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A Thesis Presented

Reg. No. MCM05083126 To The Committee on Academic Degrees In partial fulfillment of the requirements For a degree with honors Of M.Com (Accounting)

School of Accountancy & Finance,

The University of Lahore July 2010

2 The Thesis committee for ---------------------------------- certifies that this is the approved version of the following thesis:

(The effectiveness of the use of costing techniques within an organization)



__________________________ (SARFRAZ)


To our parents and Teachers whom supervision, affection and prayers enables us to complete my thesis.


We are Thankful to ALMIGHTY ALLAH who has enabled us to complete this thesis. We are also thankful to our Teachers for their valuable advices and their continuous appraisal during my work. I am also thankful to my friends for their kind in this thesis.


Manufacturing costing methods are accounting techniques that are used to help understand the value of inputs and outputs in a production process. By tracking and categorizing this information according to a rigorous accounting system, corporate management can determine with a high degree of accuracy the cost per unit of production and other key performance indicators. Management needs this information in order to make informed decisions about production levels, pricing, competitive strategy, future investment, and a host of other concerns. Such information is primarily necessary for internal use, or managerial accounting. As there is not much of data available on my topic The effectiveness of the use of costing techniques within an organization I have very much access in to all of material. My research has been to piece of collection of data from all sources to build up strong arguments regarding this research. I have been used deductive reasoning as there is ample research done on this topic which helps me to prove my argument. In this dissertation in literature review, researcher has discussed published information in a particular subject area and information in a particular topic area. A literature review has been just a simple summary of the sources, but it usually has an organizational pattern and combines both summary and synthesis. A summary is a recap of the important information of the source, but a synthesis is a re-organization, or a reshuffling, of that information. It might give a new interpretation of old material or combine new with old interpretations. Literature reviews provide you with a handy guide to researcher's particular topic. I have collecting secondary data for my research as there is rich but small and difficult data available for my research question and I have been direct access to relevant topic levels. During research collected the relevant data and than use methods for analysis the collective data to get for better result. After analysis of data, tables and graphs have been drawn and explanation has been constructed. After completion of first four chapters, conclusion has been made and recommendations for further improvements of concerned topic have been constructed at the end.


CHAPTER NO.1 INTRODUCTION---------------------------------------------------------------------------------9 COST ------------------------------------------------------------------------------------------------9 1.1Accounting Vs opportunity costs--------------------------------------------------------------9 1.2Comparing private, external, social, and psychic costs-------------------------------------9 1.3Privatecost ----------------------------------------------------------------------------------------9 1.4Cost estimates and cost overrun---------------------------------------------------------------10 1.5Path cost------------------------------------------------------------------------------------------10 1.6Biological cost-----------------------------------------------------------------------------------10 COSTING METHODS (MANUFACTURING) -----------------------------------------------11

7 OVERVIEW OF CURRENT METHODS------------------------------------------------------11 PROCESS AND JOB-ORDER COSTING-----------------------------------------------------11 ACTIVITY-BASED COSTING------------------------------------------------------------------11 EMERGENCE OF COST ACCOUNTING-----------------------------------------------------12 EXPANDING USES-------------------------------------------------------------------------------13 THE BASICS OF COSTING METHODS---------------------------------------------------14 FIXED COSTS--------------------------------------------------------------------------------------14 VARIABLE COSTS-------------------------------------------------------------------------------14 DIRECT COSTS------------------------------------------------------------------------------------14 INDIRECT COSTS--------------------------------------------------------------------------------15 ESTIMATING TOTAL COSTS-----------------------------------------------------------------15

8 ACCOUNT ANALYSIS-------------------------------------------------------------------------15 ENGINEERING APPROACH-------------------------------------------------------------------15 HIGH-LOW APPROACH------------------------------------------------------------------------16 LINEAR REGRESSION--------------------------------------------------------------------------16 STANDARD COSTS------------------------------------------------------------------------------16 DIRECT MATERIALS----------------------------------------------------------------------------16 DIRECT LABOR-----------------------------------------------------------------------------------17 OVERHEAD----------------------------------------------------------------------------------------17 DETERMINING PROFITABILITY THROUGH CVP ANALYSIS-----------------------17 TARGET COSTING-------------------------------------------------------------------------------18 PRODUCT COST CALCULATIONS--------------------------------------------------------19 1.1Challenges of product costing-----------------------------------------------------------------20 1.2Activity-based costing--------------------------------------------------------------------------22 1.3Theory of constraints---------------------------------------------------------------------------25 PROBLEM STATEMENT----------------------------------------------------------------------27 AIMS AND OBJECTIVES OF THE STUDY-----------------------------------------------27 1.1Cost Accumulation Method-------------------------------------------------------------------27 1.2Problems with traditional systems -----------------------------------------------------------28 1.3Product Cost Distortions and Cross Subsidies----------------------------------------------28 1.4Excluding Non-Manufacturing Costs--------------------------------------------------------28 HYPOTHESIS / RESEARCH QUESTION-------------------------------------------------29 ASSUMPTIONS AND LIMITATIONS------------------------------------------------------29 CHAPTER NO.2 LITERATURE REVIEW-----------------------------------------------------------------------30 1.1Activity Based Costing (ABC) Adoption among Manufacturing Organizations-------30 1.2Activity Based Costing (ABC) Literature --------------------------------------------------31 1.3Organizational Change Literature------------------------------------------------------------31 CHAPTER NO.3 RESEARCH METHODOLOGY--------------------------------------------------------------42 RESEARCH DESIGN----------------------------------------------------------------------------42

9 DATA COLLECTION METHOD--------------------------------------------------------------42 Type of Data used----------------------------------------------------------------------------------42 Secondary / primary type--------------------------------------------------------------------------42 METHOD OF ANALYSIS-----------------------------------------------------------------------42 ETHICAL CONSIDERATIONS----------------------------------------------------------------43 DATA ANALYSIS (RESULTS AND DISCUSSIONS) -----------------------------------43 CONCLUSION AND RECOMMENDATIONS-------------------------------------------- 43 TIME SCHEDULE AND RESEARCH PLAN---------------------------------------------- 43 CHAPTER NO.4 ANALYSIS AND RESULTS-----------------------------------------------------------------45 THE CAUSES OF PRODUCT COST DISTORTIONS------------------------------------45 Product Volume Diversity-----------------------------------------------------------------------45 Product Diversity----------------------------------------------------------------------------------46 THE LOGIC OF ABC----------------------------------------------------------------------------47 What about Fixed and Variable Costs in ABC? ----------------------------------------------48 The Rule of One-----------------------------------------------------------------------------------48 Can ABC Include Fixed and Variable Costs?-------------------------------------------------49 Should ABC Include Fixed and Variable Costs? ----------------------------------------------49 ACTIVITY VOLUM------------------------------------------------------------------------------49 HOW ARE ACTIVITY MEASURES CHOSEN? DISTINCTION BETWEEN ACTIVITIES, DRIVERS AND ACTIVITY MEASURES-----------------------------------------------------------------50 Activities--------------------------------------------------------------------------------------------51 Activity Measures----------------------------------------------------------------------------------53 THE ABC TECHNIQUE-------------------------------------------------------------------------54 FOUR STEPS IN DESIGNING AN ABC SYSTEM OR SUB-SYSTEM-----------------54 THREE STEPS TO OBTAIN ABC COSTS---------------------------------------------------54 COMPARING TRADITIONAL PVB AND ABC SYSTEMS------------------------------55 Example: Effects of Production Volume Differences-----------------------------------------55 CHAPTER NO.5 CONCLUSION AND RECOMMENDATIONS--------------------------------------------69 CONCLUSION------------------------------------------------------------------------------------69 RECOMMENDATIONS------------------------------------------------------------------------74 REFERENCES------------------------------------------------------------------------------------79



COST In business, retail and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In economics, a cost is an alternative that is given up as a result of a decision (Sullivan, arthur; Steven M. Sheffrin, 2003). In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this case, money is the input that is gone in order to acquire the thing. This acquisition cost may be the sum of the cost of production as incurred by the original producer, and further costs of transaction as incurred by the acquirer over and above the price paid to the producer. Usually, the price also includes a mark-up for profit over the cost of production. Costs are often further described based on their timing or their applicability. 1.1Accounting Vs opportunity costs In accounting, costs are the monetary value of expenditures for supplies, services, labour, products, equipment and other items purchased for use by a business or other accounting entity. It is the amount denoted on invoices as the price and recorded in book keeping records as an expense or asset cost basis. Opportunity cost, also referred to as economic cost is the value of the best alternative that was not chosen in order to pursue the current endeavour i.e., what could have been accomplished with the resources expended in the undertaking. It represents opportunities forgone. In theoretical economics, cost used without qualification often means opportunity cost. 1.2Comparing private, external, social, and psychic costs When a transaction takes place, it typically involves both private costs and external costs. 1.3Private costs are the costs that the buyer of a good or service pays the seller. This can also be described as the costs internal to the firm's production function. External costs (also called externalities), in contrast, are the costs that people other than the buyer are forced to pay as a result of the transaction. The bearers of such costs can be either particular individuals or society at large. Note that external costs are often both

11 non-monetary and problematic to quantify for comparison with monetary values. They include things like pollution, things that society will likely have to pay for in some way or at some time in the future, but that are not included in transaction prices. Social costs are the sum of private costs and external costs. For example, the manufacturing cost of a car (i.e., the costs of buying inputs, land tax rates for the car plant, overhead costs of running the plant and labour costs) reflects the private cost for the manufacturer (in some ways, normal profit can also be seen as a cost of production; Ison and Wall, 2007, p. 181). The polluted waters or polluted air also created as part of the process of producing the car is an external cost borne by those who are affected by the pollution or who value unpolluted air or water. Because the manufacturer does not pay for this external cost (the cost of emitting undesirable waste into the commons), and does not include this cost in the price of the car, they are said to be external to the market pricing mechanism. The air pollution from driving the car is also an externality produced by the car user in the process of using his good. The driver does not compensate for the environmental damage caused by using the car. A psychic cost is a subset of social costs that specifically represent the costs of added stress or losses to quality of life. 1.4Cost estimates and cost overrun When developing a business plan for a new company, product, or project, planners typically make cost estimates in order to assess whether revenues/benefits will cover costs. This is done in both business and government. Costs are often underestimated resulting in cost verrun during implementation. Main causes of cost under estimation and overrun are optimism bias and strategic mis representation (Flyvbjerg et al. 2002). Reference class forecasting was developed to curb optimism bias and strategic misrepresentation and arrive at more accurate cost estimates. Cost Plus, is where the Price = Cost plus or minus X%, where x is the percentage of built in overhead or profit margin. 1.5Path cost Also seen as a term in networking to define the worthiness of a path. 1.6Biological cost In biology, the biological cost or metabolic price is a measure of the increased energy metabolism that is required to achieve a function. Drug resistance in

12 microbiology, for instance, has a very high metabolic price, especially for anti biotic resistance (Wichelhaus TA, Bddinghaus B, Besier S, Schfer V, Brade V, Ludwig A., 2002). COSTING METHODS (MANUFACTURING) Manufacturing costing methods are accounting techniques that are used to help understand the value of inputs and outputs in a production process. By tracking and categorizing this information according to a rigorous accounting system, corporate management can determine with a high degree of accuracy the cost per unit of production and other key performance indicators. Management needs this information in order to make informed decisions about production levels, pricing, competitive strategy, future investment, and a host of other concerns. Such information is primarily necessary for internal use, or managerial accounting. OVERVIEW OF CURRENT METHODS PROCESS AND JOB-ORDER COSTING There are two conventional costing approaches used in manufacturing. The first, and more common, is process costing. Used in most mass-production settings, a process cost system analyzes the net cost of a manufacturing process, say filling bottles with soda, over a specified period of time. The unit cost for filling bottles is simply the net costs incurred while filling all the bottles during the period divided by the number of bottles filled. Since most manufacturing processes involve more than one step, a similar calculation is made for each step to arrive at a unit cost average for the entire production system. By contrast, the second major costing method, job-order costing, is concerned with tracking all the costs on an individual product basis. This is useful in settings where each unit of production is customized or where there are very few units produced, such as in building pianos, ships, or airplanes. Under job order costing, the exact costs incurred in the production of a particular unit are recorded and are not necessarily averaged with those of any other unit, since every unit may be different. Job-order costing is also widely used outside manufacturing. A single manufacturer may use both process and job-order costing for different parts of its operations. ACTIVITY-BASED COSTING Activity-based costing (ABC) is a secondary and somewhat complementary (or better, supplementary) method to the two traditional costing techniques. Whereas

13 traditional methods might classify costs in generic categories like direct materials, labor, and other overhead, ABC clusters all the costs associated with a single manufacturing task, regardless of whether they fall under the headings of labor or materials or something else. So in the bottling example activity-based costs might include operating the dispensing machines, performing quality checks, moving pallets of bottles, and so forth. Each of these activities may involve human labor, equipment costs, energy and expendable resources, and materials, but for analytic purposes the costs are all lumped together under a single activity concept. The advantage of this approach is that management can then observe which tasks cost the most versus which add the most value; this analysis may indicate that a disproportionate amount of money is being spent on low-value activities, signaling a need for process changes or for outsourcing to a vendor that can perform the tasks less expensively. Use of this method is sometimes referred to as activity-based cost management (ABCM) or simply activity-based management (ABM). EMERGENCE OF COST ACCOUNTING Cost accounting was one of three interrelated types of accounting developed at the time, the others being financial and capital accounting. Financial accounting addressed issues relating to a firm's daily financial transactions, as well as overall profitability. For example, railroads began deriving operating ratios in the late 1850s, which for the first time related absolute quantities of profit and loss to business volume. Capital accounting addressed issues relating to the valuation of a firm's capital goods. This was particularly important in the railroad industry given the unprecedented quantities of capital involved and the problem of how to account for the repair and renewal of capital. Innovations in cost accounting followed those in financial and capital accounting. Cost accounting involved the determination and comparison of costs among a firm's divisions or operations. Thus the historical development of cost accounting accommodated the development of the multidivisional firm towards the end of the 19th century. There was necessarily a considerable amount of overlap among financial, capital, and cost accounting. For example, to accurately determine unit costs, it was necessary to relate overhead costs and capital depreciation to the volume of production. At the same time, unit costs were typically used to determine prices, which in turn affected financial accounts. The separation of these types of accounting followed their historical

