Financial and Managerial Accounting Activity-Based

Financial and Managerial Accounting

Activity-Based Costing

The past century has been tormented by multiple modifications, affecting all features of the every day life. In the corporate sector, issues such as globalization and market liberalization have led to an internationalization of the run operations. And in order to cope with the emergent features and requirements, multinationals have also been striving to develop and implement more efficient and effective accounting systems. These new systems had to allow better communication, increased chances for corporate profits, and most importantly, cost reductions. In addition, they are also aimed to reduce the times of product development and ensure a more efficient management of the incurred risks.

A solution that has been promoted to resolving the issues at hand is the implementation of the ABC - "a product costing technique that has gained attention. Activity-Based Costing is a method of measuring the cost and performance of activities and cost objects. It assigns costs to activities based on their consumption of resources and then allocates costs to cost objects based on their required activities. The focus of ABC is on accurate information about the true cost of products, services, processes, activities, distribution channels, customer segments, contracts and projects" (Gunasekaran, Williams and McGaughey, 2005). Activity-Based Costing is a helpful means of identifying problems as well as opportunities. It also helps in further resolving the identified issues or seizing the opportunities. The reason why ABC is able to meet the above stated desiderates is the fact that it presents both financial and non-financial data on the corporate activities and the cost objects.

2. ABC and Traditional Methods of Tackling Overhead Apportionment

Activity-Based Costing is often used as a means to apportion overheads, and it does present some differences relative to other and more traditional accounting systems. Overheads basically refer to the indirect costs incurred by an organization (on daily basis) and can be more specifically named in terms of "indirect materials, indirect employee costs and indirect expenses which are not directly identifiable or allocable to a cost object in an economically feasible way" (Northern India Regional Council, 2004). Basically, overhead costs integrate all costs on the balance sheet, aside from the direct material and direct labor costs (Hauff, 2008).

The traditional methods include the overhead costs into a single category, whereas the Activity-Based Costing method divides overhead into a multitude of subcategories. "Activity-Based Costing (ABC) is a method for developing cost estimates in which the project is subdivided into discrete, quantifiable activities or a work unit. The activity must be definable where productivity can be measured in units (e.g., number of samples vs. manhours). After the project is broken into its activities, a cost estimate is prepared for each activity. These individual cost estimates will contain all labor, materials, equipment, and subcontracting costs, including overhead, for each activity" (United States Department of Energy).

In other words, Activity-Based Costing organizes the indirect costs in more categories that the traditional systems. The latter simply use machine hours to achieve the apportionment of the overheads. To best understand the mechanism, take the example of two items manufactured by the same organization. The first is a low volume product, which requires increased attention, numerous tests and machine start-ups, as well as special design and engineering. The second item is a high volume one, which is manufactured on continuous basis and requires less attention. By using the traditional systems, the organization would allocate the overhead in terms of machine hours. This ten means that the first product, despite the increased efforts, would register a low overhead as it has consumed few machine hours. The second item on the other hand, despite the little efforts and attention required, would be allocated enormous amounts of indirect costs. As a result then, the true costs of manufacturing the two items would be wrongfully calculated. With ABC however, this would not happen. "Activity-based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine" (Accounting Coach, 2008). The modern system will also consider design, engineering, testing, machine start-ups and other features and efforts which consumer company resources. It will then allocate overhead according to the resources consumed and costs incurred at each stage. Finally, these calculi would only be applied to the products which required the additional efforts. For instance, the low volume item would be allocated the design, engineering and testing costs, whereas the high volume product would only be assigned the machine costs (Accounting Coach, 2008).

In a more simplistic formulation, ABC allows manufacturers to better allocate indirect costs to various products and as such be better able to set their prices. Another difference between the traditional systems and ABC resides in the procedures followed in their implementation. They can be succinctly presented as follows:

Traditional methods:

Cost centres are identified and established within the organisation

Cost centres may be producing or service centres

Wherever possible a direct charge is made to a cost centre ie allocated overhead

Where overhead is jointly incurred it is apportioned to the cost centres on an equitable base

The overhead cost for the service centre is then transferred to producing centres

The total overhead cost for each producing centre is then divided by for example, machine or labour hours per the cost centre

An overhead recovery rate results

This is then used to absorb the overhead to products

If planned activity levels are actually achieved then overhead may be fully recovered in the short run" (Dunn, 2003)

Activity-Based Costing:

accounting for and collection of overhead allocation of overhead to form cost pools associated with 'value adding' activities identification of cost drivers determination of cost driver rates ie: pool / driver volume recovery and charging of overhead to product / service based upon the demand for the activity" (Dunn, 2003)

3. ABC, Decision Making and Process Control

As it has been previously established, Activity-Based Costing has the primary advantage of a better allocation of the overhead expenditure. This has numerous implications upon the organization, such as giving it the ability to better calculate the price, the amortisation or other components of overhead. Also, it supports the manufacturer in making more informed decisions, better delegating the process of decision making and ultimately, better monitoring and controlling the organizational processes.

Relative to the connection that Activity-Based Costing has with decision making, Gavril Salvendy (2001) states: "Armed with more accurate product cost information, managers can contemplate improved strategic decisions on product lines, product prices, capital expenditures, and organizational performance. That is why the application of ABC is referred to as activity-based management."

Robert Kaplan and Robin Cooper (1998) believe that most of the contemporaneous organizations have reached a third stage of development in terms of their implemented accounting systems. The first stage revolved around a poor and inefficient accounting system. The second stage revolved around an accounting system that looked at the external data. Finally, the third stage sees the implementation of systems which also look at the internal forces, such as the overhead apportionment dealt with by the Activity-Based Costing system. By being therefore better able to analyze the internal forces, costs, capabilities and limitations, managers are able to make better informed decisions. Ergo, ABC is a tool for more informed decision making.

