Activity Based Costing – Definition, Advantages, And Case Studies

What is Activity Based Costing and how does it work?

Activity based costing may be defined as one of the widely costing techniques being used in the industries and businesses to allocate the indirect cost to the product and to different activities as the direct costs with relation to production are being automatically allocated or proportioned in the ratio of the sales being made. This is a technique whereby the total pool of resources are being assigned to different activities and then those activities are being assigned to the different cost objects. The costs are then divided based on the cost drivers. Now, what does the cost drivers means? It is simply the allocation base or the unit of the activity that causes the total activity cost to be changed. More of units of cost driver, more will be the total costs, like the electricity cost for which the cost driver can be machine hours being used in deveral products. All the types of costs can basically be divided among 3 types namely fixed, variable and semi variable. These costs may be allocated based on the time used in terms of machine hours or labour hours, space used for storage costs, volume for allocation of freight costs, the efforts burnt in the sale of particular product type, etc. It is one of the best techniques to effectively and efficiently manage the limited resources of the company.

Few of the advantages of the activity based costing include:

1. It provides the realistic costs being incurred for manufacturing the given products,
2. It helps in determining the costs accurately and proper allocation amongst different products,
3. It also shows what are the inefficient processes and helps in eliminating them thereby saving of wasted costs
4. Profit margins can be determined precisely and thereby manufacturing overheads can be better justified(Eddy, et al., 2004). 

Besides these advantages the techniques also suffers from a number of shortcomings as well which are enlisted below:

1. Collection and analysis of the data can be time consuming and may require a lot of effort.
2. It may not be reasonable for the small company as the costs may be high
3. ABC reports not always conform to the generally accepted accounting principles and therefore cannot be used for external reporting purposes
4. The data which is produced through ABC analysis may conflict with that produced from traditional costing methods with respect to managerial performance.
5. For ABC to operate in a correct manner, deep understanding of the organization and its structures is required. Furthermore, the specialized knowledge of costing, cost drivers, allocation, cause and effect relationship is also required(Visinescu, et al., 2017).

The two journal articles which have been considered here for discussion on the given topic are “The Value of Activity-Based Costing in Competitive Pricing Decisions” by Eddy Cardinaels; Filip Roodhooft, and Warlop Luk and “The Measurement and Management of Unused Capacity in a Time Driven Activity Based Costing System” by Veyis Naci Tanis and Hasan Özyapici.

The 1^st journal paper discusses on what are the merits of the Activity based costing for price setting especially in the manufacturing industry where there is heavy price competition. As per the study, the ABC costing has greater benefits over the volume based costing in the baised cost allocation is being made which further result in accounting losses. ABC costing tends to remove the irrelevant competitor feedback from the final decision making process. 

The purpose of the study is to determine how far the cost methods used are important in decision making when limited data is available with the accountants in terms of price fixation. There is a huge pressure in the market conditions in terms of pricing output and it was presumed earlier that the cost system plays a minimal role and ususally the price is driven by the market feedback which generally supersedes the accounting information (Heminway, 2017). However, with the study, it was discovered that in the multimarket setting, the traditional costing methods can give biased results and costs estimates for the product in the heterogenous market and when such cost estimates are over allocated or under allocated or a particular market segment then given firms may have accounting losses which are actually profitable in the market place. Briers et al. in 1999 studied the impact of baised costing methods in the multiproduct matket and found that the biased cost data led to improved  pricing decisions based on the market feedback and the benchmark report received by the companies but it did not involve any direct competition notr did they test the ABC system (Eddy, et al., 2004). Howver, later on the test were conducted in the experimenta market conditions with 2 hypotheses being assumed. These 2 hypotheses were prices are profits are optimal when the businesses receive informatuive market feedback rather than the uninformative market feedback. The 2^nd hypothesis was that the benefits of ABC system over the biased cost data setting fall as and when the market feedback becomes more and more informative. In the experiment, 2 groups of participants were made consisting of 131 management accounting and cost accounting qualified students who were given cost data and asked to allocate the costs using the traditional costing systems and the ABC costing system. In the ABC case, the allocation of the customer costs was done based on 3 activities namely ordering, delivery and software handling. Then the ABC system allocated the cost of activity across 2 market segments based on the respective cost drivers like number of orders, deliveries and software handling. Then the results were conducted and checked and the primary objective was to see the impact on the profits over ten different periods and to check the robustness of the process, average of the 1^st five results were carried out and it was found that the interaction between the market feedback and the accounting report on allocations is holding minimum relevance. Thus, the 2^nd hypotheses was proved wrong and was concluded that the competitors operate in the competitive market and where the information is limited. Based on rationality and the most appropriate cost drivers, if at all the companies are able to allocate the indirect costs amongst the activities, it gives the most appropriate and relevant cost to be considered for the product. It not only makes the product competitive in the marketplace but also helps in correct price fixation (Dan, 1995).