14 institutional separation. That is, until the innovations of E.I. Du Pont de Nemours & Co. in the 20th century, financial, capital, and cost accounting operations were carried out in relative autonomy within firms. Cost accounting was first used by the Louisville & Nashville Railroad in the late 1860s. This enabled the company to determine such measures as comparative cost per ton-mile among its branches, and it was by these measures, rather than earnings or net income, that the company evaluated the performance of its managers. The accounting methods developed by the railroads were adopted by the first large manufacturing firms in the United States upon their formation in the last quarter of the 19th century. EXPANDING USES The largest U.S. manufacturing firms in the 1870s were textile producers. Because these years were a period of hardship for the industry, textile producers began to devote more attention to the determination and control of costs. By 1886, Lyman Mills, one of the country's largest textile producers, began to determine unit costs for its various products, though it did not use this information to make pricing or investment decisions. The Standard Oil Trust, formed in 1882, also began to determine the comparative costs of their different refineries in the 1880s and on this basis opted to concentrate production in their largest units. However, the enterprise did not accurately account for overhead or capital depreciation its determination of costs. The firm with the most detailed and sophisticated costing methods in the 1880s were the Carnegie Company, a steel producer. In this case, the connection between costing methods in the railroad and manufacturing industries was direct, as Andrew Carnegie patterned the organization of his firm after the Pennsylvania Railroad, where he had been an executive. Carnegie's costing method was referred to as the voucher system of accounting. In this system, each of the company's departments kept track of the quantity and price of materials and labor for each order. These data were aggregated into cost sheets that the company's accountants were able to produce on a daily basis. Though the Carnegie Company made extensive use of its cost sheets to determine prices, it focused on prime rather than overhead and depreciation costs.


THE BASICS OF COSTING METHODS FIXED COSTS One of the key issues in conventional costing methods (i.e., process costing and job-order costing) is distinguishing among types of costs. A basic distinction is made between fixed and variable costs. Fixed costs are those costs that are invariant with respect to changes in output and would accrue even if no output were produced. Such costs might include interest payments on the purchase of plant and equipment, rent, property taxes, and executive salaries. The notion of fixed costs is restricted within a certain time frame, since over the long run fixed costs can vary. For example, a manufacturer may decide to expand capacity in the face of increased demand for its product, requiring a higher level of expenditure on plant and equipment. VARIABLE COSTS Variable costs change proportionately to the level of output. For manufacturers, a key variable cost is the cost of materials. In terms of total costs at increasing output levels, fixed costs are constant and variable costs are increasing at a constant rate. In terms of unit costs at increasing output levels, fixed costs are declining, and variable costs constant. Manufacturers are vitally interested in unit costs with respect to changes in output levels, since this determines profit per unit of output at any given price level. The characteristics of fixed and variable costs indicate that as output increases, unit costs will decline, since there is constant variable cost and lesser fixed cost embodied in each unit. These costing methods thus suggest that it is in manufacturers' interest to run, within the limits of plant design, at high capacity levels. DIRECT COSTS Costing methods distinguish between the direct and indirect costs of any costed object. Direct costs are those costs readily traceable to the costed object, whereas indirect costs are less-readily traceable. Direct costs typically include the major components of any manufactured good and the labor directly required to produce that good. Direct costs are often subdivided into direct material costs and direct labor costs. Direct costs are also referred to as prime costs.

16 INDIRECT COSTS Indirect costs include plant-wide costs such as those resulting from the use of energy and fixed capital, but indirect costs may also include the costs of minor components such as solder or glue. While all costs are conceivably traceable to a costed object, the determination of whether to do so depend on the cost-effectiveness with which this can be done. Indirect costs of all kinds are sometimes referred to as overhead, and in this sense prime costs can be distinguished from overhead costs. ESTIMATING TOTAL COSTS Several methods are used in manufacturing to estimate total cost equations, in which total costs are determined as a function of fixed costs per time period, variable costs per unit of output, and the level of output. These methods include account analysis, the engineering approach, the high-low approach, and linear regression analysis. In all these methods, the central issue is how total costs change in relation to changes in output. ACCOUNT ANALYSIS In account analysis, all costs are classified as either strictly fixed or variable. This has the advantage of ease of computation. However, some costs may be semi variable costs or step costs. Utility bills are typically semi variable in that they contain fixed and variable components. Step costs increase in discrete jumps as the level of output increases. In account analysis, such costs are typically categorized as either fixed or variable depending which element predominates. Thus, the accuracy of account analysis depends in large part on the proportion of costs that are not strictly fixed or variable. For many manufacturing firms, account analysis provides a sufficiently accurate estimation of total costs over a range of output levels. ENGINEERING APPROACH The engineering approach infers costs from the specifications of a product. The approach works best for determining direct material costs and less well for direct labor costs and overhead costs. The advantage of the engineering approach is that it enables manufacturers to estimate what a product would cost without having previously produced that product, whereas the other methods are based on the costs of production that has already occurred.

17 HIGH-LOW APPROACH In the high-low approach, a firm must know its total costs for previous high and low levels of output. Graphing total costs against output, total costs over a range of output are estimated by fitting a straight line through total cost points at high and low levels of output. If changes in total costs can be accurately described as a linear function of output, then the slope of the line indicates changes in variable costs. The problem with the high-low approach is that the two data points may not, for whatever reasons, accurately represent the underlying total cost-output relationship. That is, if additional total cost-output points were plotted, they might lay significantly wide of the line connecting the two initial high-low points. LINEAR REGRESSION Linear regression analysis addresses the shortcomings of the high low approach by fitting a line through all total cost-output points. The line is fitted to minimize the sum of squared differences between total cost-output points and the line itself, in standard linear regression fashion. The drawback of this approach is that it requires more data points than the other approaches. STANDARD COSTS The relation of total costs to output levels is combined in the idea of standard costs. Standard costs are estimates of unit costs at targeted output levels, including direct materials costs, direct labor costs, and indirect costs. Standard costs are used to prepare budgets for planned production and to assess production that has occurred. The estimation of standard costs requires the separate estimation of standards for direct materials, direct labor, and overhead. DIRECT MATERIALS Direct material standards are the easiest to estimate. Costs are determined from the prices of all necessary material inputs into the product, plus sales tax, shipping, and other related costs. Unanticipated price changes complicate this otherwise straightforward process. Since standard costs are a measure of unit costs, it is also necessary to determine the quantity of materials per unit. This can be done using an engineering approach.


DIRECT LABOR Direct labor standards are somewhat more difficult to estimate. The determination of costs must account for wages, though if workers in a production process are earning different wages, it is necessary to estimate a weighted average of wage costs. The cost of benefits, employment related taxes, and overtime pay must also be accounted for. As with direct material standards, the quantity of direct labor required to produce a unit of output can be estimated with an engineering approach. Average set-up time and downtime must also be included in the estimation. Many union contracts codify labor time standards, which can make budgeting easier. OVERHEAD Overhead standards are the most difficult to estimate, and they are typically accounted for in an approximate manner. The problem of accounting for overhead costs per unit of output was noted above it is often difficult to trace indirect costs to a particular product. The problem is made more complicated if these costs are highly centralized within a plant and if multiple products are produced within a plant. Overhead standards are typically estimated by taking total overhead costs and relating them to a more readilyknowable measure, such as direct labor hours, direct labor costs, or machine hours used. Direct labor hours was traditionally the most widely-used measure for determining overhead standards, but the growth of automated plants resulted in a shift to machine hours used. DETERMINING PROFITABILITY THROUGH CVP ANALYSIS Cost equations are combined with revenue equations to determine profitability at different levels of output. This is referred to as cost-volume-profit (CVP) analysis. That is, net income equals total revenue minus total cost; total cost, as noted above, equals average variable cost times the quantity of output plus fixed cost; and total revenue equals price times the quantity of output sold. Combining cost and revenue equations reveals that net income equals price times quantity of output sold minus average variable cost times the quantity of output minus fixed costs. That is, where P = price, Q = quantity of output, AVC = average variable cost

19 FC = fixed costs This is referred to as the cost-volume-profit equation, and is one of the most widely-used of cost accounting tools. CVP analysis allows a firm to determine a breakeven point, the level of output at which total revenue equals total cost. That total cost and total revenue functions will be equal at some nonzero level of output is assured by the fact that at zero units of output, total costs will be positive as a result of fixed costs and total revenues will be zero. This is based on the assumption that the unit price for which a product can be sold is greater than the unit cost, so that total revenue increases faster than total cost as output increases. In addition to estimating profitability across a range of output levels, firms use CVP analysis to determine whether projected sales are sufficiently beyond the breakeven point to warrant production. Economic theory also concerns itself with changing costs as a function of changing output within a given plant. This is an analog to the slope of an accountant's cost function curve and is referred to as marginal cost. In his essay, "Economic Concepts in Cost Accounting," Shillinglaw describes the relationship between mainstream economic theory and cost accounting as follows: "Cost accounting springs mainly from the needs of managers and others to make decisions affecting the allocation of economic resources. This might suggest that cost accounting is based directly on a fairly welldefined set of concepts drawn from economic theory. The truth is something else. The uneasy and ambiguous relationship between cost accounting and economics is nowhere more apparent than in the application of the concept of short-run marginal cost." In mainstream economic theory, marginal costs are generally assumed to be decreasing at lower levels of output, more or less flat over medium levels, and increasing at an accelerating rate at higher levels. As noted above, cost accountants generally base their calculations on the assumption that costs change at a constant rate with respect to output. TARGET COSTING A related practice that has also enjoyed quite a bit of attention since the mid1990s is target costing, which is a method of engineering a product and its manufacturing process from the start with a specific cost model in mind. This approach, which is essentially an elaboration of the engineering costing approach, attempts to create an optimally efficient process from the startwith a profitable yet marketable selling price

20 in mindrather than waiting until a product is already being manufactured and then setting prices and looking for cost savings. Some implementations of target costing actually don't involve accountants as much as they involve product marketing managers, engineers, and others who are part of the actual design and production processes. IMA guidelines also exist for target costing systems. PRODUCT COST CALCULATIONS Many organizations produce mountains of cost data but provide management with little or no useful information on cost and performance. This leads to wrong decisions. In many organizations, the management doubts the traditional cost figures and often ends up with unofficial cost analyses. (Walker 1999.) Financial accounting is organized to produce the kind of official financial statements required in the country where the companys financial statements are announced. In these statements, product costing is not required, and the financial departments do not need to pay attention to them (http://herkules.oulu.fi) The three reports that together describe the financial state of the company are: Profit and Loss statement (P/L). Balance Sheet, i.e. Liabilities and Equity statement (L/E). Cash Flow statement (C/F).

The P/L statement consolidates the companys revenues and expenses over a period (month, quarter, year) categorized in a standard form (list of accounts) and expressing the profit of the business period. The C/F statement presents the cash inflows and outflows over the period, and the L/E statement concludes the accumulated wealth at the end of the period. The definitions of these statements are presented in Appendix 1 (Atrill & McLaney 1997). Total cost has been defined in many ways. Atrill & McLaney (1997) present the concept of full costing in their book: Full costing is not concerned with variable cost, but with all the costs involved with achieving some objective, for example making a particular product. Monden (1989) emphasizes the total cost of the quality in Japanese automobile industries. The necessary steps in total cost management: Plan a product that meets the customers demand for quality.

