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 Activity Based Costing 
Management Accounting 
Sam O’Neill 
January 2018 
Part 1 
The evolution of Activity Based Costing dates back to the USA in 1980s. Two professors, Cooper and Kaplan realised that within some large US manufacturing firms, there was a great focus on activities and cost drivers, moving away from the traditional methods. Traditional costing methods assigned costs to products based on an average overhead rate. This method involves pooling all indirect costs in production and then equally applies these costs throughout the company using one appropriate cost driver, such as machine hours. Hayden, 2017. These companies had become frustrated and believed the traditional approach to appoint overhead costing was outdated. Cooper and Kaplan published papers and wrote case studies at Harvard University, documenting their findings. Cooper and Kaplan, 1988. 
Activity based costing is a method used in accounting which identifies the activities that a company performs. This allows for indirect costs to be assigned to the products they are producing. This type of system recognises the relationship that exists between costs, activities and products. It is a more logical approach compared with traditional methods as it enables indirect costs to be assigned to products with greater accuracy. Investopedia, 2018. 
Put simply, “Activity-based costing traces overhead costs to products by focusing on the activities that drive costs.” – Weetman, 2006. 
Activity-based cost management systems have evolved in response to significant changes in the competitive business environment faced by both service and manufacturing companies. 
Schnoebelen, 1993. These changes occurred as organisations were adapting and changing their nature. The nature of companies was changing from the traditional manufacturing companies producing physical, tangible products to the growing number of services being offered by companies as a result of the rise of the tertiary sector. This made it far more difficult to decide how to appropriately apportion costs as services offered can differ from customer to customer. This saw an increase in indirect costs related to changes in processes, novel ways of handling relationships with customers and increased investment in sophisticated operating systems. Drury, 2017. 
Increases in automation in production resulted in labour resources either being replaced or reallocated to different departments within the business. Greater importance was placed on fixed overhead costs, moving away from variable ones. This is because fixed cost overheads needed to be included in the product cost. It became obvious that production volumes no longer were the main drivers of overhead costs. This resulted in organisations seeking a costing system that was more realistic when it came to tracking the consumption of resources that gives rise to cost. Weetman, 2006. The overall objective of an activity-based cost management system is to improve the quality, content, relevance, and timing of cost information. In general, more managerial goals can be met with an activity-based system compared with a functional-based system. Schnoebelen, 1993. 
It must be acknowledged that assigning some costs can prove difficult through this method. Indirect costs which can be difficult to assign to a particular product produced include management or administrative staff salaries as these costs are not directly associated with a certain product produced. Activity based costing is usually implemented in large firms with 
the both the financial and labour resources to do so. It is also optimal for organisations for organisations who have intense competition who produce a diverse range of products, with each consuming varying levels of the organisations resources. Drury, 2017. 
According to Weetman in 2006, there are 5 main steps to implement Activity Based Costing within an organisation. 
1. Identify the major activities which take place in an organisation. – Perhaps it is a manufacturing company focusing on bottling. For example, the major activities would be bottling products, labelling and then shipping to a distributor. 
2. Identify the factors which most closely influence the cost of an activity. These factors are called the cost drivers and are a direct indication of how the activity demands cost. 
3. Create a cost pool for each activity and trace costs to cost pools. A cost pool is a grouping of individual cost items. Bhimani; Horngren; Data; Foster, 2008 
4. Calculate a cost driver rate as the total costs in a cost pool divided by the number of times that the activity occurs. 
5. Allocate costs to products using the demand for each activity 

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It can be seen that there are far more advantages than disadvantages when it comes to an organisation implementing an Activity Based Cost system. 

• It enables organisations to make better use of their resources as it highlights how resources are being used. In doing so, it results in companies making efficiency improvements where necessary. 
• Justifications can be made when additional resources are required as the current resources within the organisation are presented accurately and transparently. 
• Increased accountability in different departments which can identify gaps existing between resource usage and their priority. 
• It can take management accounting to a new level when we compare it to traditional methods where overheads were mainly focused on factory floor operations. Activity Based Costing takes into account all overhead costs, which include off-factory floor activities which are becoming increasingly important for organisations, such customer service and quality control. 
• Throughout the years the complexity of manufacturing has increased due to more complex production processes, increase in product ranges offered by organisations and shorter product life cycles. Through multiple cost drivers that Activity based costing lends to organisations, these cost drivers recognise the complexity that exists. CPA Australia, 2012. 
• It allows for management to make more accurate decisions on pricing and product mix. For example, it can help to identify correct selling price, by including all cost drivers. 


