Activity Based Costing in Manufacturing Industry

The rapid changes in the business environment (macro environment) and the development in the information technology forced organizations to change their communication, collection, measurement and data analysis.These necessitated organizations to bring in necessary changes in management accounting (Burns and Vaivio 2001). The modern business enterprises find Activity-Based Costing (ABC) as an improved costing system by which the problem of large number of indirect costs and their allocation problem can be overcome.

It has been observed that ABC method is the most sought after innovation in the field of management accounting in the last two decades. The method was originated in the Unites States of America during the 1980s as an improved system to enable better cost allocation by means of classification of more costs as direct (Cooper and Kaplan, 1988).Activity-Based costing systemThe development of ABCThe costing system that initially preferred labor productivity adopted traditional costing and now it is based on the production level and allocation of overhead costs as percentage of direct labor cost. But its reliability was much less due to increase in overhead cost and reduction in direct labor cost.This resulted in distorted cost prediction and poor strategic decision making (Johnson and Kaplan, 1987). So business concerns adopted manufacturing concepts such as Just-In-Time (JIT), Total Quality Management (TQM), Information System (IT) and so on for attaining the objective of maximization of profit through minimization of cost.

It is advisable to a firm to change its variable cost to fixed overhead because of changing nature of organization,  changing production process relate to increase in indirect costs, new ways of dealing with the consumers, the new investment in more complicated operation system and so on (Innes and Mitchell 1995). So the concept of Activity-based costing (ABC) was adopted which suit the increasing would overhead cost.How Different ABC is from TCSThe experts argue that TCS focus more on direct labor hour, machine hours etc. to allocate indirect costs to products in order to correlate the volume of resources with number of units produced for each product without caring the items like material handling, material procurement, performing set-ups, production scheduling and inspection activities will lead to under estimation of cost (Brimson 1998).Although TCS could perform well when there is limited number of items and the proportion of direct material and labor were large, and overhead proportion was small, this inappropriate allocation led to failure. So the ABC could be applied when there are unlimited products and there is much proportion of overheads than direct costs.

It is further found that ABC focuses more on tracing the overheads than allocation. Of course, TCS has been advocated on being simple and economical for any organization, however the present day competitive business setting has no room for old tools which may not be good enough to support strategic decision-making.Traditional costing system emphasizes the use of volume-related measures like direct labor hour or machine hours to allocate overheads to products. The traditional system correlates resources consumed with the units produced. The resources consumed are measured in relation to the units produced for each product.The most basic drawback of this system is that it does not take into consideration the non-volume related activities.

These include activities like material handling, material procurement, performing set-ups, and production scheduling and inspection activities. Since    resources are related to their production volumes, it results in distorted product costs or under estimated cost.The traditional costing systems were formulated years ago, when most organizations had a narrow range of manufactured products and as a result, the direct labor and material expenses were the dominant factory cost. The volume of overhead cost was very small and even if there was some inappropriate allocation, the variations were insignificant.

Organizations of the contemporary era produce a wide range of products and as a result, the Prime Costs (Direct expense) lost its importance and overhead costs become more prominent. The intense global competition made correct cost information vital which resulted in the genesis of ABC.Advantage and Disadvantage of ABCAdvantageEven though the TCS is economical and easy to implement, it leads to distorted cost (Mishra and Vaysman, 2001) which affects the company in setting the right price for its product, which in turn result in failure. So it is appropriate to adopt ABC that enables them to take sound decisions with regard to product cost which facilitates to earn maximum profit.According to Procter (2002), ABC facilitates in the company in determining accurate product cost by withdrawing unnecessary items in product line which can lead to cost control and increase their profitability.

Even though ABC is expensive to implement than TCS, the improved and cheaper information technology made product cost calculation easier (Gunasekaran et al., 1999). But the Proctor (2002) recommends that it is quite economical to adopt TCS in spite of its frequent cost errors.The cheaper information technology affects the cost effectiveness of ABC i.e.

it decreases the operating costs and increases the effectiveness of organization.The ABC system can also be widely  applied in stock valuation, product or service pricing, output decisions, cost reduction, value added analysis, activity mapping, new product or service design, consumer profitability analysis, performance measurement, cost modeling and budgeting (Innes and Mitchell 1995).DisadvantageThere are different criticisms given by distinguished personals, in the context of Gunasekaran et al. (1999) ABC requires maximum involvement of resources such as man hours, capital and equipment and more employees and also the implementing of ABC results in production loss, factory floor blockage and lack of participation.According to Weetman (2006), ABC cannot be practically applied to provide accurate result due to lack of inappropriate allocation as written in ABC scheme, even though it provides reliable cost information and suggest that ABC can be successfully applied when there is accounting records, structured coding system and a systematic following of cost behavior principles, but these requires huge investment cost.

Kaplan and Anderson (2003) claims that ABC cannot be applied in forward decision making because of depend upon past data and also points out that there can also be chance of bias in the cost data or negative attitude from employees, moreover it new line.Mishra and Vaysman (2001) claims that the success of ABC depends upon incentives and informational aspects of manager i.e., the firm can earn high profit when uncertainty of information is high which is just opposite to TCS model.The current state of ABCABC in practiceAs per Better Management survey of 528 companies covering different industries in using ABC according to their size; 34% are adopting it greatly, 20% are piloting and 32% are likely to use it more (See Appendix 1). It is predicted that, usage of ABC was less by manufacturing industry compared to other industries dealing in communication and financial services.

  (See Appendix 2)Time-Driven Activity-Based CostingThe new alternative approach “Time-Driven Activity-Based Costing” was introduced to overcome the limitation of ABC model such as process and resource expenditure transform, adding of new product line and increasing complexity of industry, which uses only unit cost of supplying capacity and the time need to complete an activity (Kaplan and Anderson 2003).It possesses many advantages like projected and installed capacity, easy to format process change, conformity in estimation of unit times, easy to handle number of transactions, visibility to process efficiencies and capacity operation and is able to predict future resource demands. It also acts as a major tool in providing cheaper, accurate and enforceable information.ConclusionIt is seen that the improvement in information technology has led to significant development in accounting management theory.

One of such theory is Activity-Based Costing (ABC) which provide number of benefits, the important among are reduction in direct labor cost, avoided distorted cost, sound decision making by managers by accurate measurement of product cost and appropriate allocation of overheads.At the same time it has defects such as expensive and time consuming, depends on historical data and difficult to update changing process, etc (Kaplan and Anderson, 2003).Hence ABM by using ABC information in strategic decision making such as pricing and product-mixing, cost reduction and process improvement and product design which will help to improve the overall efficiency of company. There is yet another alternative approach ‘Time-Driven Activity-Based Costing’ which is quite cheaper, easier and effective compared to ABC as propagated by Kaplan and Anderson (2003).ReferencesBrimson J A (1998), Feature Costing: Beyond ABC, Journal of Cost Management, January-February, pp. 6-12Burns, J.

and Vaivio, J. (2001), Management accounting change, Management Accounting Research, 12, 389-402, Retrieved 8th June, 2009, from http://www.sciencedirect.comCooper R and Kaplan R S (1988), Measure Costs Right: Make the Right Decisions, Harvard Business Review, September-October, pp.

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