Activity-Based Costing Essay, Research Paper

Brief Introduction to ABC

Activity-Based Costing (ABC) started as a methodology that recognises the need to understand how costs actually relate to individual products and services (Cooper & Kaplan, 1989) that later resulted in a more refined system of allocating overheads to products and services, according to the demand of each activity.

Homemade Pty Ltd – Food (Dikolli & Smith, 1996:47-55) was a pilot project where it took part in an ABC feasibility study during the mid 90s. This company has been chosen for this study because it has met some of the prime criteria of ABC. The criteria are diverse product or service lines, high overhead, large distribution costs, (Downes, 1996:49) to name a few. Homemade manufactures 170 types of finished stock and is a market leader. It relied heavily on labour and incurring high overheads in processing food in terms of machinery, salespersons’ pay and occupancy of factory floor. Three other companies are selected to observe ABC implications in their systems to see if there is difference or similarity as compared to Homemade. These companies are NASA’s Lewis Research Centre (LeRC) – Government, Tampa Electric – Public Utility and Mobil – Oil & Gas (see as attached at Appendix). They have fulfilled the following prime criteria and have already gone through the phase of actual happenings when they adopted ABC into their costing systems.

1. Product / Service Diversity & Customers

Companies with more diversity in products, the harder it is for them to trace the source of profitability, especially when they are catering to various consumers. For example, LeRC conducts research and development in both aerospace and aeronautics, specialising in micro-gravity science, aero-propulsion and space systems. Its internal customers include government agencies, defence affiliates and the Congress itself. Without ABC, the sources and uses of funds are hardly visible, (Walters et al., 2000) because it is difficult to measure its employees’ time spent on a given activity. Similarly, Mobil supplies more than 30,000 lubricants to retail customers and their costing system could not address cost to produce each product individually. (Kang, 2000)

2. High Overheads & Large Distribution / Marketing Costs

Large companies usually incur high overheads than of direct costs because they spend more in distribution and marketing costs. Indirect costs, such as promotion costs, outlet manager’s wages and depreciation of machinery are not accounted into the cost per unit of product or service. For instance, Mobil produces and supplies more than 30,000 lubricants, and operates lubricant affiliates in more than sixty countries with forty manufacturing locations. Its wide coverage is to market its lubricants to the consumers. Therefore, it will be incurring high overheads. However, the cost per unit lubricant will not include the salaries of salesmen selling it. Without ABC, these extra costs will not be accounted for and cost per unit will not be accurate. Similarly, Tampa Electric uses six generating plants to cater to 550,000 customers: commercial, residential and industrial including the extent of urban and rural. The overhead and distribution costs incurred during the transportation of electricity to these places are not accounted in the cost per unit of electricity because in traditional costing, these costs are represented by resource drivers.

After the implementation of ABC, it is obvious to see that some of the decisions made in those companies have been changed. These changes are made to better reflect product costs, identify unnecessary costs that reduce profitability and clearing any extra work contributed from unstructured costing system. Common decision points can also be categorised under several groups.

1. Cost Allocation & Pricing

Non-value added costs are identified, therefore been reduced. Sales are no longer to target volume, but for the purpose of profitability. ABC allocated overhead costs according to their activity drivers instead of volume drivers. Specific activities that are contributing to non-value added costs could be separated. For example, Tampa Electric discovered that testing of meters in house versus the field would save approximately $50,000 and replacing residential meters is considerably less expensive than repairing them. For pricing purposes, the price per unit can be maintained the same while reducing costs to generate substantial profits. Mobil will be able to produce thousands of product and package combinations without increasing the costs that affect the profitability level. Homemade prepared cross-functional expenditure analysis to detect any ‘hidden’ items in the general ledger and a five-stage decision process has been developed to define activities according to their nature, either for activity-based management (the process dimension) or activity-based costing (the cost dimension) purposes. (Dikolli & Smith, 1996:52)

2. Add / Drop Product / Service Lines

Unprofitable product lines can be dropped and new lines added. By removing these lines, it can eliminate very much of the cost subsidies such as electricity, raw materials and direct labour that have been incurred during the making of product or service. Mobil has closed multiple manufacturing facilities with excess capacity because ABC has identified the importance of profitability rather than volume growth. “Profit focus and business simplicity are the themes and the business results are their tangible manifestations.” (Tom Kang, 2000) Similarly, Homemade has eliminated one product family from the product range after it is found out that there were changes in excess of 100% for the two low-volume non-standard products. (Dikolli & Smith, 1996:54)

In order to facilitate the successful implementation of ABC, there has been identified that certain key ‘organisational’ variables are essential for companies that took the ABC’s path. Nevertheless, these variables can and have increase the likelihood of successful implementation (Hilton, 2000:224) in all selected companies.

