleiner (1997), where the system might report set-up costs for a

product which include material movement in the amount, or the system might break the cost

down and report separately the amount for set-up from the amount for material movement.

The third step is to identify activity centres. This is simply grouping activities into

activity centre within the production process. For example, they can be grouped into receiving

and manufacturing centres.

The fourth and fifth steps are correlated; first and second stage driver selections, where

different measures of resource consumption can be used. The information about the

consumption of resources at the activity centre level is often superior to that of the product level.

According to Jong No & Kleiner (1997), the first stage is to trace the cost of input into activities

in each centre. The second stage is to trace the costs into selected drivers in each activity.

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 The implementation of ABC must be structured sensitively to “determine the actual

design of the system and how well it will be accepted by staff, Cooper (1991a. Cited in Jong No

& Kleiner, 1997, 71). The implementation plan is to ensure the success of ABC. It has seven

phases; first is to conduct a seminar on-site where an introduction to the concepts and benefits of

ABC is given to the management team. Second is to form and educate an implementation team

within the organization. Third is to design and gather relevant data. Direct costs are analysed,

then overhead is examined to identify the cost drivers. Fourth is to report to executives on the

progress and findings. The fifth phase is to conduct an executive seminar to the top management

so that more commitment will be generated towards ABC system. Sixth is to explain the results

so that they can understand how the system differs from the existing one. Finally an analysis of

the activity-based product costs is done and finding ways to change operations for reducing costs

Jong No & Kleiner (1997, 71-72).

“Initially, managers viewed the ABC approach as a more accurate way of calculating

product costs. But ABC has emerged as a tremendously useful guide to management action that

can translate directly into higher profits” Cooper & Kaplan (1991, 130).

As for all scientific functions, there are ways and processes of going about those

functions. It is also one reason why the adoption of ABC is costly. Organization needs to bring

in technicians who understand and who can implement this method, thus ensuring higher profits.

The technical accounting of ABC is thus outlined. These are the processing steps:
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 1- Record all the costs (direct and indirect)

2- Categories and group those cost before allocating them to departments.

3- Identifies activities that determine overhead costs.

4- Identifies cost drivers and allocate appropriate overheads to them

5- Calculate activity-cost driver rates

6- Absorb both direct and indirect costs into a product or service

An example of the whole process can be seen in the Appendix 1

Like everything else, ABC has its advantages and disadvantages.

“It gives a more accurate costing of products/services and other cost pools. It generates a
better understanding of overheads. It is easier to understand by everyone. It utilizes unit cost
rather than just total cost. ABC integrates well with continuous improvement programs like Six
Sigma. It makes visible waste and non-value added activities. It supports performance
management and scorecards. It enables costing processes, supply chains, and value streams. It
portrays how work is done. It can be used to benchmark the organization performance. ABC
help managers manage overheads, and understand profitability of products and customers and
therefore, is a powerful tool for decision making”(http://www.accounting_for_management.com/
2011)

However, ABC has its limitations and advantages. It is costly and requires cognitive

approach by a rare segment that can understands it and who are capable of implementing it

effectively and efficiently. Not all managers understands ABC’s concept and nor can they use it.

Managers can misinterpret the costing data, thus not utilizing it effectively to changes occurred

by a decision at hand. ABC is a virtual analysis that is not conforming to the conventional

accounting principles. Therefore it is not always reported strategically as required. Antos (2011)

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added that ABC consumes a lot of time to collect data, that it is costly to buy, implement and

maintain, and that it makes waste visible which some executives and managers don’t want their

boss to see, although this can be perceive as an advantage.

An example of how ABC was introduced in the hospitality industry is outlined. The

application of ABC was to a support kitchen (bakery) in a Las Vegas casino, with the objective

of establishing an ABC of each item produced in the bakery and to determine if ABC can be

used to eliminate monthly allocations for all production kitchens. The bakery is among five

others which provide fresh baked bread to fifteen revenue producing outlets and five other sister

properties. Yet it was designed to produce for eleven properties.

During the time of global economic recession, casino revenues fell and food prices and

labour cost increased. One casino in Las Vegas motivated the F&B departments to increase

productivity and to reduce costs, waste and inefficient operations, Vaughn et al., (2010, 1033).

They conducted this research in a support kitchen. They applied the five steps of designing

ABC. From gathering relevant data to finally conducting an ABC menu engineering (ABC ME)

analysis to determine if allocations could be eliminated and to establish if some outlets would be

affected by the change. It was discovered that only 33.3% were value-added and 66.7% were

non-value added to products. As the bakery was labour intensive, limiting overtime and

lessening part-time workers were the alternatives. Supervision was the activity consuming the

greatest portion rate at 77%. Increased training to develop more autonomy was the alternative.