To better understand how Activity-Based Costing influences managerial decisions, one should look at a real life example. This has been offered by Chellasamy and Ligy (2008) and they present how simple allocation and ABC method could lead to different results, leading as such the manager to wrongful, or at least different, decisions. The organization presented is analyzing its performances in terms of three customer channels: store, catalog and the internet. In the case of Simple Allocation, the company considers the accounting, marketing, information technology and call center costs as overhead based on the number of customers in each of the three channels. The table below shows how the Simple Allocation would calculate the performances of the customer channels:

Store

Catalog

Internet

Revenue

Number of Customers

Cost per Customer

Call-Center Costs

Net Revenue

Margin

Source: Chellasamy and Ligy, 2008

The results indicate that all three internet, catalog and store channels are registering good performances. Given that the catalog and the internet have retrieved the highest scores, further investing in them would be the obvious decision.

The ABC analysis of the costs would however lead to different conclusions. It would be based on the number of incoming calls that each channel generates, or the resources consumed by each channel. The table below shows how it would assess the performances of the three customer channels:

Store

Catalog

Internet

Revenue

Number of Calls

Cost Per Call

Call-Center Costs

Net Revenue

Margin

Source: Chellasamy and Ligy, 2008

Using the Activity-Based Costing system, the manager of the organization would realize that despite an immense usage of resources, the catalog channel is less profitable than the internet and the store channels. The consequent decision then, would be to increase the profitability and efficiency of the catalog channel, rather than further invest in it and achieve increased resource consumption without any real profit (Chellasamy and Ligy, 2008).

The applicability of Activity-Based Costing for decision making is directly linked to the influences that ABC has over process control. In this order of ideas, by better identifying the incurred costs or the overhead, managers can better monitor and control the evolution of products, prices, costs and consequently, profits. ABC identifies the costs incurred by each item in terms of resources consumed. Therefore, with the aid of ABC, organizational managements have the ability to control resource allocation.

Activity-Based Costing reveals yet another significant feature: it has the ability to evaluate the costs of not producing an item. This basically means that with the aid of the ABC, managers are able to know how much they have lost due to machine malfunctioning, product damaging, increased inventory costs or time spent waiting for a machine component to be replaced. "Activity-Based Costing therefore gives not only much better cost control, but increasingly, it also gives result control" (Drucker, 2006).

4. Systems of Control within Organizations

As established by Kaplan and Cooper, organizations can be qualified in terms of their implemented control systems. Vicxo Software currently finds itself at the border of the second and third stages. In other words, it used to implement a control system based on revealing the features of the external environment. More recently however, they have understood the need for an internal control system as well and they are now striving to implement it.

The company discussed hereby activates in the it industry, with focus on developing software applications. Most of their contracts are signed with international partners and they have successfully collaborated with Ford Motors Corp, General Electric or UPC. The organization employs 170 staff members, out of which 120 are developers and testers. The remaining 50 individuals hold administrative positions, such as management, accounting or human resource. The 50 individuals which do not write code, and therefore do not register profitability, can be considered as generators of overhead expenditures.

The control system implemented by Vicxo Software is a strategic one, in the meaning that it focuses on the development of those strategies which will support the organization in reaching its overall goals. "Strategic control focuses on the dual question of whether: (1) the strategy is being implemented as planned; and (2) the results produced by the strategy are those intended. The basic criteria used to answer these questions are derived from: (1) the strategy and action plans developed to implement strategy; and (2) the performance results that strategy is expected to produce. If a deviation occurs, then feedback takes place and the strategic management process recycles" (Schendel and Hofer, 1979).

This type of control system is a more traditional one and it is based on three stages: first of all, the management at Vicxo Software develops the strategy; secondly, they implement it, and thirdly, they evaluate the results. They generically base their conclusions of review and feedback, which is not always the most favourable course of action. To better explain, feedback comes only after the strategy has been implemented and the results retrieved. It may then be too late to readjust the strategy to better meet the organizational demands of Vicxo Software. Also, this type of control considers numerous standards, which are taken for granted (Barnat, 2005). As a result, any deviations which might incur are likely to pose significant threats on the beneficial outcome of the implemented strategy.

5. Objectives of the System of Control

Vicxo Software aims to establish itself as an organizational leader in the field of information technology. They strive to achieve this desiderate by developing and implementing the most suitable strategies. In developing these strategies however, they must place an increased emphasis on the forces that affect the organization from both internal and external environments. This then means that the control system they are striving to implement is the appropriate course of action. Foremost, the strategic control system is dually implemented, in the meaning that it develops both business as well as it strategies which are aimed to support the company in reaching its established desiderates. Consequently, the goals of the control system are divided among the it and the administrative sectors.

The organizational goals that Vicxo Software hopes to meet through the implementation of the strategic control system are met at varying degrees and can be succinctly presented as follows:

IT Objectives of the Control System

Ensuring a better communication between developers and testers - has been achieved with the aid of a controlled corporate culture

Reducing errors in programming - has been limitedly achieved; a better control of the staff members increases their focus and attention, but also causes stress, leading as such to other errors

Increasing operational efficiency - this has yet to be fully achieved. The management has insisted on increasing the amounts of work performed within the same period of time, rather than ensuring that the quality of the tasks performed is increased

Achieving a better internal control over developers and testers - this has been achieved as the control system allowed managers to identify the amounts of time spent on productive work, procrastination and the performances registered by each employee

Business Objectives of the Control System

Reducing operational costs - this has been achieved, but the cost was that of letting some employees go and suffering the consequences of reduced employee morale