Activity Based Costing (ABC).

Activity Based Costing (ABC).

Introduction

Accounting has always been a fundamental part of any business. It seeks to determine the profitability of a business by ensuring that all entries are posted at the right place so as to give a clear idea or picture of the position of the company. Needless to say, there exist various modes of accounting and assigning costs and expenses. These modes have continued evolving, with some accounting methods being relegated to the periphery and some new modes coming up as a reflection of the growth that the field has been experiencing. Nevertheless, one of the most popular methods of accounting is Activity Based Costing (ABC).

ABC refers to a methodology of costing that is mainly used to directly mark overhead costs to costs, thereby assisting managers in making the appropriate decisions pertaining to the product mix, as well as competitive strategies to use. The methodology can drastically alter the way in which managers price their products, determine their product line’s mix, evaluate new technology or identify sourcing components’ location (Narasimhan & Thampy, 2002, pp. 99). The use of this technique has been rising steadily as far as enhancing the accuracy of information pertaining to product cost is concerned (Drury, 2006, pp. 362). Traditional costing methods are known to allocate overhead costs in an arbitrary manner, often on the basis of direct labor hours (Yin, 2009, pp. 48). It is worth noting, however, that direct labor hours are not usually an adequate representation of the percentage indirect resources that certain cost objects may have consumed within a certain period. This, therefore, breeds distortion of product cost. Nevertheless, ABC technique solves this problem by examining the manufacturing system as being made up of activities. The technique allocates the activities’ costs to the cost objects via utilization of cost drivers that embody the use of indirect resources through cost objects, in a more accurate manner that the arbitrary methods used by traditional costing methods.

This system allocates costs to activities on the basis of their utilization of those resources and allocates costs to objects on the basis of their utilization of the activities (Viavio, 2008, pp. 67). The technique has been depicted as a full-absorption method of costing that has gained more use than conventional methods, thanks to its incredible tracing of costs, as well as an accurate assessment of costs (Viavio, 2008, pp. 67). It allows organizations to follow costs that are associated with activities carried out to deliver services or produce products. It is not merely a new set of techniques or rules for allocating overheads to value inventory rather it underlines a way of looking at operating costs, and offers techniques to divide the underlying activities that result in the existence of the costs (Turney, 1996, pp. 33).

This technique of accounting has varied benefits. First, the technique allows for scientific and equitable pricing of products that utilize less activity resources, as well as increase the cost of products that use more of the activity resources of a firm (Popesko, 2010, pp 13). In addition, it assists organizations to offer top-ups or value-added services to the existing products based on the actual costs incurred. Third, the technique is known to get rid of unprofitable items from the line of production, in which case it increases the profitability of an organization without increasing the prices (Drury, 2006, pp. 362). This comes as a valuable option especially during times of recession. On the same note, it allows for the elimination of the cost of running or maintaining non-remunerative activities, something that increases the overall profitability of the organization (Cowton et al, 2008). This technique also allows for the allocation of resources to items that utilize fewer resources or profitable items. In addition, it safeguards compatibility with scorecards of performance management through revealing the contribution of every person to the cost of the products, and, therefore, the profits accruing to every person (Partanen, 2000, pp 134). The technique has been cited as effective in exposing inefficiency and waste thereby productivity. In addition, it allows for the identification, as well as the elimination of non-value adding activities such as duplicate processes and needless inspections.

According to Stratton et al (2009, pp. 31), the technique, however, has been giving significantly less than the desired yields. ABC technique has been abandoned by most companies, which cite the fact that it does not capture the intricacy of their operations (Partanen, 2000, pp 134). In addition, it takes significantly long to implement and is costly to build, as well as maintain (Kulmala, 2002, pp 37). On the same note, other companies have criticized it as impractical as it mainly involved the definition of activities and attempting to make a subjective judgment on the amount of overhead that has been used (Dandago, 2003, pp. 53). This had to be carried out on a regular basis, in which case companies relegated it to the periphery and adopted other techniques. This led to the drop of the technique to the 22nd position from 11th position in a period of seven years (Stratton et al, 2009. Pp. 31).

In spite of the negative reports pertaining to the utility of ABC, there are numerous case studies and reports of companies and organizations that incorporate ABC techniques and even reported satisfaction. These include DB Schenker AB (Austria), AstraZeneca AB (London) NCC Construction AB (Nordic Region), and Indian companies.

DB Schenker

DB Schenker is a leading passengers and Logistics organization based in Vienna Austria. It offers its customers with solutions for logistic services in air, rail and road transport, as well as storage and consulting services (http://www.schenker.at/english/company/history.html). In a 2007 interview with its chief accountant named Jan Saarsoo, it was revealed that the working method of the company mainly revolves around delivering items from one point to another, operations that would not be considered complex. Schenker mainly involves direct costs, which make up the largest part of the company’s total cost as the company rents equipment that is used in carrying out the duties from lumpers. The company makes use of standard cost so as to estimate the amount of expenses that should be incurred in carrying out a certain service (Majid & Sulaiman 2008, pp. 47). Mr. Saarso states that the company’s expenditure mainly results from resource consumption. As much as the traditional methods of cost allocation were serving the company in a satisfactory manner, they were unreliable in decision making decisions. The company applied ABC in the form of a project so as to evaluate the amount of expenses that went in carrying out a certain order. This was done in 2006 as a project rather than a full implementation of the model. The company observed that the model was effective in the provision of information pertaining to the consumption of resources, as well as the expenses that go to the production of an output. In addition, the ABC model has come in handy as a communication tool where the company communicates with employees in clarifying the amount of any service activity would cost to carry out.  The company also noted that the ABC model was an effective tool for communicating when negotiating with customers as it gives a clear view of the amount of material, money and time consumed by an activity. On the same note, the company realized that it had been carrying out some activities for free, whereas it was paying for the same activities (Majid & Sulaiman 2008, pp. 47). However, the model presented a number of challenges for the company. For example, the company could not update the model, thanks to its resource and time commitment, as well as its complexity. The company considered the numerical data as challenging to align in the appropriate manner.

AstraZeneca AB (Sweden)

AstraZeneca Company was established through the amalgamation of two large companies that dealt with pharmaceuticals, which were British Zeneca Group and Swedish Astra. The two companies are known for their developments and innovations in the pharmaceutical industry, as well as their science-based cultures and vision (http://www.astrazeneca.com/About-Us). The company produces different products extending from syringe to pastille, the manufacture of which demands machines of varied types. It is worth noting that there are variations in the products of the company from one country to another, which makes the process complex. According to Eva Markstrom, the company’s process manager, direct costs make up the largest percentage or component of the total cost of the company and are only incorporated in the process of manufacture. Other costs considered direct include marketing and energy (Cowton et al, 2008, pp. 27). The company sets the products’ prices in line with the manufacturing costs, thereby making it independent of the prices in the market. ABC makes up the key cost system in Astra Zeneca. The production of a single process involves about 9-10 activities. The fundamental reason for using the ABC model is that it allows every product to bear its own expenses. In essence, the model is mainly used in making decisions pertaining to products including product outsourcing and setting prices of products. In some instances, for example, it is less costly to purchase components of a certain product than to manufacture it, in which case the model supports these decisions thereby.............