21 Determine a target cost under which the customers demand for quality is attainable using a blueprint based on value engineering (cost reduction in a narrower sense). Determine which processes achieve the target cost in production performance. (Monden 1989.) In this text, total cost includes all meaningful expenses between the revenues and the bottom line in the P/L statement. 1.1Challenges of product costing The pricing of products depends notably on the competition in the market. In a weakly competed market, such as a closed market, the sales price can be calculated as follows: Sales price = cost + profit Since competition is not strong, the changes in the company costs and profit targets can be incorporated into the sales price. In modern open markets, competition is very strong and the pricing equation changes to Cost = sales price - profit The sales prices are defined by the market competition and the products competitiveness. Profit should never be bargained to ensure the companys survival in the long run. Thus, costs are the target function that can be influenced by the companies. (Lumijrvi et al. 1995) One basic difficulty in product costing is that products do not drive all the company expenses. For example, it would be very artificial to allocate general management costs, administration, general IT-support and human resource costs, etc. on products. Even within a factory, there are many questionable costs, not directly driven by the type, number or volume of products. In addition, there are costs that are driven by substantial material vendors and customers. In fact there is no single correct (product) cost figure (Walker 1999). Product costs are always calculated from the financial transaction data of the cost centers of the organization. Several methods exist, and each company uses a method of its own. The simplest product costing method is to use only the direct costs. In the early days, labor cost used to have more meaning. Everything was done manually, and output volume was directly dependent on the number of employees involved. When machines

22 began to substitute labor in production, machine costs became less visible. Most machine costs are depreciation costs, which are not comparable to direct labor costs. It is possible to calculate the hourly cost of a machine by using deprecations and interest on invested capital plus operating and maintenance costs, but this not directly visible in the P/L statement. The following cases also easily remain as hidden costs in traditional accounting (http://herkules.oulu.fi) What is the (account) name for the costs of the unmanned hours of the factory? Depreciation and interests on the capital run every second (for 8760 hours a year), but manufacturing operates for 2000 6000 hours a year, depending on how many shifts are used. What is the (account) name for the cost of the standing hours due to poor product demand, material shortage and machinery breakdown? How do we visualize the costs of poor product quality, rework, repair, etc? In the standard costing method, product cost is calculated based on BOM and the capacity demand of the product. Direct costs include the raw material (component) prices and the labor cost for the product-specific work time. Indirect costs are expressed in terms of multiplier factors and extras onto direct costs. This standard cost is used as an average target product cost and followed up by comparing with the actual cost calculated similarly. (Uusi-Rauva et al. 1994) The system features that correspond to these objectives are illustrated in Table. A lot of attention has been given to the implementation of ACMS. Three different (concurrent, pilot and phase) approaches to implementation have been recognized and described. Data validity control is also considered a very important measure of system quality. (Schnoebelen 1993b) Table. Integrated Advanced Cost Management System (ACMS) features (Schnoebelen 1993b


In this text, product cost means the material plus direct labor costs and the overhead costs, including machine depreciations. The scope of the definition ranges from the factorys incoming material storage and to the semi-finished product inventory. Therefore, product cost is only a part of the product business case, which aims to describe the total costs of the product during the CE and PE processes. 1.2Activity-based costing One well-known advanced costing method is activity-based cost (ABC). The main advantage of ABC is the more direct assignment and traceability of costs. ABC was originally developed in manufacturing, but it is being adopted in other areas, such as services and the public sector. ABC adds value to the financial accounting system by incorporating operational and quality information with financial data and assigning this information to objects, i.e. the initial drivers of the costs. Secondly, it also monitors the way in which these activities have been utilized to produce the objects, i.e. the products and services. An activity is an operative unit focusing on limited actions. Typical activities are selling, purchasing, assembling and packaging.


Figure: ABC costing from resources through activities to objects All these activities inevitably utilize resources; people, materials and consumables, machines, money, facilities, etc. In each activity, the resources are spent on objects, i.e. products or services. Figure illustrates the cost drivers - the relationships between the resources, activities and objects. The resource driver indicates how much resources an activity requires, and the activity driver defines how much an object utilizes an activity. In the literature, the names of the drivers vary, i.e. they are called input drivers, volume drives, level drivers, etc. The selection of correct drivers is an essential success factor for good calculation results. An incorrect driver may lead to erratic results. (Lumijrvi et al. 1995) In proactive cost calculation, we estimate the resource costs for any activity. To avoid further confusion in this text, the following definition is used. Both resource and activity drivers may consist of two parts: driver quantity and driver value. Driver quantity indicates the numbers of occurrence, and driver value indicates the rating of a transaction. ABC can use several level drivers to allocate the overhead expenses on an object. The purpose is to use the most descriptive driver for the costs. The resource cost of unit level activities is divided by the number of transactions differently from the calculations on a batch or any higher level of activity.


Figure: Different levels of costs This feature has been found useful in revealing the hidden costs of small batches in the Rautaruukki Raahe Steel works. (Pesonen 1992, Pesonen 1994). The ABC method was also demonstrated in the telecommunication industry, where the cost efficiency of generating new products was studied well before the products were launched. The study focused mainly on product variation costs during the manufacturing (Ojala 1997). The product cost is calculated based on the known activities, resource quantities and resource usage in an activity by object. If we can estimate the characteristics and volumes of the future products, it is also possible to estimate the cost roadmaps using ABC. The unit cost of an activity (i) for a product j as Unit cost (i, j) = cost driver value (i) * cost driver quantity (i, j) The addition of a discrete time parameter t into the formula results in cost roadmaps. Unit cost (i, j, t) = cost driver value (i, t) * cost driver quantity (i, j, t), where t is a discrete time variable (e.g. day, period, quarter, etc.), i is an activity, j is a product. ABC analysis highlight for managers where their action will likely have the greatest impacts on profits (Cooper & Kaplan 1991). For example, the reduction of the product

26 test time will also reduce the unit cost of the testing of the product. These changes can already be considered during the CE process using the cost roadmaps, provided that we have at least an estimate of the product cost driver quantities. During the PE process, the managers should attempt to re-evaluate the products and search for ways to reduce resource consumption. This might lead to a need to re-design the product with fewer components by implementing continuous improvement programs or adopting new technologies. Walker (1999) suggests integrating ABC with other techniques, such as: Attribute-Based Costing (ABCII), which integrates market research, quality function and other techniques, (Limited factor) Contribution Analysis and On-Line Analytical Databases (OLAP).

Attribute-based costing separates the cost of products and services from the cost of various other external and internal cost objects. In short and medium term, (ABCIIbased) contribution analysis a powerful technique for exploring profitability at the product, channel, market segment and customer levels. Limited factor contribution analysis gives an enhanced view of product profitability: In Table, product A appears to be more profitable when the percentage of sales contribution is used. If there were limited capacity hours available and demand for the product, the annual contribution of B would be over threefold compared to a situation where only B was sold. Table: An example of contribution analysis (Walker 1999). Account Sales Direct costs Contribution Hours (per product) Contribution per hour A 100 40 60 20 3 B 100 60 40 4 10

27 OLAP database systems provide the advantage that they enable data from different systems, such as spreadsheets, accounting, etc., to be automatically combined, processed, and presented (Walker 1999). 1.3Theory of constraints Noreen et al. (1995) analyzed the theory of constraints (TOC) and its implications for management accounting. Goldratt believes it is necessary to purge the term product cost from our vocabulary (Noreen et al. 1995). Goldratt argues that activity-based costing cannot give reliable answers to the question of what impact will this decision have on throughput, operating expenses and assets. Goldratt insists on this point because he believes that the term product cost is synonymous with fully allocated product costs in the minds of many managers. Goldratts theory has three building blocks: Throughput, operating expenses and assets (Goldratt 1990). Throughput is defined as the rate at which the system generates money through sales. Operating expenses are defined as all the money the system spends in turning inventory into throughput, and assets as all the money the system invests in purchasing things it intends to sell. Profit is measured by throughput minus operating expenses and profitability by profits divided by assets. (Goldratt & Cox 1992) Accordingly, they motivate managers to apply the theory of constraints because many managers seem to focus their energies on cost reduction rather than on profit enhancement. This brings out the key strength of TOC its simplicity: Only the workload and the capacity of the bottlenecks are essential. TOC is defined as an analysis procedure of anything that limits the system achieving higher performance versus its goal. TOC thinking is based on the following continuous improvement procedure: Identify the systems constraint(s). Decide on how to exploit the systems constraint(s). Subordinate everything else to the above decision. Elevate the constraint(s).

28 If a constraint has been broken, go back to Step 1. Do not allow inertia to cause a system constraint. (Goldratt 1990) A comparison of the most frequently used accounting practices is illustrated in Table. Table: Comparison of variable costing with throughput accounting (Noreen et al. 1995).

The official definition of throughput is revenue minus total variable costs. However, some companies exclude all the other expenses, such as the variable selling and shipping costs, considering direct material the most significant factor. Thus, a simplified version of throughput accounting is also used. The visible difference between conventional and throughput accounting is the handling of direct labor, which is considered as a fixed cost. The variable cost nature of direct labor seems to be more a historical reminder than contemporary reality. In many companies, labor cost is, in practice, treated as a fixed cost. (Noreen et al. 1995) TOC has been successfully applied also with ABC. Southwestern Ohio Steel has implemented a pricing model based on ABC and TOC. This model has been used to analyze and justify manufacturing cycle-time improvements. (Campbell 1995.) Fritzsch suggests that the conflicting viewpoints of product cost of TOC and ABC can be resolved using different time horizons. ABC is recommended for strategic planning and TOC for the short-term purposes. As the time horizons increase, the solutions produced by TOC begin to look more and more like those produced by conventional cost accounting techniques. Applications of ABC in strategic planning appear to be well documented. These implications seem obvious, but the writer does not verify his statements thoroughly. (Fritzsch 1997)

29 PROBLEM STATEMENT More importantly, whether ABC is used as a replacement for traditional inventory valuation or as a stand alone method, it provides information about how and why resources are consumed. Thus, according to ABC advocates, it is not just an inventory valuation method, or just a separate product costing method. Activity based costing is a resource consumption model that can provide a wealth of information to aid in decisions concerning product and process improvements. AIMS AND OBJECTIVES OF THE STUDY 1.1Cost Accumulation Method Another clarification regarding how ABC fits into the overall cost accounting system has to do with cost accumulation. Remember that there are two basic cost accumulation methods, job order costing and process costing. Activity based costing is not a cost accumulation method, therefore it does not replace these methods, but instead ABC is used to enhance the accuracy of the product costs determined in both job cost and process cost environments. Most of the illustrations of ABC in textbooks are based on two to four products which seem to imply a process orientation. However, since there are likely to be more product variations or differences in a job cost environment than in a process cost environment, it is logical to assume that the potential benefits of using ABC are greater for companies that produce a large number of products to customer specifications, than for companies that have more focused processes dedicated to a few generic products. 1.2Problems with traditional systems Two main problems tend to occur when traditional inventory valuation methods are used to provide information for management decision purposes. One has to do with product cost distortions, or cross-subsidies and the other relates to the exclusiveness of traditional product costing. 1.3Product Cost Distortions and Cross Subsidies First, in traditional costing, only production volume related measures are used to allocate overhead costs to products, even though many products do not consume indirect

30 resources (overhead) in proportion to the volume of products produced. Since many types of indirect resource costs are caused by, or driven by, non-production volume related product characteristics such as size and complexity, traditional costing tends to distort product costs. This means that too much overhead cost is allocated to some products, while too little overhead cost is allocated to other products. These distortions are frequently referred to as cross-subsidies. Generally, ABC solves this problem by separating overhead costs into different cost categories referred to as cost pools. Costs that are caused by, or driven by, the same activity are pooled together and then allocated, or traced, to products using an appropriate measure of the activity volume. 1.4Excluding Non-Manufacturing Costs A second problem with traditional cost systems is that tracing product related administrative, marketing and distribution costs to product inventories is not a generally acceptable procedure allowable for external reporting. However, engineering design, marketing, distribution and customer service costs are clearly part of the costs of placing a product in the hands of the customer. Since these non-manufacturing costs may differ substantially from product to product and from customer to customer, ABC traces these costs to products and customers using additional cost pools and activity measures. Thus, the ABC approach provides the potential for more accurate product costs for management decisions concerning product planning, product design and introduction, product design changes, product pricing, make versus buy, product distribution, product service and product discontinuance. ABC also provides potential benefits to many service oriented industries such as banking, insurance, health care, and transportation. HYPOTHESIS / RESEARCH QUESTION H1 Activity based costing is not a cost accumulation method, therefore it does not replace these methods, but instead ABC is used to enhance the accuracy of the product costs determined in both job cost and process cost environments H1 Activity based costing is a cost accumulation method, therefore it does replace these methods, but instead ABC is used to enhance the accuracy of the product costs determined in both job cost and process cost environments.

31 ASSUMPTIONS AND LIMITATIONS To keep the illustrations in this chapter fairly simple, I have concentrated on manufacturing costs, but remember that non-manufacturing costs are also traced to products and services using the ABC approach.



1.1Activity Based Costing (ABC) Adoption among Manufacturing Organizations In the traditional accounting system, treatment of overhead fails to adequately capture causal relationship between product and cost incurrence. Under the system, costs are best seen as controlled by the departments. The traditional overhead costing system emphasizes on the efficient use of resources, and focuses on product. Furthermore, traditional cost accounting reports financial information such as ROI, profit and market share. In the 1980's many criticisms were raised regarding the ability of traditional cost accounting to provide relevant, timely, and accurate information to the management. ABC emerges in recognition that traditional costing system produced inaccurate information. In ABC, costs are seen as best controlled by managing activities. Emphasis is shifted to the effective use of resources. ABC improves accuracy over traditional system by using multiple cost drivers including set-up hours, number of orders, and number of shipping. In addition, it also integrates financial and non-financial information in the reports. ABC has been studied from various perspectives for quite some time in many countries. Even though studies have shown that the adoption of ABC benefits the organizations, its level of adoption is still considered low. Many organizations hang on to the traditional cost accounting methods in dealing with overhead costs. This study attempts to investigate the status of ABC adoption among manufacturing organizations in Malaysia, and the factors influencing its adoption. It is also interesting to learn from the experience of two firms already adopted ABC yet still at the initial stage, and another firm which has reached a mature stage of ABC adoption. The literature review for this study includes three main area of research: ABC, organizational change, and implementation literature 1.2Activity Based Costing (ABC) Literature

33 Jones and Dugdale (2002) traced the development of ABC from as early as 1980's. They explored the rise of ABC through the understanding of how management accounting theories and practices come into being, and by identifying the relationship between the two. While the primary focus of the study was on the construction of ABC between 1984-1992, their study also established the link to other theories and practices such activity accounting, total cost accounting. Activity Based Budgeting, Activity Based Cost Management, and Activity Based Management. A review of literature on ABC looks into various variables that have been used in previous research. ABC implementation studies have focused on factors leading to ABC success as measured in various ways. Variables such as implementation success, satisfaction, and attainment of ABC stages are commonly used in ABC literature. However, most of these studies have not segmented the adoption stages of ABC. Their focus is mainly on factors that lead to ABC success, which can be measured in various ways. 1.3Organizational Change Literature ABC has also been linked to the theory of organizational change that can be classified into technology, products, structure, and culture. Like other changes in accounting systems, ABC adoption and implementation in organizations can be considered as an administrative procedure. Therefore it can be classified as a structural change which success depends on the top-down approach. According to Daft (1991), the overall model of a planned change is made up of four events: (1) Forces for change (2) Need for change (3) Initiating change, and (4) Implementing change. For the purpose of this study, this model is used as the basis to guide the researcher in the data collection process. According to the organizational change theory, change occurs in stages. Lewin (1952) suggested that three stages of change are involved; (1) Unfreeze, (2) Change, and (3) Refreeze. Kwon and Zmud (1990) adopted the organizational change theory to develop the IT implementation stage model. Instead of using the three-stage model as proposed by Lewin (1952), Kwon-Zmud the model describes IT innovation as a sequence of six stages; (1) initiation, (2) adoption, (3) adaptation, (4) acceptance, (5) routinization,

