Understanding Activity-Based Costing System: Advantages And Disadvantages

What is Activity-Based Costing System?

Various systems of cost accounting have come up with growing need of more users friendly and easy to understand methodology of cost accounting. The traditional system of cost accounting has its flaws in allocation of common overheads amongst different departments. To cope up with this issue the activity based costing system was introduced. Activity based cost accounting is a method of accounting which first identifies the costs and assigns the cost to the activities of overhead then assigns the costs to the products. The activity based costing allocates indirect costs to products in a more scientific manner than the traditional method. In the activity based costing is adopted mostly in the manufacturing industry. It improvises the dependence of cost data which produces costs which are apparently true and it makes the classification of the costs which are incurred by the company during its process of production better. The basis of this accounting system is the activities and so the name activity based costing. These activities refer to any task, event or work unit with a pre-determined objective; some examples of these activities are machine set up, production runs, designing products, etc. in the activity based accounting system the activities are considered as the cost drivers, which is also known as activity drivers. A cost driver is the base of cost allocation (Naci & Hasan, 2012). Few examples of cost driver or activity drivers are purchase orders, production orders, quality inspections, machine set ups, etc. The activities can be measured based on two classifications: firstly, the transaction drivers, which includes the counting of number of times an activity has taken place and secondly the duration drivers which measures the time that have been taken by an activity to complete. The primary difference between the traditional cost accounting system and the activity based costing system is that the traditional costing system places reliance on the volume such as labor hours or machine hours for allocating the indirect cost or overhead cost to the products whereas the activity based costing system categorizes the activities into five levels, which are not directly correlated to the number of units being produced. These five levels of activities are product level activity, unit level activity, customer level activity, batch level activity and the organization sustaining activity. The activity based cost accounting system has various advantages and disadvantages as well. We have in this assignment discussed the advantages that the activity based cost accounting system along with its drawbacks below (Visinescu, et al., 2017).

Advantages of Activity-Based Costing System

The activity based cost accounting system is very advantageous to the organization in various sectors. We have here discussed few of the advantages. These are as follows:

1. The activity based cost accounting system helps in bringing about more accuracy as well as reliability in the determination of product costs by centring the attention mainly on the cause and effect relationship in the incurrence of cost. The ABC system has highlighted that the main reason for the incurrence of costs are the activities and not the products and a product is produced by performing activities. The ABC system of accounting gives more accurate cost of products in case of a manufacturing industry with a diversified range of products instead of traditional cost accounting system which tends to produce inaccurate product costs(Linden & Freeman, 2017).
2. The activity based system of cost accounting helps in cost reduction and in the recognition of the activities which does not add any value to the product by identifying the actual nature of behaviour of the cost. With the use of the activity based costing managers can control those activities which cause higher fixed costs since this system of cost accounting enables the identification of cost attributable to each activity.
3. ABC is about the use of cost drivers. It uses various activity drivers which are usually based on the transaction instead of the volume of the product. Thus, it helps in tracing the indirect cost to the products(Knechel & Salterio, 2016).
4. The activity based costing helps the managers of an organization in a better decision making by producing more reliable cost data. The managers can fix proper selling prices of the products produced by the organization.
5. The activity based costing helps in the management of costs. By using the activity based costing the rates of different cost drivers can be calculated as well as the detail of volume of transaction which enables the managers in the management cost as well as the appraisal of the performance of various departments.
6. Activity based costing is the process of pooling the costs of activities and recognizing the cost drivers for allocation of costs. In this process the spare capacity of production is also identified along with the resources that are required for the production process. This enables the management to prepare activity based budgeting for reducing the costs. Thus, activity based costing helps in using the spare capacity as well as in cost reduction.

