Activity-Based Costing

The Activity-Based Costing (ABC) methodology was first introduced by (Cooper and Kaplan, 1987) as a more efficient way of costing compared with the traditional accounting methods. A comparison of ABC and the known traditional cost accounting methods was done by (Park and Kim, 1995). Their research claims that the main advantage of ABC is its ability to more accurately reflect indirect costs of different products. However, (Park and Kim, 1995) concluded that it takes more effort in obtaining accurate information concerning the consumption of resources at each activity of a process and their cost driver rates. Lewis (Lewis, 1993) came up with a

definition for ABC as: “a method for accumulating product cost by determining all cost associated with the activities required to produce the output”. More critical, (Lewis, 1993) spotted two differences between ABC system and the traditional system; firstly, cost pools are defined as activities rather than production cost centres and secondly, the cost drivers used to assign activity costs are structurally different from those used in traditional cost systems. ABC gained popularity over the years due to dissatisfaction with the distortions created by traditional costing systems and has a wide usage both with accounting academics and in business practice (Cooper and

Kaplan, 1987). According to (Turney, 1991), ABC model consists of a ‘cost

assignment view’ and a ‘process view’ which has ‘activities’ in between the two views. In the cost assignment view, information on resources, activities, and cost objects are provided whiles the process view gives both non-financial and financial information regarding cost drivers and key performance measures and indicators for each activity or process. The consumption of resources by products based on ABC could be analysed by modelling the causal relationship between products and resources used during a production process. ABC then gives a good understanding of process activities that demands costs as well as providing more accurate cost information on products to help in decision making (Cooper, 1988). Figure 2.2 shows the components of the ABC model, showing the relationship between cost objects, resources, resource drivers, activity drivers, activity elements, activity cost drivers and activity centre.

Figure 2. 2: Activity Based Costing Model (Turney, 1996) 2.1.2.1 Activity Based Costing in Manufacturing

ABC analysis model was developed and used by (Tseng and Jiang, 2000) to help in evaluating the different manufacturing costs for multiple feature-based machining methods, restricting the shape of the part to prismatic parts and prismatic features suitable for machining on 3-axis milling centre. Tornberg (Tornberg et al., 2002) also combined ABC and process modelling for the evaluation of various design options in cost. In their research, they modelled processes using graphical flowcharts form design, purchase, to manufacturing. For design and development activities for machining rotational parts, (David Ben-Arieh, 2003) adopted activity based costing technique for cost evaluation. ABC methodology was adopted and used in push and pull manufacturing systems for the estimation of manufacturing and production cost where the two systems were compared to verify their effects on cost (Özbayrak et al., 2004). A product cost-estimation framework was proposed by (Park and Simpson, 2005) in support of product family design based on ABC consisting of three phases: allocation, estimation and analysis. Other research also suggests the combination of ABC with two or more approaches for quicker and more accurate cost estimation (Niazi et al., 2006), (Tornberg et al., 2002). According to (Gunasekaran and Sarhadi, 1998), new concepts in manufacturing technologies including design for quality, design for production and design for distribution which aims at eliminating the non-

value-adding activities in processes has their roots from ABC methodology. The implementation of ABC method of costing is confirmed in five different firms in Finland ranging from metal and engineering to food industries. The research looked into the following: (i) the reasons why the companies wanted to implement ABC, (ii) the cost drivers for different manufacturing environments, (iii) the implementation issues including behavioural and managerial aspects, and (iv) the results obtained from the implementation of ABC (Gunasekaran and Sarhadi, 1998).

A research conducted by (David Ben-Arieh, 2003) adopted and modified (Cooper and Kaplan, 1999) ABC model, stating the implementation process of the activity based costing methodology. According to them, the implementation follows the following steps:

i) Identify cost centres

ii) Analyse indirect costs and calculate their cost-drivers rates

iii) Assign resources to each cost centre and determine cost centre driver rates

iv) Identify activities

v) Analyse each activity and find the total cost for each activity

vi) Define activity drivers for each activity and find activity cost-driver rate

vii) Estimate the cost of new parts via activity cost-drivers spent

Limitations of ABC - Limitations of the ABC technique noted by (Roy, 2003) are: it

is time-consuming when properly implemented and it is expensive to implement and operate in an entire company. Other disadvantages identified using ABC its difficulty in making it the only costing method. Allocation of overhead cost is complicated and requires experienced personnel. Jawahar (2009) also mentioned that due to the numerous cost pools and multiple cost drivers of ABC systems, its use of may be more complicated when compared with the traditional product costing systems. Due to the complexities involved in the use of ABC systems, Saxena, et al, (2010) is of the view that more time is needed for the analysis of the activities taking place in the activity centres, tracing of cost to activities and determining of cost drivers.