34 and (6) infusion. It further suggested that success in achieving each stage is influenced by various factors such as (1) individual characteristics, (2) organizational factors, (3) technological factors, (4) task characteristics, and (5) external environment. Kwon and Zmud argued that stage differentiation is not distinct, and the significance of the above factors might vary across stages. S tudies by Krumwiede (1998), Krumwiede and Roth (1999) illustrate the

adaptation of Cooper and Zmud (1990) IT Stage model to the adoption and implementation of ABC. Krumweide (1998) study divided ABC adoption and implementation into ten stages as follows: (1) not considered (2) considering (3) considered then rejected (4) approved for implementation (5) analysis (6) getting acceptance (7) implemented then abandoned (8) acceptance (9) routine (10) integrated. Krumweide argued that while contextual factors may indicate that ABC adoption is appealing, implementation issues are more related to the organizational factors. Studies done by Krumweide looked into organizational factors after ABC adoption was made. The study by Krumweide and Roth ( 1999) divided the ABC stages into the followings; (1) initiation (2) adoption (3) analysis (4) acceptance (5) action (6) Activity Based Management (ABM). Initially, the organizations that face pressure to improve their costing system will consider a change from traditional costing system to ABC. The proponents of ABC will then campaign to get approval for ABC adoption. Once the management has granted their approval, an ABC team will determine the scope of the system and develop a model for implementation. They will seek acceptance from other parties that will be affected by the system. At this stage, there is a general consensus that ABC system provides better information to the organization as compared to the traditional system used. The information generated from ABC system will then begin to be used. At the final stage, ABC is perceived as a normal part of organization's information system. Its continuous usage is expected to lead to the organization towards process improvement. Issues associated with implementations can be studied at two levels of analysis: an organizational or macro level approach and an individual or micro level approach (McGowan & Klammer, 1997). The researches that use micro level approach tend to focus on the individual rather than the organization. Intended benefits of the

35 implementation may be defined as enhancing decision-making skills, productivity, or use of the system. System success is measured in terms of perceptions of improvements in system quality, attitudes, or satisfaction of individuals involved (Mc Gowan and Klammer, 1997). The guidelines that are derived from the macro level perspective emphasize the importance of planning and development to achieve organizational objectives. The emphasis may be on users as a group or subsystem of the organization. Shields (1995), Swenson (1995) and Anderson (1995) are among those who conducted their research through this approach. They believe that macro level studies of ABC implementations have revealed several interesting findings: Managers, in general view ABC systems more favourably than their traditional overhead costing systems (Shields, 1995; Swenson, 1995). The degree of success of ABC implementation varies across circumstances. Shields (1995) found success to be strongly linked with behavioural and organizational variables, but not to technical variables such as the type of software or the nature of the system. Anderson (1995) argued that the factors that influence implementation are context specific. Anderson concluded that the extent to which specific organizational and technological factors, individual and task characteristics, and environmental factors influence implementation success vary across the stages of implementation. Implementation research can be further characterized as factor or process studies (Schultz & Ginzberg, 1984). The focus of factor research is on the contextual variables associated with the implementation and their likely impact on the implementation success. The contextual variables include the characteristics of the organization, problem, technology and people involved in the implementation efforts. Process research focuses on the procedures involved in system implementation. The goal is to identify characteristics of a process that are most likely to lead to successful implementation. Hence implementation success is viewed as a sequence of stages that must be attended. Research by Mc Gowan and Klammer (1997), and Krumweide (1998) integrated both factor and process variables into one model.

36 The results of several case studies and surveys that document the implementation of ABC indicate that organizations benefit from the system. For instance, Haedicke and Feil (1991) described Hughes Aircraft Company's experience in ABC implementation and how it assisted management of the company to achieve world class status. Foster and Gupta (1990) examined the implementation of ABC at an electronic instrument manufacturing company and presented information regarding the attitudes of managers and employees towards the system. Foster and Gupta, however, found that the system had not been established long enough to assess its behavioural consequences. A research by Bhimani and Pigott (1992) examined the impact of changing the pattern and content of information on the behaviour of non-accounting staff at British pharmaceutical company. Their findings show how management accounting techniques can extend beyond technical use and are useful to break down functional barriers. Agyris and Kaplan (1994), use ABC as an example to describe the necessary requirements for successful implementation of a technical innovation. They focus on the importance of education and sponsorship in enabling change to occur. Finally, Anderson (1995) presents a case study of General Motors Corporation's experience with the adoption of ABC. She developed a model of cost system change that eventually described the effect of individual characteristics, and organizational, contextual and technological factors on the success of ABC during six stages of implementation. Other than case research, survey research has also contributed to the understanding of ABC implementation in organizations. Mailed questionnaire by Bailey (1991), Innes and Mitchell (1991) and Nicholas (1992) to managers of UK firms reported positive findings on benefits and future of ABC. Swenson (1995) presented the results of a telephone survey of 50 financial and operating managers' satisfaction with ABC at 25 manufacturing firms. It indicated that participants view ABC as an improvement over their old cost management systems. Shields (1995) reported the results of applying a comprehensive model to the study of the behavioural consequences associated with ABC. He concluded that attending to the technical aspects is insufficient to achieve general success with ABC implementation. The findings highlight the need to focus on behavioural and organizational variables in the implementation process. Libby and Waterhouse (1996) examined the relationship between management accounting and control systems and several organizational and contextual variables at 24 Canadian

37 organizations. They presented evidence of strong positive relationship between changes in management accounting control systems and organizational capability to learn. A comprehensive study on ABC among developing countries, especially from the Asian region is limited. In Singapore Ghosh and Chan (1997), in a longitudinal study surveyed companies from various industries in Singapore on the management accounting practices used in their organizations. ABC was ranked twelfth in terms of management accounting techniques used. ABC was used by 12 percent of their sample from organizations in various industries. ABC however was not included among the management accounting practices surveyed in their earlier study in 1984-1985. Based on the findings, they concluded that ABC is slowly being accepted and used by various organizations in Singapore. The study however did not test for any variation between industries. In Malaysia, an extensive study on ABC is non-existent. The studies are limited to surveys of firms on the use of various management accounting tools including ABC. The study however focused specifically on the adoption of ABC among organizations in manufacturing industry. Chun, Kassim, & Minai (1996) conducted a study on management accounting practices among manufacturing organizations in Malaysia by using the Federation of Malaysian Manufacturers (FMM) Directory as the sampling frame. The study did not focus on ABC and issues in relation to this system. Instead, the study adopted a more general approach by looking at the extent of usage for various traditional and non-traditional management accounting systems. Chun et al. (1996) in their survey on 92 companies from food, textile, chemical, fabricated metal and electrical and electronics industries in Malaysia found that on the average overhead cost represents 17 percent of total production cost. Their study found that ABC is relatively infrequently encountered in Malaysia. The reasons cited that firms were slow to adopt ABC because they neither not convinced of its benefit nor felt comfortable with the existing cost system. They also found that dual or multiple costing systems are common among ABC adopters. The traditional system was used to cater for financial accounting reporting while ABC is used for cost management and strategic decisions. Chun et al (1996) findings also show that 89 out of 92 respondents believed that information generated by management accounting systems was useful. A significant

38 percentage of the respondents found the information important to perform management functions - planning, control and decision-making. Abdul Rahman et al. (1998, 2003) did two consecutive studies on ABC practices in Malaysia by using survey method. The first study found that ABC adoption rate among public listed companies in Malaysia was 4.2 percent. In another study, they found that 18.3 percent of the small and medium industries in Klang Valley area introduced some forms of ABC method in their business. The same study found that two most important problems cited by the respondents were high cost (69.2 percent), and impossibility to use ABC to prepare financial statements (53.8 percent) Gunasekaran et al. (1999) concluded that ABC system was not used much in European countries. ABC was used by 4 percent of companies in Belgium and The Netherlands. The system was used mainly as a secondary cost system. The study cited four cases using a conceptual model for decision to adopt ABC that was influenced by conditions favouring ABC applications, factors against ABC implementation, implementation of ABC, and timing of ABC. In other countries, Ghosh and Chan (1997) reported that overhead represented an average of 12 percent of production costing various industries. Murphy and Braund (1990) reported 34 percent, and Kerremams (1991) reported 31 percent in UK and Belgium respectively. A study by Shields and Young (1989) developed a comprehensive theoretical model that was applicable to ABC based on the assumption that ABC is an administrative innovation in organizations. They argued that the adoption decision and implementation was determined more by specific behavioral and organizational variables. Similarly, earlier studies have shown that implementation issues may emerge if organizations neglect the organizational factors involved in making the change in cost management systems (Agyris & Kaplan, 1994; Cooper et al., 1992; Shields, 1995). Anderson and Young (1997) have argued that certain contextual variables may affect both adoption and-implementation stages of ABC while organizational factors may affect implementation stages only. Accordingly, Krumweide (1998) tested organizational factors on ABC adopters only. Her findings showed that although the model overall predictive accuracy was 72.4 percent, the Likelihood Ratio Index for the logistic regression analysis is relatively low at 0.22. Based on that, Krumweide suggested that

39 firms considering ABC adoption should give special consideration to organizational factors as well. Therefore, the present study tested all groups of independent variables (external, technological, and organizational) for their influence on ABC adoption. Cooper and Zmud (1990) implementation stage model has consistently been used as dependent variable in previous studies on ABC. Their model include six stages; (1) Initiation (2) Adoption (3) Adaptation (4) Acceptance (5) Routinization (6) Infusion. Krumweide (1998) further refined them into ten stages; (1) Not considered (2) Considering (3) Considered then rejected (4) Approved for implementation (5) Analysis (6) Getting acceptance (8) Implemented then abandoned (9) Acceptance, and (10) Routine system. Cooper and Zmud (1990) provided definitions to each stage used in their study in relation to process and product while Krumweide (1998) provided descriptive definitions on the ABC stages used in her study. Krumweide (1998) admitted that in her (and any other) model, stage distinctions are not as clear-cut. Organizations may lie somewhere between two stages or even reside in more than one stage simultaneously. It is assumed that organizations go through these stages in such sequence. The later classification of ABC implementation stages by Krumweide (1998) is seen as very comprehensive. It is also highly comparable with that of Cooper and Zmud (1990). Variables like implementation success, satisfaction, and attainment of ABC stages are commonly used in ABC literature. However, most of these studies have not segmented the implementation stages of ABC. Their focus is mainly on factors leading to ABC success as measured in various ways. Two problems emerged as the result of using a combined multiple stages: Factors not found significant may have been significant for certain stages but masked by less significant (or significant in different direction) for other stages. Factors that were found significant may have had coefficients that were biased by varying parameter estimates in different stages. Thus it is possible that no single stage had the parameter coefficients that were reported. In other words, important differences between specific stages would have been missed if only binary dependent variables (adopt/ non-adopt, user/ non-user) were used (Krumwiede, 1998).