Although, the Activity base3d cost accounting system has plenty of advantages, it still suffers from various drawbacks. These drawbacks are mentioned below:

1. The activity based cost accounting system involves identification of cost drivers and cost pools which is not very easy. This process is not only complex but can also prove to be very expensive. It does helps in cost reduction but can end up increasing the cost to the organization(Heminway, 2017).
2. There are various difficulties involved in following this method of cost accounting. Some of these difficulties relates to the identification of cost drivers, allocation of common costs, calculation of rates of cost drivers, etc.
3. The activity based cost accounting system involves the estimation of the cost of various activity pools by the management of an organization along with the measurement of the cost/ activity drivers for forming the base for the allocation of costs. There are so much calculations and estimation involved with this method of cost accounting which makes it costly and cause difficulties in measurement.
4. As we have discussed above about the amount of costs involved in the implementation of this system of cost accounting, it rather makes it unsuitable to smaller firms and organizations. Moreover, it is more advantageous to those organization which involves using of cost plus pricing, in which case the activity based cost accounting system provides the cost of product with more accuracy(Gooley, 2016).

For a better study on this topic of Activity based cost accounting system we have considered two journals. The first journal is “Measuring the Success of Activity Based Cost Management and its Determinants” by George Foster of Stanford University and Dan W. Swanson of University of Idaho. The second journal being consulted id “Satisfaction with Activity Based Cost Management Implementation” by Annie S. McGowan of Texas A & M University and Thomas P. Lammer of University of North Texas.

We have discussed both the journals in details in the upcoming paragraphs. But to brief it up, in the first journal the authors have compared the success of various alternative measures of the activity based cost management along with its various determinants. While in the authors of the second journal have examined the satisfaction level of the employees of the organization where the activity based cost accounting system has been implemented (Goldmann, 2016).

In the first journals the authors have examined the approaches for the measurement of success of the activity based cost accounting system. The two approaches which were used for the measurement are the Priori classification approach and the other one is the factor analysis approach. There are four measures of priori types which have been discussed in the journals. These are: Firstly, the measures which are in respect of the application of activity based cost management decision making. This measure assumes that the use of ABCM information and the success in the implementation is positively correlated (Fay & Negangard, 2017). The more substantial use of the ABCM information will render the implementation more successful. This is supported by some examples of clued Cotton (1993), Luke and Granlund (1994), Innes and Mitchell (1995) and Krumwiede (1997); secondly, the measures the basis of which is the decision actions with which ABCM information’s are taken. As per this measure, the ABCM implementation is considered successful only when it causes changes in the decisions. If does not causes any changes in the decision then it is considered as unsuccessful. This measure has been used by Innes and Mitchell (1995); thirdly, the measure the basis of which is dollars improvements, which is the result of ABCM. This measure depicts either the management estimate summary or the clear differentiation between the dollar cost and dollar revenues with the use of ABCM and without the use of ABCM. The success of this measure might be time consuming where there is detention between the implementation of ABCM and when the improvement in dollar becomes visible. The examples of this measure are Shields (1995) and Krumwiede (1997); and lastly the measure which is based on the evaluation of the management of the overall success of the activity based cost management. This basis of this measure is the unidentified description of how the success is to be analyzed. The examples of this measure are Mc Gowen and Klammer (1997), Shields (1995) and Swenson (1995).  Factor analysis is the alternative measure to use as an alternative to the above priori classification. Factor analysis helps in the recognition of classification of various success measures. There are several takes which have been used for guiding the variables postulated to be the determinants of the success of ABCM. The development of the database which has been used in this research was financed by the American Productivity and Quality Centre (APQC) and by a consortium consisting of Advanced Manufacturing International (CAM-I). The focus of the research was on the usage of ABCM by the managers of various organizations and associated factors of best practices. There were four alternatives a priori ABCM success measure, success measures of   ABCM information use (SM – U), success measures of decisions actions taken (SM – DA), success measures of dollar improvements (SM – $I) and success measures based on management evaluation (SM – ME). All these have been discussed by the authors with the help of tabular presentations and charts in the journal (Eddy, et al., 2004).

