Activity-Based Costing in a Service-Based Organization Activity-Based

¶ … Activity-Based Costing in a Service-Based Organization

Activity-Based Costing operates on the conventional approach and applies a two-stage allocation instruction and other cost drivers. First, the system identifies the important activities and overhead costs assigned to each activity in proportion to the resources used. Consequently, for each of these cost pools, cost drivers are identified. Secondly, the assumed overhead cost driver is assigned proportionally to the final outputs of the cost pool. The most important aspect of a proper ABC design system is that activities and resources are assigned to cost items based on their use.

In service-based organizations, the ABC system must show the actual physical structure of resources and activities and cost items. It is necessary to undertake a precisely executed, correct analysis of operations rather than of the cost figures in the general ledger. Therefore, design is everything in an ABC system because each organization uses different levels of resources in performing different activities with different types of cost items. Service organization must exercise caution in depicting their operations as a reasonable facsimile of their specific structure. The management must be careful not to take examples from other organizations in a literal manner, despite the fact that consultants and industry interest groups promote comparative information (Dowless, 1997). It is most important that the organizations understand themselves explicitly before comparing their results to those of others. A good design will also attract the definition of strategic goals and measures within the organization. Most service-based organizations such as banking, telephone, insurance, railroad or distribution organizations have their own unique economic and physical structures that are depicted properly in activity-based costing.

Implementation of Activity-Based Costing System

It is important to do a pilot run prior to implementing activity-based costing for the organization. Without proper piloting, organizations are most likely to overshoot their budget, waste time and resources on collection and analyzing data needed for activity-based costing model. This can result in frustration and eventual non-implementation of the ABC.

It is important for the implementation staff to seek the top management's support (Accounting For Management, 2011). Thereafter, they should identify the important data needed. The organization should approve smaller and quick projects, such as a single process or pilot plants. If successful, the management will undertake more implementations and eventually make it a priority for other sectors of the organization.

The implementation staff needs to develop a computer based ABC system that can be used on an infrequent basis for strategic decision-making. This model should be a simple and upgradeable with data that is already available or easily collected. In any case, simple model tends to be far more accurate compared to many traditional cost allocation methods. The input field must be supported by the existing information system.

Smaller service based-firms should creatively seek reasonable activity cost drivers from their data through collaborations. Here the team's greatest task would be to identify the parts of selected activities that are expensive. They should however pay close attention to detail in this step as many activities may have hidden cost.

It is recommended that the implementation staff comprise of most knowledgeable staff that will apply what is required of them and strictly follow the laid down procedures for successful implementation of ABC (Andersen, 1999). A common mistake in the implementation process is putting managers on the team. They are most unlikely to get enough information from accountants or other analysts.

Cost Measurement Problems for Service Organizations

Implementation of ABC system is a process that needs extensive resources in a service-based organization and it is therefore expensive to maintain once implemented. This is because of the information analysis on various activities collected, checked, and entered into the system.

Additionally, ABC can produce product margin numbers that do not much the numbers produced by manual costing systems. However, managers are accustomed to using traditional costing systems in running their operations. This can confuse the organizational operations.

The data from ABC can easily be misinterpreted and must be used with care when making decisions. In view of that, before engaging into making any significant decision using ABC data, managers need to identify costs that are relevant to the current situation.

Reports collected by ABC systems are not consistent with generally accredited accounting principles (GAAP). Consequently, it might be mandatory for firms to engage in multiple cost system for both internal and external reports.

ABC can present difficulties in the initial data collection stages. This is usually due to lack of differentiation of related and unrelated information. This might result in use of much forgotten information, which has not been used in traditional systems, resulting in doubt.

Implementation Problems and Their Solutions

According to Clark & Mullins (2001), the implement of ABC is commonly met by resistance at the management level. "The problems here is identifying the suitable cost pools and related activity cost drivers" (Clark & Mullins, 2001).In addition the management resist the process due to the cost implications. The process is expensive and time consuming. This includes the cost of capturing the internal accounting model and the time it takes in involving and training the staff. The remedy here would be the adoption of custom designed ABC that is suitable to the organization's needs.

One other challenge in implementing ABC is in the identification and selection of the appropriate drivers. This is because it is usually difficult to identify a driver responsible for a particular activity. For instance, identifying the driver for an activity such as getting clients on the internet is not easily identifiable. A rule the root cause is key in providing information to the management, but it is not always easily identifiable especially in the initial implementation stages.