40 While understanding the importance of differentiating the stages of ABC implementation, the present study was unable to classify the stages according to either one of the studies mentioned earlier. Instead, the present study classifies ABC application into adoption and non-adoption. This is due to the infancy of ABC in Malaysian manufacturing environment. It is anticipated that in manufacturing industry in Malaysia, most organizations are non-adopters of ABC. Furthermore, among those who adopt the system, the majority is at their early stage of implementation. Therefore it is anticipated that differentiating the stages further is not statistically justified. According to Cooper (1988), traditional cost systems tend to report distorted product costs when the products consume a variety of inputs. In addition, product diversity also reduced the accuracy of reported cost. The distortion occurred because traditional cost systems reports average product cost based on limited allocation bases (direct labor and machine hours). The system was not able to capture an accurate overhead cost consume by each product. As a result, certain product may be overstated while another understated. Volume based cost systems are unable to differentiate adequately between overhead consumed by low and high volume products (Cooper, 1988). As percentage of overhead to total product increases, it becomes more important to effectively manage the overhead cost. Traditional cost system uses few volume based allocation bases. Thus it was not able to show the relationship between a product and the overhead level it consumed. ABC, in contrast provides a better insights into this relationship. The findings from logistic regression analysis of the present study showed that IT quality was not significant in ABC adoption. Krumweide (1998) made an interesting finding regarding V3- IT. While IT was found to be not significant in her logistic regression analysis, this variable emerged as a significant variable with a positive coefficient in ordered logistic regression analysis. Her finding suggests that ABC adoption is positively associated with strong existing IT. Due to the small number of adopters, the present study did not include an ordered logistic regression on the variables. In relation to V5 - Training, Krumweide (1998) found that training is related to reaching the highest stage of ABC implementation. She explained that her study reflected level of training relating to the design, implementation, and usage of ABC. However, she

41 combined the three phases due to their high correlation with ABC success in the study by Shields (1995). In the present study, most of the ABC adopters are at the initial stage of ABC implementation. Therefore, it is expected that training is not an important factor of ABC adoption among these organizations. However, a significant relationship between training and ABC adoption would probably be seen should the sample represents a different group of ABC adopters. The present study provides empirical evidence on the status of ABC adoption among manufacturing organizations in Malaysia that participated in the survey and the case study. The present study uses certain factors derived from previous research conducted in other countries such as US, UK, and Australia. The study reveals that organizations in Malaysia still use the traditional method of overhead costing, instead of the ABC. The scenario is slowly changing as overhead cost increase and machine intensive approach dominates the production scene. Overhead represents a large portion of total production cost for most of these organizations. They found the need for a more accurate costing is inevitable in order to compete in the competitive business environment. A search for a new method to overhead costing system leads these organizations to ABC. The few ABC adopters are at the infancy stage of ABC adoption. There are limitations to this study. Although this study takes into considerations the work of previous researchers in the area, it has to admit that the empirical research on the subject in Malaysian environment is limited. Therefore this study should be viewed as an initial step toward that purpose. As more data will be available, future research should follow up on similar issues presented in this study so that the latest development of ABC in Malaysia is well documented. Due to the infancy stage of ABC adoption in Malaysia, this study does not differentiate the different stages of adoption process. This study grouped the organizations into either ABC adopters or ABC non-adopters. Krumweide (1998) illustrated the importance of differentiating the various stages of ABC. She found that the important differences between specific stages would have been missed if only binary dependent variables were used. It is hoped that as more companies shift to ABC, future research will be able to address this concern. Researchers will then have better opportunities to refine the model of ABC adoption. In short, the existence of larger

42 population of ABC adopters and emergence of competing theories will call for empirical studies to determine the merit of these models in explaining the ABC adoption process. In relation to the issue discussed above, the participants in the case study represent organizations at the early stage of ABC adoption. Therefore the study only report the most up to date development related to ABC at these organizations. The study however is not able to document the whole process of change as it is currently an on going affair. Future research should revisit the organizations for a more up to date development to explore more areas within this field of research. The existing adopters' effort towards ABC infusion or ABM (Activity Based Management) will provide a more comprehensive sequential experience of ABC adoption from the perspective of a particular organization. This is an important avenue for understanding the system. The respondents of the survey in this study were accounting managers. They were purposely chosen to represent their organizations as they are seen as the person with understanding of the area under study and the knowledge of the accounting development in their organizations. The respondents are most likely to be informed about ABC in their organizations. There are some limitations to using primarily accounting related managers as they may have different opinions about ABC than production related employees (Anderson and Young, 1997). This group may likely exhibit ownership bias toward reporting ABC adoption (Anderson and Young, 1997). Generalizing the results of this study to the entire population in Malaysia should be done with caution. Finally, this study focused on whether or not organizations adopt ABC, from the sole perspective of the Accounting managers. It does not attempt to survey the views and opinions of other interested parties inside the organizations such as the management and the other employees. In addition, it does measure the effectiveness of the system once it is in place. It is suggested that future researchers should consider these concerns in their research endeavor. The findings from the survey have shown that most manufacturing organizations in Malaysia have not adopted ABC for their overhead costing. Among those who adopted the system, most are at the analysis stage of adoption. ABC was mainly adopted during the period of 1990 to 1999. Although that is the case, the increase in capital-intensive

43 production environment and the growing overhead cost, it is anticipated that ABC will be more prevalent in the future. This study tested several factors for their influence on ABC adoption. Usefulness of cost information for decision-making, organization support, and performance measures were found to be significant. The descriptive case study on three selected organizations supports the findings of the survey. A change from traditional overhead costing system to ABC is mainly due to external forces such as competitive market and environmental uncertainty. In addition, the case study also further explains the factors that influence ABC adoption which were investigated in the survey. It is expected that more manufacturing organizations will adopt ABC as their overhead costing system in this globally competitive business environment.



RESEARCH DESIGN As there is not much of data available on my topic The effectiveness of the use of costing techniques within an organization I have very much access in to all of material. My research has been to piece of collection of data from all sources to build up strong arguments regarding this research. I have been used deductive reasoning as there is ample research done on this topic which helps me to prove my argument. DATA COLLECTION METHOD Type of Data used Secondary / primary type In this dissertation in literature review, researcher has discussed published information in a particular subject area and information in a particular topic area. A literature review has been just a simple summary of the sources, but it usually has an organizational pattern and combines both summary and synthesis. A summary is a recap of the important information of the source, but a synthesis is a re-organization, or a reshuffling, of that information. It might give a new interpretation of old material or combine new with old interpretations. Literature reviews provide you with a handy guide to researcher's particular topic. I have collecting secondary data for my research as there is rich but small and difficult data available for my research question and I have been direct access to relevant topic levels. METHOD OF ANALYSIS During research collected the relevant data and than use methods for analysis the collective data to get for better result.

45 ETHICAL CONSIDERATIONS Surely during my research I have did respect of ethical issues. Who response to my research normally and remain confidential because privacy is one of the ethical issue in undertaking research use of this data should protect and individual right to anonymity .Researcher should respect the individual rights. I have concentrated all these points during my research. o Not to be harasses or be offered inducement to participate. o Except the researcher to abide by the extent of the consent given and no find research without first seeking and obtaining permission. o Not to answer any question. o Try to target right person. o Not to be subject to question that creates stress or discomfort. o Not to be contact to the people unreasonable time. o Not to participate o Not to be subject to any attempts to prolong the duration of the interview or observation. ANALYSIS AND RESULTS After analysis of data, tables and graphs have been drawn and explanation has been constructed. CONCLUSION AND RECOMMENDATIONS After completion of first four chapters, conclusion has been made and recommendations for further improvements of concerned topic have been constructed at the end. TIME SCHEDULE AND RESEARCH PLAN Time has been spent for this dissertation as follows: o Introduction chapter o Secondary Data collection o Review of Literature 1 week 1 week 1 week

46 o Data analyzing & organizing o Computer Composing o Final draft o Total Time 1 week 1 week 1 week 6 weeks



The main purpose of this chapter is to introduce the concepts and terminology associated with activity based costing and to discuss how activity based concepts are used to produce more accurate product costs than those obtained in the traditional cost systems presented in previous chapters. The first chapter places emphasis on the conceptual material underlying activity based costing and addresses the learning objectives listed first chapter. This chapter covers aims and learning objectives. THE CAUSES OF PRODUCT COST DISTORTIONS There are two main causes of product cost distortions in traditional costing, i.e., where a single production volume based overhead rate is used by each product department. These include product volume differences (or product volume diversity) and product differences (or product diversity). Product Volume Diversity Cost distortions from product volume differences occur when a company produces one, or more, high volume products (i.e., a relatively large number of units) and one, or more low volume products (i.e., a relatively small number of units). Generally, the low volume products will receive too little overhead when a single production volume based departmental rate is used and high volume products will receive too much overhead. Conceptually, the idea is that each type of product requires engineering, purchasing, inspection and other support, regardless of the number of units produced, thus these support costs do not vary in proportion to the number of units, but instead vary with other factors that are unrelated to production volume. If the costs of support activities are allocated to products on the basis of a production volume related measurement such as direct labor hours, low volume products will not receive cost allocations in proportion to their demands on these activities. Product Diversity Cost distortions from product differences occur when there are

variations in product size and product complexity. Small products tend to require less

48 production volume related input (such as direct labor time) than large products, although they do not require less support in proportion to their size. Therefore small products tend to be under costed, while large products tend to be over costed. Product complexity generally refers to product design complexity. Products with complex designs are likely to require more engineering work, more materials related support (e.g., purchasing and materials movement), perhaps longer machine setups and more inspections than less complex products. These additional demands on the various support activities generally cause relatively complex products to be under costed and relatively simple products to be over costed. In addition, products that require a relatively large number of parts, unique parts and relatively more, long or complex machine setups tend to be undercharged with overhead while products that require relatively few parts, common parts, and relatively few setups, short or simple setups tend to be overcharged. The generalizations in the previous paragraphs are summarized in Exhibit. The effects of product volume differences and product sized differences are illustrated in the examples below. The effects of differences in product complexity are illustrated in some of the problems at the end of this chapter. EXHIBIT: SUMMARY OF COST DISTORTIONS THAT TEND TO OCCUR IN TRADITIONAL COST SYSTEMS TYPE OF PRODUCT TYPE DIVERSITY CHARACTERISTIC Production volume Low Volume specialty High Volume main line Product Size Small Large Product Complexity Complex design Simple design OR TYPE OF COST DISTORTION THAT TENDS TO OCCUR IN TRADITIONAL COST SYSTEMS Undercost, i.e., too little overhead is allocated to these products. Overcost, i.e., too much overhead is allocated to these products. Undercost Overcost Undercost Overcost


Product Materials Requires many, or unique Undercost requirements parts, i.e., only used on a single product. Requires few, or common Overcost parts, i.e., same part used on many products. Product Machine Requires many, long setup requirements complex machine setups. or Undercost

Requires few, short or simple Overcost machine setups.

THE LOGIC OF ABC Activity based costing is based on the following ideas. First, designing, producing and distributing products and services requires many activities to be performed. Performing these activities requires resources to be purchased and used. Purchasing and using resources causes costs to be incurred. Restated in reverse order, the ABC logic is that resources generate costs, activities consume resources and products consume activities. Thus, a company's activities are identified, then costs are traced to these activities (or activity cost pools) based on the resources that they require. Then, costs are assigned, or traced from each of these activity cost pools to the company's products (or services) in proportion to the demands that each product (or service) places on each activity. In ABC, a measure of the relevant activity volume is used to trace each type of costs, rather than exclusively using measurements (or allocation bases) related to the volume of the products or services produced. Using this logic, ABC tends to solve the problems created by traditional cost or inventory valuation methods. The ABC logic is illustrated in Figure.


There are still two stages in assigning costs to products in a manufacturing environment, i.e., 1) from service departments (activities) to producing departments, and 2) from producing department activity cost pools to products. What about Fixed and Variable Costs in ABC? The traditional concepts of fixed and variable costs are frequently de-emphasized in activity based costing. This is because the ABC logic looks at costs from a long run perspective while the traditional fixed/variable cost behavior methodology is based on a short run perspective. The ABC designer explicitly recognizes that all costs tend to be variable in the long run. Therefore, one of the objectives of ABC is to determine the main causes of these long run cost variations. ABC designers attempt to answer the following question. What creates the demand for the output of each of the company's main activities? The Rule of One To help managers understand the conceptual difference between the long run and short run perspectives, Cooper and Kaplan utilize an idea they refer to as the "Rule of One". According to this rule, if a support department, or activity, uses only one unit of a particular type of resource, such as one person or one machine, then the cost of that resource can be classified as fixed. However, if more than one unit of the resource is required, then classifying the resource cost as fixed is not beneficial for product costing purposes. Something caused the demand for the resource to be greater than one. Perhaps this driver can be identified and used to trace the costs more accurately to the products or

51 services that ultimately consume the resource through activities. Although some activity costs tend to be fixed, i.e., not respond to short run changes in activity volume, these fixed costs represent management commitments that are made to support a past, present or expected future activity level. Generally, all costs are driven by something, even if the driver appears to be inactive. Can ABC Include Fixed and Variable Costs? Does the de-emphasis on the fixed-variable cost methodology in ABC mean that activity cost cannot be separated into short run fixed and variable cost categories? The answer is that fixed and variable activity costs can be identified and traced to products and services using separate activity based rates. One potential advantage of using separate rates for fixed and variable costs is that idle capacity (or unused resource) costs can be identified for each activity if the activity rates are based on practical capacity rather than normal or planned activity volume. There is another potential advantage in the area of cost control. If ABC is used as the company's inventory valuation method, it would allow variance analysis to be performed for each activity. Should ABC Include Fixed and Variable Costs? The answer to this question is controversial. Some critics argue that the fixed/variable cost methodology should be eliminated because it motivates managers to add more business volume and variety in an attempt to lower the fixed costs per unit without adequately considering the long run effects. However, the additional product variety and diversity tends to cause the so called fixed costs to increase, which defeats the original purpose. Thus, the whole process is much like a dog chasing its tail. ACTIVITY VOLUME Activity volume refers to an input or output measurement of the quantity of work performed to accomplish an activity. These activity volume measurements may represent the frequency, duration or physical volume of an activity. However, the key difference between traditional costing and activity based costing is that ABC uses both production volume and non production volume activity measures to trace costs to products. Some examples of common activities and representative activity measures are presented in Exhibit. EXHIBIT: EXAMPLES OF ACTIVITY COST POOLS AND ACTIVITY MEASURES ACTIVITY COST POOL Machining parts Purchasing Receiving and Storing POTENTIALLY USEFUL PROBABLE COST ACTIVITY MEASURES CLASSIFICATION* Number of machine hours. Unit level.

Number of purchase orders or Product or batch level. ordering hours. Number of purchase orders or Product or batch level.


shipments received. Engineering Packing Shipping Machine Setup Materials handling Number of engineering work Product level. orders or hours. Number of shipments, number Product or batch level. of cubic feet or packing hours. Number of pounds shipped. Product or batch level.

Number of setups or setup Batch level. time. Number of times handled or Product or batch level. material handling hours.

Inventory control and materials Number of part numbers or Product or batch level. planning administrative hours. Inspection and quality control Number of inspections inspections time. or Product or batch level.