Disadvantages of Activity-Based Costing System

The authors of the second journal have examined the level of satisfaction that the employees have achieved by implementing the activity based costing as the system of cost accounting. The activity based cost management system has been considered as a major tool for enhancing the various accounting, business and behavioral practices in an entity. The examination of the level of satisfaction of employees has been done based on four factors which are four implementation sites. The focus of this study is mainly on the results related to various information systems in the organization. The authors have discussed various theoretical literatures which help in the evaluation of the variables and in the recognition of different ways for expanding the current of the users on the activity based cost management. These literatures are, firstly activity based cost management literature, which provides that the benefit an organization gets from the implementation of activity based cost management can be identified with the help of various case studies on the basis of which the implementation process has been documented; secondly, the implementation literature, the issues related to this literature can be studied at two levels, macro level and micro level, that is, an organizational approach and on an individual approach. At the micro level or the individual approach, the focus is on the individual rather than on the organization, while at the macro level, the focus lies on the organizations collectively. The authors have tested various hypotheses in relation to the above research. These hypotheses are: firstly, the satisfaction of the employees with the implementation of the activity based cost management is positively correlated with the approach of the top management (Dan, 1995). As per the findings of Manley (1975), the personal involvement is very important with the implementation. The participation of the users helps [s in the improvement of implementation process, but this literature does not support the significant impact of the user participation with the implementation; secondly, the satisfaction of employees is directly positively correlated with their participation in the process of implementation. As highlighted by Shields and Young (1979), the development of the idea of improvement depends highly on the responsibility of the management and the employees as well. The mangers are likely to accept those system goals which are in line with the organizational goals; thirdly, the satisfaction of the employees is directly correlated to the proper descriptions of the goals and objectives of the implementation, this makes the employees to understand the goals of the organization and work toward achieving it; fourthly, the satisfaction of the employees also depends on the extent to which the management has shared the objectives of the implementation within the organization, proper training is also required for the employees to understand the objectives of implementation; fifthly, the satisfaction of the employees are directly and positively correlated to the amount and adequacy of training received by them for the activity based cost management system; sixthly, the satisfaction of the employees is directly correlated to the amount of resources available for the activity based cost management project, the inadequacy of resources required for the project is tend to leave the employees unsatisfied and morally down; seventhly, the satisfaction of the employees also depends highly on the extent to which the implementation system is related to the system of performance evaluation, the employees are tend get motivated if there is performance appraisal by the management; and lastly, the satisfaction of the employees with the activity based cost management is also directly correlated to the information quality which the activity based cost management system yields (Choy, 2018). The authors have also discussed the various variables in the ABCM system. These are dependent variables and independent variables. The author has represented the above data and information with the help of various charts and tables.

Both the journals discussed above have some similarities which have been identified during the study of the above journals. These similarities are stated below:

1. Both the journals are based on the activity based cast management system. In both the journals the authors have discussed various studies and researches done on the application of the activity based cost accounting system.
2. Both the journals have reflected the significance of the activity based cost management as the cost accounting system in the organizations.

While studying both the journals we have also observed little dissimilarity between both the above discussed journals. We have point out these dissimilarities in the points mentioned below:

1. While the first journal discusses about the various measures of the success of the activity based cost management, the other journal measures the level of satisfaction of activity based cost management implementation(Bromwich & Scapens, 2016).
2. In the first journal, various determinants of the ABCM model are discussed whereas in the second journal the authors have emphasized on the reasons for dissatisfaction amongst the employees based on ABCM implementation.

There are various points that we have learned from the study of the first journal. These points are summarized below:

1. The success determinants of the activity based cost management are based on five variables. These variables are the support from the top management, training for implementation, performance evaluation link, quality initiatives link and adequate amount of resources.
2. The measurement of the success of the activity based cost management forms a part of the general test to measure the success of any key change in the methods of the management(Alexander, 2016).

The various learnings that we have observed from the second journal are also discussed in brief below:

1. We have learned that there are various variables which are significant to the implementation of activity based cost management. These variables are quality of information, involvement of users and also allows the involvement and support from the top management which  is highly important for the implementation of activity based cost management system. If the top management does not participate in the implementation, it tends to make the employees agitated.
2. The performance evaluation on the activity based cost management system increases the moral of the employees. This makes the implementation more successful. User participation is very significant for the improvement of the activity based cost management system. The more the participation the more effective the cost accounting system will be(Belton, 2017).The organization who are planning to implement the activity based cost management system must pay attention to the impact of the incentives and the process of such impact on the organization.

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