The Activity Based Costing (ABC) System

A.   Introduction

Business recently is in uncertain and competitive condition, neither in large or small scale of industries. Every company seems to apply its strategies to win the competition in the market. Therefore, reliable information about cost is very important for decision making. Companies that can effectively gather and spread relevant information to all their departments might be successful to be great companies in the world (Compton, 2009). One thing that should be considered is about efficiency. In order to know how to improve efficiency, companies need to know information related to the costing method implemented to production activities, so they can identify each cost appropriately.

Costs can be divided into direct costs and indirect costs or overheads. Direct costs are easier to be assigned to cost objects than indirect costs because direct costs can easily be traced to particular cost objects, while indirect costs cannot. Assigning process of indirect costs involves cost allocation of resources that are consumed in company activities. There are two costing system that can be applied, direct costing system, which only assigns direct costs to cost objects, and absorption costing system, which assigns direct and indirect costs to cost objects. Absorption costing system can be divided into Traditional Costing Systems and Activity Based Costing (ABC) System (Drury, 2013).

B.   The Purposes of Calculating Full Absorption Product Costs (Absorption Costing System)

There are two purposes of assigning costs to products by manufacturing companies, for financial accounting and managerial decision-making. Full absorption costing focus on the second purpose because it more concern on providing useful information for managers, so managers understand accurately the costs that are required by each product and then they are able to determine whether a product is profitable or not. Therefore, if managers can identify the resources consumed by products, they will be able to pinpoint the source of profits or loses, and then make appropriate decision (Drury, 2013).

If a company manufactures only one kind of product, all of costs can be directly assigned to the product. In fact, however, costing systems rarely assign costs straightforward because companies often produce different products that use several common resources in different proportions. All production costs should be shared to products in an appropriate manner (Innes and Mitchell, 1990). In this case, a well-designed costing system, such as absorption costing system, is needed.

Absorption costing system assigns all of costs related to production process, such as direct materials, direct labour, and overhead (variable and fixed overhead). This method offers wider scope of costs than direct costing because it assigns not only direct costs, but also indirect costs. Therefore, manager will get more comprehensive information about production costs for decision making.

C.   Traditional Costing and Activity Based Costing (ABC) System

1.    Traditional Costing System

Traditional costing system allocates indirect costs or overheads based on volume, such as direct labour hour or production machine hour (Mark, 2009). There are two stages of cost allocation in traditional costing system. In the first stage, all manufacturing indirect costs (overheads) are assigned to production and service cost centres, then the cost assigned to service cost centres are reallocated to production cost centres. Subsequently, in the second stage, each overhead rates are computed and assigned to cost objects or products (Drury, 2013)

Traditional costing system has only one or few overhead cost driver for each department in a company. This system assigns costs directly to products, instead of activities associated with production. In this system, the total costs which are incurred to produce a number of products are divided among various products in volume basis, where the cost drivers are often financially based (Mark, 2009). Besides that, traditional costing system negates non-manufacturing costs that might also relate to production of a product such as administrative expenses (Johnson, 2015). Those disadvantages can lead managers to mistakenly believe in profitability of their products. In other words, this system often gives misleading information for managers in decision making.

2.    Activity Based Costing (ABC) System

Activity Based Costing (ABC) System assigns costs based on cause-and-effect relationship between the costs and the activities driving the costs (Kumar and Mahto, 2013). The activities consist of various task, events, or works, such as setting up machines, purchasing material, inspecting items, and processing orders from customers (Drury, 2013).

Comparison between traditional and ABC system can be seen in Figure 1. ABC system also uses two-stage allocation process. However, ABC system use many activity cost centres (activity cost pools), while traditional system pools overheads by departments. Furthermore, ABC system not only use volume-based cost drivers, like traditional system, but also non-volume-based cost drivers, for example number of set-ups. ABC system can more accurately measure consumption of resources by cost objects because ABC system use a large number of cost centres and variety of second-stage cost drivers, and assign activity costs to cost object based on cost driver usage (Drury, 2013). 

Figure 1. Comparison between Traditional Costing and ABC System

Source: Drury, C (2013) Management Accounting for Business 5^th edition

Changes in technology, competition, information associated with costs, and demands for variety of products from customers, impact necessity to improve costing system to be more sophisticated. ABC system offer more accurate product costs and reduce distortion of information of product cost from traditional costing system (Cooper, 1988b and Kaplan, 1994, cited in Al-Omiri and Drury, 2007, p.400).

ABC system is often considered more useful than traditional costing system. Kumar and Mahto (2013) summarized some positive points of ABC system. First, ABC provides more accurate data and detailed information on all activities and processes in company, compared to traditional costing system. In this case, ABC enables managers to improve financial performance by managing cost effectively. Second, ABC reflects company’s performance, so it can be a benchmark for business performance compared to the competitors. Finally, ABC not only can be implemented in manufacturing, but also in distribution, agriculture, and service business. Johnson (2015) also stated that the main advantages of ABC system is the accuracy because it negates irrelevant cost and gives greater understanding for internal manager regarding production costs.

D.   Activity-Based Management (ABM)

Activity-based management is a cost management for application of ABC system. ABM concerns in managing business based on activities in the organisation. It needs an understanding about factors that cause activities and that lead changes of cost incurred in activities. ABM also provides information about activities that involve more than one department. For instance, the activities related to customer’s orders can be evaluated from production and distribution departments. Furthermore, ABM enables managers to identify costs that can be potentially reduced by classifying activities into value added and non-value added activities. Managers can focus on reducing costs in non-value added activities, because it will not decrease the quality of product’s service to the customers (Drury, 2013).