* This classification scheme is discussed below. A key idea in ABC is to find an activity measure for each activity that is closely related (correlated) to the activity costs involved. As indicated in Exhibit, a production volume related measure might be appropriate for some types of costs, (e.g., machine hours for machining), but non-production volume related measures are more appropriate for other types of activity costs. For example, the number of purchase orders might be an appropriate choice as the activity measure for purchasing costs, while the number of engineering work orders might be a more appropriate basis for tracing engineering costs. The cost classification scheme referred to in the right hand column of Exhibit is discussed below. HOW ARE ACTIVITY MEASURES CHOSEN? ABC designers normally use interviews with knowledgeable managers to define activities, cost pools and cost driver relationships. Although the statistical tools discussed might also be used to aid in this process, there are some serious problems that limit their usefulness for this purpose. First, analyzing short run data may produce very misleading results. This is because performing correlation analysis with short run data is not likely to reveal the drivers of long run variable costs, i.e., the costs identified as fixed costs in traditional costing. Another key idea in ABC is that reducing the volume of a particular activity measurement will not necessarily have a short run effect on the cost of the activity. Reductions in activity requirements may simply create idle or excess capacity. Data collected for a longer period (e.g., two or three years) might be more useful for identifying drivers and activity measures for long run variable costs, but the data would have to be adjusted to remove the influence of non stationary factors such as changes in production processes, inflation and seasonal variations. There is a second potential

53 problem when attempting to use statistical correlation analysis to identify cost drivers and activity measures to represent them. The overall correlation between an activity measure and the overall demands placed on the activity by the company's products may be fairly high, although the correlation of the activity measure with the demands of some specific products is relatively low. For example, if ninety-eight percent of a company's products require short machine setups, (e.g., one hour) while the other two percent require long setups, (e.g., eight hours) then, the overall correlation between the number of setups required and setup costs would probably be fairly high. However, assigning setup costs to products on the basis of the number of setups would tend to undercost the products that require long setups and overcost the products that require short setups. The main point of this discussion is that accurate cost tracing requires high correlation between the activity measure and the demands of each specific product, not just high overall or average correlation. DISTINCTION MEASURES BETWEEN ACTIVITIES, DRIVERS AND ACTIVITY

Conceptually, the three terms activity, driver and activity measure have different meanings although these terms are frequently used interchangeably in accounting literature. The purpose of this section is to clarify the conceptual distinction between activities, drivers and activity measures. Activities Activities represent the types of work performed in an organization. For example, purchasing represents a main activity for a company. The activities chosen in the ABC design process usually represent main activities that are made up of many sub-activities, tasks and sub-tasks. For example, many different types of work must be performed in the purchasing department, but all of this work may be conveniently classified as purchasing so that the complexity of the ABC design is kept to a manageable level. The different types of activities, along with some examples, are summarized at the top of Exhibit. EXHIBIT: ABC CONCEPTS AND TERMINOLOGY Activities - A type of work or function. Type Main activities Definition Examples

A major type of work, function Purchasing raw materials. or high level activity. A lower level type of work, or activity that supports a main Preparing purchased orders. activity. A minor type of work that Calling vendors. supports a sub activity. Part of a task. Dialing a vendor's phone

Sub activities

Tasks Sub tasks



Drivers - Whatever causes the need for activities to be performed? Type Definition Examples

Primary drivers

The initial cause of an activity Company's overall objectives, that requires resources, i.e., customer demands and product whatever creates the demand specifications. for an activity. A resource consuming activity Purchasing raw materials, that is caused by a previous preparing purchase orders. activity or event.

Secondary drivers

Activity measures - A unit of measure chosen to represent an activity volume. Type Frequency measures Definition The number of times activity is performed. an Examples Number of purchase orders, number of engineering work orders.

Duration measures Physical measures

The time consumed performing Ordering hours, engineering the activity. hours, machine hours. The quantity of a resource Cubic feet processed by an activity. shipped. packed, pounds

Cost and Activity Drivers Cost drivers and activity drivers are essentially the same. A driver is an underlying cause of a cost. Normally, whatever drives an activity also drives the costs of the activity. Conceptually, there are primary drivers and secondary drivers. A primary driver represents the initial cause of an activity. A secondary driver represents an activity or event that is caused by a previous activity or event. For example, the primary drivers of purchasing costs may be factors such as customer demands, product design characteristics (e.g., number of parts required) and the number of vendors selected. Therefore, purchasing is technically a secondary driver of purchasing costs. This terminology is summarized in the middle section of Exhibit.

55 To obtain a better grasp of these concepts consider the following idea. All of a company's functions and activities require resources that generate costs; therefore all activities are cost drivers. However, all functions and activities are performed to support the company's objectives, e.g., to generate profits, increase market share etc., thus all functions and activities are technically subordinate to these primary drivers. Activities merely represent secondary cost drivers, although the distinction between primary and secondary is likely to be forgotten or ignored after the system is designed. It is also useful to note that although activities are cost drivers, drivers do not have to be activities. Drivers may be events or other phenomena. Activity Measures Conceptually, an activity measure is not necessarily an activity, or a cost driver or an activity driver. An activity measure is instead a unit of measurement chosen to represent the activity volume and the primary driver. The activity measure provides the basis for tracing or linking the activity costs to the products that consume the activity. To understand the difference between the activity measure and the activity driver, consider the following example. The number of purchase orders might be chosen to represent the volume of work performed by the purchasing department, but the number of purchase orders is driven by whatever drives the purchasing activity. Primary, or higher level drivers are likely to be such things as the number of products produced, the number of raw materials and parts required for each product, whether the parts are common to many products or unique requirements for a single product and the number of vendors involved. Thus, to say that the number of purchase orders is the driver for purchasing costs tends to confuse the issue. Although ordering causes costs, the number of purchase orders is secondary. The number of purchase orders is a dependent variable because it is caused by something else. However, since there may not be a convenient measure of the primary driver, or drivers, the number of purchase orders often serves as a reasonably accurate substitute for tracing purchasing cost to products. Another example may help to clarify the point. The number of direct labor hours is frequently used in traditional cost systems as the basis for allocating overhead costs to products. As a result, accountants frequently say that direct labor time is the cost driver. However, the number of direct labor hours depends upon, or is caused by, the level of production activity which in turn is driven by the company's objectives and customer demands. Thus, the number of direct labor hours is simply a convenient activity measure chosen to represent production activity. The lower section of Exhibit summarizes the terminology that relates to activity measures. There are different types of measures including frequency, duration and physical measurements. Simple frequency measures that indicate the number of times an activity is performed are appropriate when each occurrence of an activity requires the same amount of time and resources, e.g., where each purchase order requires the same amount of time to prepare on a standard form. Duration measurements and physical measurements are more appropriate where the time or resources needed to perform an activity are not uniform.


THE ABC TECHNIQUE FOUR STEPS IN DESIGNING AN ABC SYSTEM OR SUB-SYSTEM The concepts discussed in the previous sections of this chapter can be summarized into four steps. Designing an ABC model, system or sub-system requires: 1) identifying a company's main activities, 2) determining the primary and secondary drivers for these activities, 3) aggregating activities into homogenous cost pools and 4) selecting activity measures to represent each pool. Homogeneous activity costs are those costs that are consumed in the same proportions. Recognizing these relationships allows the designer to combine homogenous costs into a single cost pool to simplify the system. Although this concept is somewhat vague when stated in this simple way, it should become clear to you after studying the examples presented below. THREE STEPS TO OBTAIN ABC COSTS After the system has been designed, ABC costs per unit can be calculated using historical costs or budgeted costs. ABC calculations can be based on annual activity costs obtained from historical records, or budget estimates made for a subsequent period. In either case, three steps are required to determine unit ABC costs once the data is available. These steps include: 1) Calculate the activity overhead rates for each activity cost pool by dividing the total annual cost of each cost pool by the total annual quantity of the activity measure associated with each pool. More precisely in equation form: Rj = Annual costs of activity j Annual quantity of activity j where: Rj = the activity overhead rate for activity j. j = the number of the activity. If historical information is used to develop ABC unit costs, i.e., data from a prior period, then the annual costs and quantities in the calculation are established by the prior period activity levels achieved. If the ABC system is designed with budgeted data, then the annual cost estimates and annual quantities of the activity measures would depend on the capacity level chosen. Popular alternatives include practical capacity, normal or average capacity, and planned volume. 2) Determine the total annual costs of each product by multiplying the activity overhead rates by the activity quantities associated with each product as follows, Ci = Di + G(Rj)(Aji) where: Ci = Total annual cost of product i. Di = Direct cost of product i. Aji = Quantity of activity j consumed by product i. Rj = the activity overhead rate for activity j.

57 j = the number of the activity. i = the number of the product. G = Greek sigma or summation sign meaning "the sum of". 3) Calculate each product's unit costs by dividing the total annual costs for each product i by the number of units of product i produced. ABC unit cost for product i = Ci Units of product i. These three steps are illustrated in the examples provided below. COMPARING TRADITIONAL PVB AND ABC SYSTEMS A variety of illustrations could be provided to show how product cost distortions occur in traditional production volume based (PVB) costing and how these distortions are eliminated when activity based costing is used. Two related examples are provided to show how product volume differences and product size differences tend to affect product costs. Some other types of cost distortions appear in the problems provided at the end of this chapter. Although the examples are based on manufacturing firms, similar cost distortions frequently occur in service organizations. Example: Effects of Production Volume Differences Assume that Company A produces two products, V1 and V2 with the annual production volumes and product characteristics presented in Exhibit. To emphasize the key issues involved without unnecessary complications, assume that the firm has only one production department so that all service department costs are allocated to this single department in stage 1 cost allocations. This simplifying assumption allows us to ignore the first stage allocations that would only distract from the issue that we want to examine. To further simplify the illustrations, we will also assume that the activity costs are perfectly correlated to the activity measures chosen. Of course this is an unrealistic assumption, but when there are only two products, it allows us to isolate the cost distortions caused by production volume differences and product size differences precisely. EXHIBIT: ANNUAL PRODUCT DATA FOR COMPANY A PRODUCT RELATED DATA V1 V2 1,000 $50 1 $10 2 8 4

Annual production quantity in units 100 Material cost per unit $50 Direct labor hours per unit 1 Direct labor cost per hour $10 Number of purchase orders required per year 1 Number of engineering work orders required per year 4 Number of machine setups required per year 2

58 The company's main activities have been combined into five activity cost pools along with appropriate activity measures based on management interviews. These five cost pools and the activity measurements associated with each cost pool appear in Exhibit. EXHIBIT ANNUAL ACTIVITY COSTS FOR COMPANY A ACTIVITY ANNUAL COSTS ACTIVITY MEASURE Number of purchase Number of engineering work Number of machine Number of direct labor Number of materials dollars orders orders setups hours

Purchasing and receiving $24,000 Engineering 18,000 Machine setup 24,600 Machining, power & maintenance 22,000 Materials planning & handling 11,000 Total factory overhead costs $99,600 ======

The way this illustration is designed, we can further simplify the problem by aggregating, or combining these five cost pools into only two homogeneous cost pools, one for non-production volume related costs and one for production volume related costs. This is possible because the consumption proportions for the three non-production related costs pools (purchasing/receiving, engineering and setups) are the same and the consumption proportions for the two production related cost pools (machining/power/maintenance, and materials planning/ handling) are the same. Since each unit of V2 requires twice as much of each type of non-production related costs as each unit of V1, these three cost pools can be combined into a single homogeneous cost pool and traced to products using any one of the three activity measures, i.e., number of purchase orders, engineering work orders or setups. Each of these measures reflects the 2 to 1 consumption ratio. Since each unit of V2 requires the same amount of direct material and direct labor as V1, the two production volume related cost pools can be combined and traced to products using either direct labor hours or materials dollars. Both of these measures reflect the 1 to 1 consumption of production volume related resources. The activity costs and measurements after combining the homogeneous cost pools are presented in Exhibit. EXHIBIT ANNUAL ACTIVITY COSTS HOMOGENEOUS COST POOLS ACTIVITY POOL Non-production volume Production volume Total factory overhead costs FOR COMPANY A COMBINED

ANNUAL COSTS related $66,600 related 33,000 $99,600

ACTIVITY MEASURE Number of purchase Number of direct labor hours orders

Calculating ABC Costs for Company A

59 Step 1: Calculating Activity Overhead Rates Rj = Annual costs of activity j Annual quantity of activity j Activity overhead rates for the two cost categories in Example 7-1 are calculated as follows: 1. Non-production volume related = $66,600 3* = $22,200 per purchase order. * Total purchase orders = 1 for V1 and 2 for V2. 2. Production volume related = $33,000 1,100* = $30 per direct labor hour. * Total direct labor hours = 100 for V1 and 1,000 for V2. Steps 2 and 3: Determining Total Annual Cost Ci = Di + 3(Rj)(Aji) And Unit Cost For Each Product The calculations for steps 2 and 3 are presented in Exhibit. In step 2 the activity overhead rates are multiplied by the quantities of the appropriate activity measures to obtain the overhead costs traced to each product. Then in step 3, the unit ABC costs are determined by dividing the cost traced to each product by the annual production quantities from Exhibit, i.e., 100 units for V1 and 1,000 units for V2. Direct material and direct labor costs are also included in the exhibit to show the total unit cost for each product. As indicated at the bottom of Exhibit, the unit ABC costs are $312 for V1 and $134.40 for V2. Comparing ABC with Traditional PVB Costing For Products V1 and V2 Now suppose Company A uses the traditional production volume based (PVB) costing approach where all overhead costs are allocated to products using direct labor hours as a single allocation basis. Then the total overhead rate would be calculated by dividing the total activity overhead costs in Exhibit by the total number of direct labor hours, i.e., 1,100 total units multiplied by 1 hour per unit. This calculation produces a total overhead rate of $90.55 per direct labor hour ($99,600 1,100 DLHs = 90.54545). Overhead costs for each product are $90.55 since each product requires 1 direct labor hour. This is very different from the ABC unit overhead cost of $252 for V1 and $74.40 for V2 that are calculated in Exhibit. Adding direct material and direct labor costs of $60 provides a total unit cost of $150.55 for each product. Thus, the traditional costing approach would understate the unit cost of the low volume product V1 by $161.45 and overstate the unit cost of the higher volume product V2 by $16.15. EXHIBIT COMPANY A OSTS TRACED TO PRODUCTS V1 AND V2 SING AN ACTIVITY BASED COST (ABC) SYSTEM COST POOL OR CATEGORY ACTIVITY RATE MULTIPLIED BY QUANTITY OF ACTIVITY MEASURE (Rj) C1=COS T TRACED TO V1 ABC UNIT COST V1* C2=COS T TRACED TO V2 ABC UNIT COST V2**


(Aji) 1. Non-production volume related: 2. Production volume related: Total Overhead 3. Direct Material: 4. Direct Labor: Totals ($50)(100) ($50)(1,000) ($10)(1hr)(100) ($10)(1hr)(1,000) ($22,200)(1 PO) ($22,200)(2 PO'S) ($30)(100 DLH) ($30)(1,000 DLH) $22,200 3,000 $25,200 5,000 1,000 $31,200 ======= $222.00 $44,400 $30.00 30,000 $252.00 50.00 50,000 10.00 10,000 $312.00 ====== $134,400 ======= 10.00 $134.40 ====== 50.00 $74,400 30.00 $74.40 $44.40

* C1 = $6,000 + ($22,200)(1PO) + ($30)(100DLHs) = $31,200. ABC unit cost for V1 = $31,200 100 units. ** C2 = $60,000 + ($22,200)(2POs) + ($30)(1,000DLHs) = $134,400. ABC unit cost for V2 = $134,400 1,000 units. Using Proportions Rather than Activity Rates A different way to solve relatively simple ABC problems is use proportions as illustrated in Figure below. Although the non-production volume related costs could be combined as above, each activity cost pool is kept separate in Figure to provide a somewhat different view of the solution. The proportions used are based on the data in Exhibit. For example, V1 required 1 purchase order and V2 required 2 purchase orders, therefore purchasing and receiving costs are allocated 1/3 to V1 and 2/3 to V2.