To counter this problem, one need to first, limit the drivers, the recommended number is between 10 and 20. It is not advisable and counterproductive to spend time mining data for un-retrievable data. In addition, one can prioritize the time spent on most valuable drivers.

Secondly, construction of the design dictionary is usually problematic in the implementation of ABC systems. This dictionary is the forms the structure for gathering information on time the staffers spent on activities. This is usually a compromised element of the ABC because of the inability to obtain the right information for the first choice driver. It is a frequent obstacle to successful implementation of the ABC modeling.

The remedy in this case is to limit the information of the required item. It is important that the activity design exclude activities such as waiting, checking or error messages (Barrett & Robinson, 2007).

Roztocki (2001), reveal that ABC does not account for the necessary cost such as capital cost, investment risks as well as cash flow. This is mainly because it does not consider the balance sheet.It fails to focus on the total product cost.

Comparison of ABC Implementation in Service Based and Manufacturing-Based Organizations

The first similarity between the activity-based costing systems in the two industries is that it is used in the correction of past shortcomings. Activity-based costing is the most appropriate way of developing a system that directs an organizations costs to the products and services. It provides for a cross functional and an integrated view of organizations in relation to their daily operations.

Secondly, similarity between the ABC in service based and non-service-based organizations is that adoption and familiarity of activity-based costing is the same. Service-based organizations providing services using overhead at differing rates benefit from activity-based costing while and manufacturing-based organizations with multiple products that place different demands on overhead.

Furthermore, accurate Cost assignment to each sale allows the organizations to assess the profitability of each client and in addition ensuring that customers pay for products or services, they acquire from the organization. The system enables organizations track the profitability of clients by tracking performance of outside parties.

Overhead costs are incurred for different reasons. The activity-based costing system identifies the costs of all activities carried out in the firms. The method accurately allocates indirect and direct costs to goods and activities conducted based on consumption.

Contrasting implementation in Service Based and Manufacturing-Based Organizations

Service-based organizations have problems developing ideal activity-based cost systems because they adopt systems used in non-service-based organizations. One difference is that non-service-based systems focus on valuing products and use standard cost for direct materials (Ruhl & Hartman, 1998).

Direct materials and labor are not required in service-based organizations costing systems. It is an impossibility to calculate standard cost in service-based organizations, additionally, they have little concern for accurate cost for goods profitability analysis.

Service-based organizations are

The foremost significant difference between the activity-based costing between the two organizations is in contrast to the Pearson chi-square static table. The Pearson square illustrates that relationship among variables is significant at the .05 level. Between service based and non-service-based organizations.

The manufacturing oriented organizations the larger are more likely to implement the activity-based costing system than most service-oriented organizations; smaller, who use the traditional costing methods or had not implemented the activity-based costing. These service-oriented firms apply the ABC in small numbers and lack diverse products that would make the usage of the activity-based costing beneficial. The manufacturing companies had vast resources with a large number of specialists making them opt to implement the activity-based costing system.

Furthermore, service-based organization apply the traditional costing system that adopt a two stage approach in providing the organization indirect and support expenses to the cost of a product or service. This method involves the gathering of support expenses in cost pools and later giving them to production units based on volume drivers. The connection between indirect costs and volume drivers applied in this method uses results in inaccurate costs. The manufacturing-based organizations on the other hand, use an advanced activity-based costing system that give comprehensive and accurate results. It allocates cost to organization's resources in activities. These costs are therefore linked to the organization's products resulting to accurate measurements that are not volume related but with costs associated to a particular product.

In addition, service-based organizations use departmental overheads and not plant wide rates (Accounting For Management, Accounting For Management). These departmental rates do not accurately assign overhead costs in situations where the organization has a wide variety of goods. The departmental approach calculated by the service-based organizations, depend on the volume as an allocation factor of overhead costs to service. The manufacturing-based organizations on the other hand use the plant wide rates that assign overheads costs in relation to all products without necessarily depending factors such as volume or production.

The other difference is that the manufacturing-based organizations allocate costs based on characteristics of each unit. The details include the number of direct labor hours required to produce each unit, cost of purchasing merchandise as well as the number of days occupied by a customer (Drury, 2007 ). In contrast, the service-based organizations systems focuses on activities required to provide each service based on each service's consumption of the activities. Using ABC, overhead costs are traced to products and services by identifying the resources.

Nonetheless, Service and non-service-based organizations differ in the analysis of production expense. In the analysis of production expense in the service-based organization, the demand for support comes from product volume mixes. In the service-based organizations, expenses are determined by differences in customers' specifications. The analysis takes in to consideration the expense structure of each department and examines factors creating demand for the performed activity by the department. Manufacturing-based organizations in contrast, adopt a cost- pull quantity based approach in costing goods that isolates consumption from value.