Advantages of Activity Based Costing

The second case study answers the question as to how to manage nd measure the unused capacities in the companies by the way of  using time driven activity based costing. There are many companies which are operating and functional almost 24 hours a day and it might be difficult for them to determine what is the unused capacities. While doing so, they should be considering 2 new concepts which are real and compulsory unused capacities. The aim of the research paper itself is to increase the efficiency of ABC and TDABC system by explaining real and compulsory unused capacities per shift. The principle result of the study was to dismiss or redirect the employees to other productive areas based on the per shift rather than looking at unused capacity throughout the day (Gooley, 2016). This was not possible through traditional method of costing as the overall basis on which it works as become obsolete now and companies were now looking for more advanced methods that can help them in cost management. Also with the ABC model the issue was with the selection of the cost drivers for the allocation of the costing element within different departments and did not optimised the resources that the management of the company had and this case study highlights the same (Alexander, 2016).

The time driven activity based costing is the refined version of ABC costing that was introduced to gain the competitive advantage over the existing processes. In this approach, managers are able to know what are the resources and what is the amount of resources that will be required to complete a given activity (Naci & Hasan, 2012). There are 2 parameters for implementation of TDABC which includes the cost per unit of resources required and what is the number of units of those resources being consumed by the customers, activities or services. It aims to overcome all the shortcomings being imposed by the activity based costing and improves the efficiency in costing of goods accurately and even takes into account those costs which get eliminated or ignored under the ABC system. In simple words, it sees the time and no. of resource units required to complete an activity. In this cost per unit is estimated by using the practical capacity of the resources (Belton, 2017). Suppose, the machine actually works for 40 hours a week as per records then we can take the effective hours to be 80-85% of this which amounts to 32-34 hours per week. The key here is to take into account the practical and effective capacity otherwise the cost allocation as well as the full results would be wrong. The other parameter is the calculation of the number of units of resources being used for which the managers prefer to interview the employees or do estimates through direct observation procedures. Some organizations may even do it with employee survey as the objective is not to find the exact timing but a rough estimate. Multiplying these 2 parameters we can get the correct allocation keys (Bromwich & Scapens, 2016).

Shortcomings of Activity Based Costing

The similarities between the 2 studies are that

1. They have been initiated over the traditional costing to initate better cost management and better management of time and reduce unnecessary consumption of resources.
2. Both the costing methods are developed to make costing easier and efficient and reduce the shortcomings of the traditional method of costing(Choy, 2018).

The difference between the two case studies are that

1. In the first case study the emphasis has been on the cost drivers and in the second case the emphasis has been on time management.
2. Activity based costing was aimed to reduce the issues that were related to poor management of resources and aimed to find the correct cost drivers so that calculation of the cost is optimum and in case of Time based costing the aim was to reduce the overall time that was taken for calculation of the costing and selection of the cost drivers, and make the process very easy(Fay & Negangard, 2017). It was an upgradation from the activity based costing and the companies around the world are now preferring TDABC. It is imperative that both are good in their own ways and these artciles highlights the overall usage and similarities between the both.