Why Traditional Production Volume Based Allocations Distort Product Costs To understand why the traditional production volume based (PVB) approach distorts product costs per unit, consider the more detailed PVB unit costs calculated in Exhibit. This exhibit illustrates the cost allocations obtained in a traditional PVB system where direct labor hours are used as the allocation basis. The separate overhead cost pools are maintained to show where the distortions occur. Therefore separate overhead rates are needed for each pool. Dividing the annual costs of the non-production volume related pool ($66,600 from Exhibit) by 1,100 direct labor hours generates a rate of $60.5455 per direct labor hour. Of course the rate for the production volume related pool is still $30 per hour, i.e., $33,000 1,100, because the activity measure for this pool is direct labor hours in both the ABC and PVB systems. EXHIBIT COMPANY A OST TRACED TO PRODUCTS V1 AND V2 USING A RADITIONAL PRODUCTION VOLUME BASED (PVB) COST SYSTEM COST POOL OR CATEGOR Y ACTIVITY RATE MULTIPLIED BY QUANTITY OF ACTIVITY COST ALLOCA TED TO V1 PVB UNI T COS T COST ALLOCA TED TO V2 PVB UNIT COS T V2**


MEASURE 1.Nonproduction volume related: 2. Production volume related: Total Overhead 3. Direct Material: 4. Direct Labor: Totals ($50)(100 units) ($50)(1,000) ($10)(1hr)(100 units) ($10)(1hr)(1,000) ($60.5455) (100DLH) ($60.5455) (1,000) ($30)(100 DLH) ($30)(1,000) $6,054.55

V1* $60. 55 $60,545.45 $60.5 5


$30. 00 $90. 55 50.0 0 10.0 0 $150 .55 === ===

30,000.00 $90,545.45

30.00 $90.5 5 50.00 10.00 $150. 55 ==== ==

$9,054.55 5,000.00 1,000.00

50,000 10,000 $150,545.4 5 ========

$15,054.55 ========

* PVB unit cost for V1 = $15,054.55 100 units. ** PVB unit cost for V2 = $150,545.45 1,000 units. Production volume based allocations based on direct labor hour proportions are illustrated in Figure below for each activity cost pool.


We can see from Exhibit and Figure that each unit of V1 and V2 receive the same amount of cost in each overhead cost category. This is because each product requires the same number of direct labor hours per unit (i.e., 1 hour each). At first, this may appear to be a fair and accurate way to allocate overhead. However, since Company A produces ten times as many V2's as V1's, traditional PVB costing assigns ten times as much overhead costs to V2 as it assigns to V1. More specifically, V2 receives ten elevenths (1,000/1,100) or 90.9% of the overhead, while V1 receives only one eleventh (100/1,100) or 9.1%. This distorts the product costs per unit because V2 consumes only two thirds of the nonproduction volume related activities , i.e., 2 out of 3 purchase orders, 8 out of 12 engineering work orders and 4 out of 6 setups, while V1 consumes the other one third. The resulting unit cost distortions are summarized in Exhibit where ABC and PVB unit costs are compared. EXHIBIT COMPANY A ABC AND PVB UNIT COST COMPARISONS Amount V1 Amount V2 Cost Pool or ABC Unit PVB Unit PVB Unit ABC Unit PVB Unit PVB Unit Category Cost V1 Cost V1 Cost is Cost V2 Cost V2 Cost is Understated Overstated 1. Non production $60.55 $161.45 $44.40 $60.55 $16.15


volume related


2. Production volume related 30 Total overhead $252

30.00 $90.55 50.00 10.00 $150.55 ======

0 $161.45 0 0 $161.45 ======

30.00 $74.40 50.00 10.00 $134.40 ======

30.00 $90.55 50.00 10.00 $150.55 ======

0 $16.15 0 0 $16.15 =====

3. Direct material 50 4. labor Totals Direct 10 $312 ====

The unit cost comparisons in Exhibit reveal that the high volume product V2 subsidizes the low volume product V1. Each high volume product is overcosted by $16.15 while each low volume product is undercosted by $161.45. Since Company A produces only 100 units of V1, the distortion per unit is more significant for V1 than for V2. The graphic illustration in Figure shows this in a somewhat more dramatic way. The unit cost distortion that occurs for V1 is greater than the traditional PVB unit cost estimate. Although the unit cost distortions are not equal, the total cost distortions are always equal, except for small rounding errors. The approximate equality of the distortions for Company A can be verified by multiplying the unit cost distortions by the number of units involved, i.e., (100)(161.45) is approximately equal to (1,000)(16.15). To avoid the rounding error, we can compare the total costs in Exhibits, i.e., the total understatement for V1 is 31,200 - 15,054.55 = $16,145.45, while the total overstatement for V2 is 150,545.45 - 134,400 = $16,145.45.


Note from Exhibit that the production volume related costs are not distorted by the traditional PVB approach. This reinforces the point made earlier that a production volume related basis may be an appropriate activity measure for tracing certain types of overhead costs to products, although it cannot be used as the only basis in cases where all costs are not consumed in proportion to production volume. Example: Effects of Product Size Differences Assume that Company B produces two products V2 and V3 where Product V2 is the same small high volume product that Company A produces. However, V3 is a larger size, high volume product that requires more direct material and direct labor because of it's size, but no additional support from purchasing, engineering or setups. Also assume that Company B has the same cost structure as Company A except for the differences between the two companies related to production volume and product size. Activity costs are still perfectly correlated to the activity measures chosen for the ABC system. The data for Company B are presented in Exhibits. The same two aggregated cost pools used for Company A can also be used for Company B because the consumption proportions are the same for each of the three non-production volume related activities. The products consume all three non-production volume related activities in the same proportions. If V3 consumed of the purchase orders, 1/3 of the engineering work orders and 1/5 of the setups, then we would not be able to combine these costs into a single homogeneous pool (http://maaw.info).


Annual production quantity in units 1,000 Material cost per unit $50 Direct labor hours per unit 1 Direct labor cost per hour $10 Number of purchase orders required 2 Number of engineering work orders required 8 Number of machine setups required 4 EXHIBIT

ANNUAL ACTIVITY COSTS FOR COMPANY B EPARATE AND COMBINED HOMOGENEOUS COST POOLS ACTIVITY ANNUAL COSTS ACTIVITY MEASURE Number of purchase orders Number of engineering work orders Number of machine setups Number of purchase orders Number of direct labor hours Number of materials dollars Number of direct labor hours

Purchasing and receiving $32,000 Engineering 24,000 Machine setup 32,800 Non-production volume related $88,800 Machining, power & maintenance 220,000 Materials planning & handling 110,000 Production volume related 330,000 Total factory overhead costs $418,800 ======= Calculating ABC Costs for Company B

Step 1: Calculating Activity Overhead Rates Rj = Annual costs of activity j Annual quantity of activity j Activity overhead rates for the two cost categories in Example 7-2 are calculated as follows: 1. Non-production volume related = $88,800 4* = $22,200 per purchase order. * Total purchase orders = 2 for V2 and 2 for V3. 2. Production volume related = $330,000 11,000* = $30 per direct labor hour. * Total direct labor hours = 1,000 for V2 and 10,000 for V3. EXHIBIT COMPANY B


COST POOL OR CATEGORY 1. Non-production volume related: 2. Production volume related: Total Overhead 3. Direct Material: 4. Direct Labor: Totals

C2=COST TRACED TO V2 $44,400 30,000 $74,400

ABC UNIT COST V2* $44.40

C3=COST TRACED TO V3 $44,400

ABC UNIT COST V3** $44.40 300.00 $344.40 500.00 100.00 $944.40 ======

$30.00 300,000 $74.40 50.00 500,000 10.00 100,000 $134.40 ====== $944,400 ======= $344,400

($50)(1,000 units) ($500)(1,000 units) ($10)(1hr)(1,000) ($10)(10hrS)(1,000)

50,000 10,000 $134,400 =======

* C2 = $60,000 + ($22,200)(2POs) + ($30)(1,000DLHs) = $134,400. ABC unit cost for V2 = $134,400 1,000 units. ** C3 = $600,000 + (*$22,200)(2POs) + ($30)((10,000DLHs) = $944,400. ABC unit cost for V3 = $944,400 1,000. Steps 2 and 3: Determining Total Annual Cost Ci = Di + 3(Rj)(Aji) And Unit Cost For Each Product The calculations for steps 2 and 3 are presented in Exhibit. Comparing ABC With Traditional PVB Costing For Products V1 and V2 Exhibit illustrates the cost allocations obtained for Company B in traditional PVB costing where direct labor hours are used as the allocation basis. The separate overhead cost pools are maintained, as in the previous example, to show where the distortions occur. Thus, separate overhead rates are needed for each pool. Dividing the annual cost of the non-production volume related pool ($88,800 from Exhibit) by 11,000 direct labor hours generates a rate of $8.0727 per direct labor hour. Of course the rate for the production volume related pool is still $30 per hour, i.e., $330,000 11,000, because direct labor hours are used as the activity measure for this pool in both the ABC and PVB calculations. EXHIBIT


COST POOL OR CATEGOR Y 1.Nonproduction volume related: 2. Production volume related: Total Overhead 3. Direct Material:


PVB UNI T COS T V2* $8.0 7

COST ALLOCA TED TO V3 $80,727.00

PVB UNI T COS T V3** $80.7 3


$30. 00


300.0 0 $380. 73 500.0 0

$38,072.70 ($50)(1,000 units) ($500)(1,000 units) ($10)(1hr) (1,000) ($10)(10hrs) (1,000) 50,000.00

$38. 07 50.0 0

$380,727.0 0 500,000

4. Direct Labor:


10.0 0


100.0 0 $980. 73 ==== == units.


$98,072.70 ========

$98. 07 === ===

$980,727 ========

* PVB unit cost for V2 = $98,072.70 ** PVB unit cost for V3 = $980,727 1,000 units.


Exhibit shows that in PVB costing each unit of V3 receives ten times as much overhead costs as V2 in each overhead cost category, i.e., ten elevenths or 90.9% for V3 as opposed to one eleventh or 9.1% for V2. This is because each unit of V3 requires ten direct labor hours while each unit of V2 requires only one hour. The PVB approach distorts product costs because V3 consumes only fifty percent of the non-production

69 related support, i.e., 2 out of 4 purchase orders, 8 out of 16 engineering work orders and 4 out of 8 setups. The resulting unit cost distortions are summarized in Exhibit where ABC and PVB unit costs are compared. The PVB approach understates the unit cost of the relatively small product V2 by $36.33 and overstates the unit cost of the relatively large product V3 by $36.33. The unit cost distortions are equal because the production volumes for V2 and V3 are equal. EXHIBIT COMPANY B ABC AND PVB UNIT COST COMPARISONS Amount V2 Cost Pool or ABC Unit PVB Unit PVB Unit ABC Unit PVB Unit Category Cost V2 Cost V2 Cost Cost V3 Cost V3 Understated 1. Non Production $44.40 volume related 2. Production 30.00 volume related Total overhead $74.40 3. Direct 50.00 material 4. Direct labor 10.00 Totals $134.40 ====== $8.07 $36.33 $44.40 $80.73 Amount V3 PVB Unit Cost Overstated $36.33

30.00 $38.07 50.00 10.00 $98.07 =====

0 $36.33 0 0 $36.33 =====

300.00 $344.40 500.00 100.00 $944.40 ======

300.00 $380.73 500.00 100.00 $980.73 ======

0 $36.33 0 0 $36.33 =====

Comparing the Unit Cost of Product V2 in Companies A and B The different cost assignments to product V2 in Companies A and B are compared in Exhibit. The comparative data shows that ABC costing produces the same unit cost of $134.40 in both companies. This precise equality occurs because of the way the examples are designed. Remember that we assumed that the activity costs are perfectly correlated with the activity measures chosen and that the two companies have the same cost structure. Of course these are not realistic assumptions, but they enable us to clearly see that the nature of the PVB cost distortion for a particular product depends on the product's characteristics relative to the other products the company produces. In the examples above, PVB costing overstates the unit cost of V2 in Company A because it is a high volume product relative to V1. However, in Company B, the PVB approach understates the unit cost of V2 because V2 is a small product relative to V3.