Manufacturing-based organizations also differ in the direct labor component with the service-based organizations. The dynamic manufacturing industry with newer technologies leads to reduction in direct labor component of production while increasing overhead costs. Direct labor and overhead accounts for a minimal percentage of the costs leading to product cost distortion because of assigning overhead costs to the goods based on direct labor hours used by each product. This leads to profit maximization from the mix of manufactured goods subject to limitations of availability of resources. The service-based organizations on the other hand, do not need to decrease labor costs to increase overhead costs, profit maximization is not practical of on the available resources.

The greatest obstacle in implementing ABC in service-based organization is the lack of appreciation for the benefits. Most organizations neglect the ABC because they find it complex and difficult to implement. This requires a systematic approach, which is tasking and time consuming. Installing the activity-based costing in an organization without implementation results in failure of the process. However, the manufacturing-based organizations find the implementation quite easy due to the associated advantages the process to the industry.

Are Mr. Zurunkel doubts concerning the current costing system reliability correct?

The general manager Mr. Robert Zurunkel's doubts concerning Crocargo logistics current system reliability are correct. He thought the company made all the necessary steps to get an edge over their competitors but not everything was working out well. He thought the costing system needed investigation to correct the situation. Mr. Zurunkel further requests the accountant Ms Heidi Clare to search for additional resources concerning logistics services costing system to help negotiate fair prices with clients and tender competitively for profitable contracts.

In case of a positive answer, discuss in detail which part of the company environment/processes might benefit from the information provided by the introduction of a new system and why?

The introduction of the new costing system proposed by Ms Sarah bellum is quite beneficial to all the departments within the organization and specifically the Operations, Accounting, and the Electronic Data Processing (EDP) departments.

The Crocargo logistics company though small, was providing several undifferentiated services and lacking a suitable information system. The costing system initiated by the accountant; Ms. Clare was to help in gaining profitable outcomes for the company. This costing system stipulated that the costs of managing a single parcel equaled the total operating costs divided by the total number of parcels handled. This system was not providing reliable operation information as was confirmed by the manager; Mr. Zurunkel.

As opposed to the former volume-based system incorporated by Crocargo Logistics, the new costing system initiated by Ms Bellum would guide the managers in finding best strategies to pursue in the future. This system is useful in organization's planning and costs management in all the aspects of the business from product designing to distribution. This method provides for realistic product cost information for financial reporting purposes besides providing a better understanding of the strategic linkages existing between the various cost areas in the organization. It additionally enables managers to have a holistic view of cost management.

The other benefit of the new costing system is that it provides accurate results as opposed to the former system; it determines the position of the company in the competitive business market. This accurate information best determines the company's optimal product mix and assists the management make clearer decisions, which may have a great effect on the success of a company.

The last benefit of the new costing method is that unlike the other method, which used a single pre-determined overhead rate to absorb indirect costs to products, the new system uses actual costs incurred to determine the product cost. By emphasizing the absorption process of indirect cost, this costing system provides more information to the management and helps find better ways to manage costs.

Does a costing system based on activities lead to a service cost more consistent with the new competitive environment?

A costing system based on activities resulted in the service sector costs to be consistent with the new competitive market. The costing system is increasingly becoming important to companies in markets that are becoming more competitive. This costing method is about cost management and it uses allows service companies to reduce and control costs in order to make the correct pricing and marketing decisions to increase profitability and competitiveness in the market. This is likely to become more prevalent within the service industry with changing competition.

The service firms are increasingly becoming interested in costing accurately to make long-term strategic decisions besides day-to-day operations plans. These accurate costs are important to make important product pricing, and allocate resources appropriately. The accurate costs, along with the quantity and patterns of resource consumption, let managers know the proper price to charge for services. However, the costing method is difficult to implement in service firms since employees often work on many projects in a day and for different amounts of time. This makes it hard to trace the resources used by cost objects.

Finally, the new costing system provides benefits based on volume-based costing in markets whereby biased cost allotments lead to accounting losses that may hinder learning from superior competitors. Compared to these informative settings, additional evidence also shows that performance is negatively affected by less informative market feedback. In informative settings, this costing system outperforms traditional costing because it helps to filter irrelevant competitor feedback from the decision process.

Given the evidence from the interviews conducted by Ms. Sarah Bellum, why would the activities that emerged from the analysis be appropriate for calculating a better cost for each service?