In case there are any issues that the companies cant comprehend to with respect to time management they can opt for TDABC and in case they have issues with selection of the cost drivers they can aim for activity based costing also. Both are extremely important and better than traditional methods that had it shares of issues and there was no easy fix for that as well.

There are various learnings from both the above discussed research papers and all these lessons learned would be helpful and will beuseful for management accountants in Australia in terms of optimizing the costs and increasing the profitability. Few of the major learnings from the 1^st case study is being listed below:

1. The firms’ price demand effect is much more stronger than the competitors cross pricing demand effect. Market players will be left with the lower demand if the rival charges the lower price in the market.
2. New entrants in a particular market segment follow the trend being set by the other market players. Such behaviour is often seen when the smaller players entering the market follow the exitsing market leader(Gooley, 2016).
3. It was also seen that the prices which are determined based on the costing results from the traditional costing methods are far from optimal prices simply because of the fact of wrong allocation methods being used and as a result the prices are surged and accounting profit is less. The sales are also hit adversely in case the comprtitors price the goods at lower rate. Comparatively, when the activity based costing is being used then we see that the prices are near to optimal prices as the costs determined are the best possible costs based on appropriate allocation and thus the accounting profitability and the sales of the product increases.
4. Also, it was found that when the market feedback is uninformative, then the companies or participants using the ABC costing techniques found market feedback to be less important as compared to the counterparts using volume based costing techniques(Knechel & Salterio, 2016).

The key learnings from the 2^nd research paper which can be useful for Australian companies are enlisted below:

1. The companies who suffered from the issues of selecting of the cost drivers, TDABC aimed to remove it and also aimed to use the practical capacity of the machine that will help in calculating what would the possible output be(Naci & Hasan, 2012).
   1. The companies can manage their cost valuation in much more effective and time based manner. It is an innovative and very advanced method of cost allocation that companies can follow over the traditional method of costing(Linden & Freeman, 2017). It will also enable the companies to plan better for the future and make better estimate which is not possible in case of other methods of costing.

References

Alexander, F., 2016. The Changing Face of Accountability. The Journal of Higher Education, 71(4), pp. 411-431.

Belton, P., 2017. Competitive Strategy: Creating and Sustaining Superior Performance. London: Macat International ltd.

Bromwich, M. & Scapens, R., 2016. Management Accounting Research: 25 years on. Management Accounting Research, Volume 31, pp. 1-9.

Choy, Y. K., 2018. Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis. Ecological Economics, p. 145.

Dan, S., 1995. The benefits of activity-based cost management to the manufacturing industry. Journal of Management Accounting Research, Volume 7, p. 167.

Eddy, C., F. & Warlop, L., 2004. The Value of Activity-Based Costing in Competitive Pricing Decisions. Journal of Management Accounting Research, Volume 16, pp. 133-148.

Fay, R. & Negangard, E., 2017. Manual journal entry testing : Data analytics and the risk of fraud. Journal of Accounting Education, Volume 38, pp. 37-49.

Goldmann, K., 2016. Financial Liquidity and Profitability Management in Practice of Polish Business. Financial Environment and Business Development, Volume 4, pp. 103-112.

Gooley, J., 2016. Principles of Australian Contract Law. Australia: Lexis Nexis.

Heminway, J., 2017. Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and Organic Documents. SSRN, pp. 1-35.

Knechel, W. & Salterio, S., 2016. Auditing:Assurance and Risk. fourth ed. New York: Routledge.

Linden, B. & Freeman, R., 2017. Profit and Other Values: Thick Evaluation in Decision Making. Business Ethics Quarterly, 27(3), pp. 353-379.

Naci, T. & Hasan, O., 2012. The Measurement and Management of Unused Capacity in a Time Driven Activity Based Costing System. Journal of Applied Management Accounting Research, 10(2), pp. 43-55.

Visinescu, L., Jones, M. & Sidorova, A., 2017. Improving Decision Quality: The Role of Business Intelligence. Journal of Computer Information Systems, 57(1), pp. 58-66.