Continuation of the V-Product Sequence Two additional illustrations related to products V1, V2 and V3 are included in the practice problems that appear at the end of this chapter. Problem continues this sequence of examples with a Company C that produces products V1 and V3. Since V1 is a small, low volume product and V3 is a large, high volume product, the direction of the resulting cost distortions is easy to predict. Problem provides a fourth company in this sequence. This problem extends the Vproduct sequence to a Company D that produces all three products. In this company, Product V2 has conflicting characteristics in terms of the bias towards over or undercosting. V2 is a small, high volume product in Company D. In Company A, V2 is the low volume product, but size is not an issue. In Company B, it is the small product, but production volume is not an issue. Problem reveals that the nature of the product cost distortions become impossible to predict as the number of products and product characteristics increase.



CONCLUSION Cost allocation in firms can provide misleading information about the profitability of products, product lines, customers, and markets. Traditional cost allocation practices allocate all manufacturing overhead costs using a single driver such as direct labor hours, direct labor dollars, or machine hours. Sales-related costs are typically ignored. While technically accurate, in most complex organizations a single overhead cost driver is not sufficient to accurately assign the pool of overhead costs to the products that are being produced or the customers that are being served. Many firmsfrom manufacturing to medical and healthcare to banking and financial services to hospitality and not-for-profit organizationshave benefited from designing and implementing ABC allocation systems. Using ABC tools has helped these organizations to understand profitability more clearly, and has provided meaningful information about processes and costs associated with delivering goods and services. A well-designed and implemented ABC system is a powerful aid to management evaluation and decision making, thereby improving organizational performance. Traditional Cost Allocation Factory overhead costs in a manufacturing organization are varied and complex. These costs consist of indirect labor, indirect materials, and other indirect factory support costs. Factory support personnel include process design engineers, supervisors, maintenance workers, inspectors, purchasing agents, security personnel, and administrative workers such as accountants and human resource personnel. Indirect materials are those materials that cannot be individually associated with a product such as drill bits, shop supplies, paper goods, and maintenance supplies. Other indirect costs include utilities for the plant, depreciation of the machinery, training costs, and technology to run the production systems. Using a traditional cost allocation methodology, factory overhead costs are allocated to products using a single driver, often direct labor hours. Sales, general, and administrative costs are typically ignored in a traditional costing methodology, since they

72 are not part of the production process and are not considered in the cost of goods sold equation. Overhead costs have grown substantially in the past decades, as a result of factors such as globalization, technology, product customization, security concerns, and regulatory oversight. In the past, when overhead costs were a smaller proportion of factory costs and direct labor was a larger proportion, it made sense to allocate overhead costs to products using a traditional methodology. The direct labor base was a large proportion of costs, and overhead support costs were a relatively small proportion of total costs. The increased complexity of manufacturing operations makes the traditional methodology obsolete. What is needed to improve the understanding of costs is, first, to associate costs with the activities that are causing the resources to be used, and then to associate these activities with the products that are being produced. This way, products that require a complex set of activities or a high-cost set of resources as part of the production process will be allocated the costs associated with these activities and resources. Is Your Cost Allocation System Faulty? There are various indicators that a cost allocation system is not providing accurate information. You need a new cost system when: The volume of production increases but profitability declines. This often happens when management cannot accurately determine the cost of activities and resources associated with production processes. The product mix changes from lower- to higher-margin products, but profitability declines. This situation indicates that the high-margin product was actually using more resources than it was being allocated in the cost system. As the firm makes more of this product, more resources are consumed and profitability decreases. Managers do not trust the numbers from the accounting system and sometimes build their own cost systems. Functional managers often have good process

73 knowledge about the organization. For example, when the sales group ignores accounting information in pricing products and instead uses its own calculations, it is an indication that the accounting system is not supplying accurate information. The firm produces a mix of higher-volume standardized products or services and lower-volume customized products or services, yet the cost allocation system uses a single driver to assign overhead costs to products. A single driver ignores variation in over head costs and variation in process activity, resulting in an average number. As complexity increases in a firm, averages distort information at a segment level. ABC: How It Works Consider an organization with two primary products: The first product is well established in the marketplace, sells in high volumes, and is made from a relatively small number of components. In sum, it is a relatively simple product to make and support. Each month, 2,500 direct labor hours are used to produce 100,000 units of this product. The second product is newer and sells in smaller volumes. It requires a complex series of steps to produce, with modifications to units requested by various customers. Each month, 2,500 direct labor hours are used to produce 25,000 units of this product. Using a traditional cost allocation methodology, all overhead costs would be assigned using the number of direct labor hours used to produce each product; therefore, each product line would be assigned 50% of the overhead costs because each product line uses 2,500 direct labor hours. However, the second product is more complex to make, in that: more supervisory oversight is needed to ensure that the product is correctly made; each item has to be inspected to make sure that the modifications have been correctly done; the shipped batches are much smaller in size.

74 Each of these resourcessupervision, inspection, packing, and shippingcosts money, and the need for them is increased by the second product line. An ABC allocation would more accurately associate their costs with the product lines that consumed them, thereby assigning more supervision, inspection, and pack-and-ship costs to the second product line. The data in the following example compare a traditional costing outcome with an ABC outcome for the two products.

Benefits of ABC An ABC analysis provides management with a wealth of financial and operational information. The benefits of ABC include the following: Costs are associated with activities that create those costs. Profitability can be calculated from multiple perspectives, such as product line, customer, or market. It provides information about hidden losers and winners, i.e. which product lines/customers/markets have lower profit margins than was originally thought and which give better product margins. It provides cost rates for organizational activities that are helpful for benchmarking and making process decisions. It aligns with business process re-engineering work by helping managers to put a price tag on non value added activities, such as waste or rework. Attention is focused on process costs and how they interact with profitability segments. Armed with explicit measurements of the costs of activities and processes, management can communicate that paying attention to these factors is important. In other words, what gets measured gets managed. Making It Happen To conduct an ABC analysis, organizational data are needed about costs incurred, work performed, and the cost objectives (for example products, customers, markets) of

75 the analysis. An ABC analysis can be done for one department, for an entire manufacturing operation, or for the whole organization. However, it is often an advantage to start with a smaller-sized project (a single department or a plant) as the learning curve is steep. Gather the cost data from the general ledger or other financial records. Segment the data into cost pools, whereby each cost pool represents a related set of costs. For example, a maintenance cost pool might consist of maintenance labor costs, supervision, tools and equipment used for maintenance, and training costs for maintenance workers. Define the activities of the business (what work is performed), using the following framework: Facility-level activities: Those related to overall operations (for example management, human resources, security, legal). Cost-object level activities: Activities that support a product (for example design, testing, engineering), or a customer (for example order processing, shipping, technical support), or a market (for example advertising, sales support). Batch-level activities: Activities related to a batch, equally and at the same time (for example set-up, material handling, inspection). Unit-level activities: Activities performed for each unit of activity (for example direct labor). Once the activities of work are determined, assign the resource costs to the activities. Assign the activity costs to the cost objectives (product lines, customer, markets, etc.) according to the cost objects use of each activity. Determining the allocation basis requires process knowledge and transactional data; often statistical analysis can be used to verify relationships between transactions performed and costs incurred. An ABC analysis requires an in-depth evaluation of an organizations processes and activities, which in turn enables an allocation of costs that better reflects resource usage. Conducting an ABC analysis provides financial and operational information to

76 management that facilitates more effective decision making, thereby leading to improved financial outcomes.

77 RECOMMENDATIONS Activity based costing (ABC) is an accounting technique that aims to clarify exactly how and where a company makes its profit. ABC assigns costs to all the resources needed to carry out a particular business activity. It also accounts for indirect (soft) operating costs. The result is a fuller financial picture than is usually produced with other accounting methods (for example, standard costing), and a useful distinction between activities that add value and those that do not. Advocates of ABC use it to inform strategy about issues as diverse as organizational change, pricing, product mix, and capital investment. They also use it to help pinpoint and control costs, increase efficiency, and grow profits. Used in the right way, ABC can be such a powerful tool for assessing an organizations whole operation and informing its strategy for the future that its also becoming known as ABM: Activity based management. What You Need to Know How did ABC begin? ABC came to prominence in the 1980s, as companies strove to improve their products and services at the same time as pare down costs. They achieved impressive results, with the consequence that ABC is increasingly popularparticularly in manufacturing sectors. What does ABC involve? There are five basic stages involved in an ABC costing: Identify the product or service Identify every resource and process needed to make the product or service, and work out the cost of each Remember to include cost drivers for each resource and process Gather information such as the time taken up by each process or resource, as well as cost data

78 Use all the information and data to work out the total cost of products and services. What are the main plus points of ABC? ABC is very flexible. It can be used to access most kinds of activityfrom industrial processes to business operations to service delivery. It also takes into account a much wider range of factors than other costing methods, so it results in a fuller picture. What about the minus points? ABC involves so much data collection that it can take up a lot of time. Theres also a danger that managers get so wrapped up in tracking costs that they take their eyes off the activity itself. Who uses ABC? A wide range of businesses and professions find ABC useful, although it can be particularly suitable for those relying on people-based resources, which can be much harder to cost using other accounting methodologies. What are the pitfalls? In order for ABC to succeed, everyone involved needs to be really committed. A test run on a smaller project is a good idea before attempting anything too ambitious. Also, the organization should have a clear grasp of all its activities and resources, whats involved in each, how much information theyre going to need, and how much its going to cost to collect it all. They also need agreement about how much detail and precision theyre aiming for. What to Do Know the Key Steps Before an organization can adopt ABC, they need to: convert to the accrual basis of accounting (if theyre using the cash basis).

79 set up cost centers and allocate costs. Cost centers will vary according to the type of business or service. agree a method for costing processes and procedures.

Recognize ABC in Action Companies have successfully used ABC to prove the financial benefits of ecommerce, by working out the relative costs of electronic versus more traditional methods of handling transactions. For example, banks used it to confirm that ATM cash machines both save money and provide customers with a service they want. Another example might be publishers considering the relative merits of online and paper-based publications. Businesses offering services like consultancy or legal advice can use ABC to validate their charge-out costs, enabling them to work out more exactly how much profit they really make. Healthcare providers have also used ABC very successfully, for example, to rationalize costs, measure profits, and get ready for changeand its much easier for a medical practice to make decisions about pricing services if it understands the true cost of each component involved. In this example, individual physicians might be cost centers. Where costs are directly traceable to a specific service, they are allocated to the physician who generates income or incurs expense in relation to that service. Fixed overheads or indirect costs might be shared out equally between cost centers, or divided among them on a proportional basis. Allocate Expenses Once cost centers are identified, companies can begin allocating the expenses incurred and the income generated by each one. These will include labor costs, equipment, premises, administrative support (such as personnel, office supplies, marketing and advertising, admin equipment, telecommunications expenses)and so on. The aim is to be as comprehensive as possible, so that nothing that contributes to the balance sheet in any way is left out.

80 There are various procedures for tracking and allocating the cost of individual activities, some of which are more detailed and accurate than others. Not all companies will require the greatest level of detailand although the most refined methods will result in the most accurate picture, they will also be the most time consuming and expensive to carry out. One of the most effective methods involves undertaking time studies and allocating expenses directly. Time studies work out how long it takes to complete each task, taking an average based on a range of performances from best to worst. Often, such studies enable managers to allocate costs precisely to activities that have previously been expressed as a general overhead, or passed by completely. It takes time to collect all the data needed for such studies, but proponents say it results in cost savings of up to 14 times more than the cost of the exercise itself. It may also provide evidence in favor of policies and procedures that previously had little more than a hunch to defend them. Remember the Benefits of ABC A particular benefit of ABC lies in identifying under- or over-staffed activities within an organization. Knowledge-based businesses, whose highest costs are always its personnel, find such analysis very usefulthe more efficient its deployment of staff, the higher its profits are likely to be. Finally, ABC analysis can set valuable performance standards within an operation, or even enable a company to compare the costs of its own processes and procedures with those of the sector in general. Common Mistakes You Get Too Caught Up In the Process ABC is only a tool, but theres a danger that it can become all-consuming and dominate an organization.

81 You Underestimate the Task Setting up and maintaining ABC can be a huge and daunting exercise. Organizations may need to estimate some costs to keep the exercise within realistic boundaries. Nevertheless, a certain level of detail is essential. For example, time studies are an accurate way to allocate costs relating to personnel, or indirect costs. Other methods may need less input, but they could be so subjective that the whole exercise is compromised. Moreover, they may not identify precisely where staffing is being used inefficiently (or vice-versa), or miss significant trends. You Use the Wrong Tools If a company tries to embark on ABC without the help of specially-developed computer software, its almost certainly doomed to become a time-consuming waste of money and effort. ABC is a complex process and needs to be automated as much as possible, in the most appropriate ways. You Fail to Maintain the System Like any other accounting method, ABC is an ongoing activity that needs constant updating as circumstances develop and change. You Ignore the Implications ABC has the potential to turn the spotlight on any area of an organization and to expose its deficiencies, as well as to identify what works well. If an organization decides to adopt ABC, it needs to be ready to grasp the nettle and act on its findings, or the whole exercise becomes pointless.


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