1. Top Management Support and Commitment

The involvement of top management in the ABC implementation is crucial to make sure that all stages of transfer are completed. In Tampa Electric, the management ensured that its people spent the time needed to gather information, be available for interviews, train and learn how to use the ABC model, and manage the results. In Mobil, the management incorporate ABC into everyday business decision-making processes and ensure its sustainability by driving ABC initiatives the top-down. The Management of LeRC recruited AMS (American Management System) to help their team apply activity-based costing as a tool to implement the Internal Economy Concept. (Walters et al., 2000)

2. Organisational Culture

A successful implementation of ABC involves full participation from employees concerned, including their shared beliefs, goals and values. (Hilton, 2000:224) The employees are to be cohesive in making the full transfer of costing system be completed. All operating areas of Tampa Electric were working together to achieve the goal – expected savings target by using ABC. Mobil has also successfully used this attribute to sustain ABC in its systems because its employees are determined to build the best ABC model with the data available from existing information system and effectively communicate the results.

3. Performance / Incentive Programme

This variable will help those employees who have or not able to accept the new changes, thus still manage costs with the traditional way. Most of the time, pay is used as the change agent. In Tampa Electric, any service areas that have helped to identify efficiency and best practice will be awarded. By giving incentives, resistance to change will be greatly reduced because employees have been compensated from any loss. In Mobil, ABC is tied to a performance measurement system (Kang, 2000) where employees can get extra pay if they can incorporate ABC into their work.

4. Education / Ongoing Training

Employees are to be offered a continual opportunity to retrain and adapt their skills to the changing environment when ABC is implemented. By giving on-going training to them, they will be more committed in supporting the implementation of ABC into new business units. As in Mobil, the employees are given guidelines to progress to latter stages of ABC, train users and share their experience with other units. (Kang, 2000) Similarly, participants in LeRC are educated of relationship matrices used to integrate segments of the ABC model and that understanding the true costs is critical to survive in an internal market economy. (Walters et al., 2000)

To conclude, ABC mapped companies’ expenses from functional categories to processes. ABC systems estimate the costs of resources used to perform activities for various outputs. A company will need ABC when its cost system exhibits problem determining a product’s profit margin and with great relief when a physical inventory does not result in inventory adjustments. (Eiler et al., 1982:134) ABC can also help managers find the places in their organizations where improvement is likely to have the greatest financial payoff. (Cooper & Kaplan, 1991:132) However, the company must satisfy several prime criteria before it is qualified to take up ABC as its costing system.

Bibliography

References

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

2. Cooper, R., (1989) You Need a New Cost System When…, Harvard Business Review, January-February, 1989: 77-82.

3. Dikolli, S., Smith, M., (1996) Implementing ABC: An Australian Feasibility Study, Australian Accounting Review, 6(2): 45-55

4. Downes, F., (1996) Getting the Most Mileage from Your Cost System, Controller Magazine – June 1996: 46

5. Eiler, R. G., Goletz, W. K., Keegan, D. P., (1992) Is Your Cost Accounting Up to Date, Harvard Business Review, July-August 1982: 133-139

6. Hilton, R. W., (2000) Instructor’s Edition – Managerial Accounting, 4th Edition, McGraw-Hill International Editions

7. Kang, T., ABC Gathers Speed at Mobil, [Online], Available: http://www.bettermanagement.com, [2000, August 30]

8. Tampa Electric Generates Results with ABC/M, [Online], Available: http://www.bettermanagement.com, [2000, August 30]

9. Walters, J., Rattan, P., Smith, S., Webster, D., ABC at NASA’s Lewis Research Center, [Online], Available: http://www.bettermanagement.com, [2000, August 30]