ABM is necessity in implementation of ABC system. ABC system requires high efforts and costs, so it should be well managed, otherwise it will lower company value. The most common mistake is that companies tend to more focus on ABC system and lack of concern in ABM (Bahnub, 2010).

E.    Adoption of ABC System in UK Companies

Costing systems can be classified by level of sophistication based on the dimensions such as the number of cost pools, the number of various second-stage cost drivers, the types of cost drivers that are used in the second stage, and the usage of resource drivers in the first stage. High level of sophistication is associated with high number of those dimensions, and vice versa. Then, the level of sophistication is considered in determining costing system that would like to be applied (Al-Omiri and Drury, 2007). Relationship between level of sophistication and appropriate costing system can be seen in Figure 2.

Al-Omiri and Drury (2007) hypothesized that several factors influencing level of sophistication are the importance of information about costs, diversity of product, cost structure, intensity of competition, organisation size, the quality of IT, techniques of innovative management accounting and production, and business sector. As the result, most of those factors showed significant influence on implementation of Activity Based Costing System, except the quality of IT, diversity of products, and cost structure.

Figure 2. Relationship between Level of Sophistication and Costing System

Source:  Al-Omiri, M and Drury, C (2007) A Survey of Factors Influencing the Choice of Product Costing System in UK Organisations

In another study, Drury and Tayles (2005) examined factors or variables considered to select product costing in organisation by its level of complexity. Level of complexity is associated with the number of cost pool in the first stage, the number of different types of cost drivers in the second stage, and the nature of cost drivers. The dimensions of costing system complexity can be seen in Figure 3.

The factors examined are the cost structure, competition, diversity of products, degree of customization, size, importance of cost information to make decision, and corporate sector. The result was that only corporate sector that has significant influence to the complexity of costing system. It was likely because the financial, commercial and service organisation have high proportion of indirect costs compared with other organisations such as manufacturing organisation (Drury and Tayles, 2005).

Figure 3. Dimensions of Costing System Complexity

Source: Drury, C and Tayles, M (2005) Explicating the Design of Overhead Absorption Procedures in UK Organizations

Those finding may explain why the adoption rate of ABC system is quite low. According to the survey to the UK largest companies, the ABC system has been adopted only around 15% of the companies surveyed (Drury and Tayles, 2005). So far, many researches have not been able to prove strong link between contextual factors identified and adoption of ABC system (Al-Omiri and Drury, 2007).

In fact, even though ABC system gives some benefit to company, it also has some drawbacks. Johnson (2015) admitted that ABC system requires great resource, so it will be difficult for companies that have limited funds. The cost needed to implement and operate ABC system is much more expensive than traditional system. Besides that, the lack of understanding of ABC system can lead some users to be easily misinterpreted. Compton (2009) also explained that it is difficult to precisely trace activity costs to specific products because some activities may be related to many products. Those disadvantages might also lead many companies to not use ABC system.

F.    ABC System in Financial and Service Organisation

Drury and Tayles (2005) suggested that financial and service organisations are likely to adopt ABC system because they have more complex indirect costs than manufacturing organisations. Financial and service organisations have more indirect cost than direct costs in their cost structure.

Chea (2011) stated that financial organisations have been leading in implementing ABC system. They acknowledge the benefit of ABC system. For example, large regional banks implement ABC system for resource allocation and pricing effectively. The banks expect that the costs charged to the customers are based on effort-and-use relationship. In global insurance company, ABC system has been implemented to determine allocation methodology for transfer pricing among their affiliates. The companies want to make sure that costs charged in all of their affiliates around the world are accurate. The costs incurred in the services that are provided to all affiliates can be traced through ABC system. Furthermore, the companies have been able to reduce its effective interest rate. Another example of implementation of ABC system is in major investment banks. Through ABC system, they are able to determine the profitable products and markets, and then influence their business strategy. Besides that, ABC system leads them to improve their internal performance measures and make changes in their internal transfer pricing.

Ruhl and Hartman (1998) pinpoint the benefit of implementation of ABC system in service companies. For example, in financial service companies such as bank, the costs are driven by number of transactions, not by the volume (the number of customers). Therefore, activity based costing is more appropriate than volume based costing. In healthcare business, such as hospitals, companies set their revenue with Prospective Payment System (PPS) which lead improvement in sophistication of their costing system. This can be accomplished by ABC system. The insurance business also uses ABC system to improve their performance. ABC system enable them to evaluate the costs caused by the time consumed in the tasks, which are vary depend on the case.

G.   Conclusion

ABC system provides more accurate cost information than traditional costing system, so it helps managers in decision making. It becomes more increasingly and significantly important for companies in more competitive market because it enable managers to control their costs to make competitive pricing and increase profitability. Despite the fact that ABC system offers many advantages, this system requires high costs and resources. The adoption rate of ABC implementation is also quite low. ABC system is more likely to be implemented in financial and service organisations because their indirect costs are more dominant and complex than manufacturing organisations.

References

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Bahnub, B. (2010) Activity-based management for financial institutions. Hoboken, N.J.: John Wiley

Chea, A. (2011) Activity-Based Costing System in the Service Sector: A Strategic Approach for Enhancing Managerial Decision Making and Competitiveness. IJBM, 6 (11)

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Drury, C. (2013) Management Accounting for Business. 5^th ed. Andover: Cengage Learning EMEA

Drury, C. and Tayles, M. (2005) Explicating the design of overhead absorption procedures in UK organizations. The British Accounting Review, 37 (1): 47-84

Innes, J. and Mitchell, F. (1990) Activity based costing. London: Chartered Institute of Management Accountants

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Martin, J. (2015) Activity-Based Costing in the Service Sector [online]. Available from: http://maaw.info/ArticleSummaries/ArtSumRuhlHartman98.htm [Accessed 20 March 2015]

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