Delivery cost was also significant, thus if only one delivery could be done, expense would be

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lowered. The ABC ME also identified a lot of unprofitable items. The ABC analysis of the cost

of delivering bread to restaurants showed that some outlets were underpaying while others were

overpaying. The ABC also identified a low allocation of cost on pizza dough because the

traditional allocation was based on the food cost of bread ordered. As a result, the data were

summarized and managerial implications were discussed.

Vaughn et al., (2010) concluded that;

“the ABC concept allows management to draw some useful implications for costing and
pricing of its bakery products. Since the labour cost pool was large, it could be successfully
traced to individual products, which resulted in an effective ABC application. This approach
then allowed the casino to eliminate traditional monthly allocation methods based on food cost,
which accomplished the main purpose of this study.”

Like all technologies, the ABC has a life cycle. Turney (2008, 2) observed that; “ABC

has achieved two milestones like other mature and successful technologies.” During 1984-1987

it was the ‘Technology Trigger’ phase bringing innovations into cost accounting due to the

decrease in manufacturing industries and as a result of the “Japanese Competition” which drove

western companies to develop new costing methods that eventually triggered professors Cooper

and Kaplan to develop the ABC method. 1987-1991 was described as the “a bubble of

enthusiasm for a new technology” Turney (2008, 3). ‘The Peak of Inflated Expectations’ was

due to massive publicity of ABC. One significant discovery here was the recognition the ABC

“could revealed the sources of loss that were responsible for the decline in profitability” Turney

(2008, 4). ‘Trough of Disillusionment’ phase was in the period 1991-1995. The decline of ABC

was due to “over enthusiasm, confusion, limits to the method and supporting systems,

sustainability difficulties, and lowered expectations. Another reason was that managers were

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jumping attention to new management methods. But ABC continues to progress through

learning from errors. During 1995-2000 it was ‘Climbing the Slope of Enlightenment’. It

increased its market penetration and development. It developed from cost accounting systems

into other areas such as administration, sales, marketing, research and development, supply

chain, logistics, insurance, healthcare, packaged goods, energy, banking, etc. At this stage it was

clear that ABC has reached its ‘Plateau of Productivity’ (2000-2006). Its benefits were

recognized. New evidence of its benefits, new generation of ABC methods and software, use of

internet and business intelligence (BI) systems to report ABC data were a few factors that

triggered increase interest in ABC. Today ABC is designed to measure performance and to

guide on improving profitability. ABC helps in forecasting, limiting or increasing future

budgets. The technology is helping managers to better plan, organize, lead, and control human

resources more profitably. It is also into eco-friendly practices. It has now developed into

Activity-Based Management. It is the result of many years of development and learning.

Turney (2008, 1) describes it as a “value adder to performance management systems." ABC

allows managers to better appreciate accountings and it enlightened them to build interests and

enthusiasm in the financial aspects of their organizations.

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 References

Anon, (2011). Advantages, Disadvantages and Limitations of Activity-Based Costing (ABC)

System. Available from:
http://www.accountingformanagement.com/limitations_of_actvity_based_costing.htm [Accessed
19th May 2011].

Cooper, R., (1990a). “ABC: A need, not an option”, Accountancy (UK), September, pp. 86-8.
Cited in: Jong No, J. and Kleiner, B.H., (1997) How to implement activity-based costing: Journal
of Logistic Information Management 10(2), 68-72.

Cooper, R., & Kaplan, R.S., (1991) Profit Priorities from Activity-Based Costing. Harvard
Business Review, May-June 1991, pp. 130-135.

Jones, M., (2008) Accounting [2nd ed.]. England: John Wiley & Sons Ltd.

Jong No, J. and Kleiner, B.H., (1997). How to implement activity-based costing: Journal of
Logistic Information Management 10(2), 68-72.

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Turney, P.B.B. (2008) Activity –Based Costing. An Emerging Foundation for Performance
Management. SAS Official Home page (http://www.sas.com/resources/whitepaper/wp_5073.pdf,
19th May 2011).

Vaughn, P., Raab, C. & Nelson, K.B. (2010) The Application of activity-based costing to a
support kitchen in a Las Vegas casino: International Journal of Contemporary Hospitality
Management [Online] 22(7), 1033-1047. Available from: http://www.emeraldinsight.com/0959-
6119.htm [Accessed 12th May 2011].

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