• It may prove necessary for companies who wish to use activity based costing in their organisation to employ more accountants to assist them with the implementation of ABC, which may increase the firm’s overall costs 
• According to Kaplan and Anderson (2004), implementing an Activity Based Cost system can be very time consuming. Collecting data for the system can be very time consuming 
• It can neglect smaller firms – the benefits of implementing ABC is sometimes less than the costs implementation as costs can be high and it is time consuming. Therefore, larger firms with more resources are the ones who benefit more from ABC. Garrison et al, 2014 

Part 2 
‘Activity based approaches have been implemented in many manufacturing organisations in an attempt to provide the true cost of products. The approach has little relevance in the service industry as product cost is not needed for stock valuation.’ 
I believe it would be correct to say that activity based costing methods have been implemented in many manufacturing organisations in an attempt to provide the true cost of products. However, I disagree that it has little relevance within the service industry. This would be in line with what Kaplan and Cooper said in 1998. They believed that service companies are ideal candidates for ABC, as most of the costs are indirect versus manufacturing companies costs are direct, and easily traceable for example, direct materials and direct labour needed for individual products. 
It is necessary to look at some real world examples to validate this statement. From reviewing a case study from Drury (2015), he discusses the implementation of ABC system in a Chinese manufacturing firm ‘Xu Ji Electric Co Ltd.’. This is a state owned enterprise manufacturing a variety of electrical products. Implementing an ABC system in this situation enabled the firm to trace labour costs directly to products and customer contracts obtained and allowed for them to allocate manufacturing overheads. In doing so, the firm was able to highlight different costs associated with production as well as seeing costs associated with selling the product, such as technical support, marketing and after sales services. In turn were able to see the true cost of products. 
I think it is important that we look at the real relevance and usefulness of implementing an ABC method in a service industry. 
In 2015, Drury highlighted ABC within the health sector. This is a service organisation which can be either publically or privately run and cost assignment usually proves difficult. There is a high level of indirect and support costs associated within the healthcare industry which can make it difficult to provide the true cost of the product or in this case the services they are providing. Using ABC in this situation means that the hospital can allocate indirect and support centre costs to products or services based on consumption of resources. 
For example, a patient requires three blood tests as part of a procedure. This would mean the three blood tests required three uses of some resources within the pathology department. In the case of another procedure, only one blood test is necessary, requiring only one use of the recourse in the pathology department, therefor implying a lower cost. The traditional absorption costing method which may allocate operating theatre hours, healthcare professionals salaries and so on to blood tests doesn’t give a true cost of the blood tests. By utilising ABC in this situation it gives a much more accurate way of providing the true cost of the blood tests, it is far more realistic at allocating costs to the procedure. 
Therefore, I would disagree with the statement that the approach has little relevance in the service industry as product cost is not needed for stock valuation. Although product cost is slightly different to that of a physical product produced, I believe that the product cost is needed in some way for stock valuation, in this case the blood tests. 
I think that implementing ABC within the service industry has more relevance than ever before. Service organisations may supply their resources in advance and are reliant on usage of the activity. Which can often fluctuate due to individual use. Using the traditional method, these costs were fixed and irrelevant for most decisions. Profitability analysis was not something that was thought to be relevant or helpful for decision making. The majority of service industries were either government owned monopolies or the environment in which they operated in was protected and highly regulated which resulted in no competition existing. There was no incentive to look at different costs to try and be more profitable. Drury, 2015. 
I believe today, as many of these government owned monopolies are now privately owned and regulations have loosed when entering particular industries. This has driven competition; as private company’s goals are to make a profit. Therefore, loss making or overly expensive, inference activities have been highlighted and stopped or optimized to make better use of the resources involved in the activities. 
Overall, I agree that activity based approaches have been implemented in many manufacturing organisations in an attempt to provide the true cost of products. 
But I disagree that the approach has little relevance in the service industry as product cost is not needed for stock valuation. The approach is relevant in the service industry, as each indirect costs are highlighted so that we can make more efficient use or eliminate these costs – driving profitability for companies operating in the service industry. 
Cooper, R,. & Kaplan, R. (1988). Measure Costs Right: Make the Right Decisions. Harvard Business Review 
Investopedia, (2018). Activity-Based Costing – ABC. Accessed at https://www.investopedia.com/terms/a/abc.asp 
Garrison, R,. Noreen E. & Brewer, P,. (2014). Managerial Accounting. 15th Edition. McGraw-Hill Higher Education. 
Weetman, Pauline. (2010) Management Accounting. 2nd Edition. Prentice Hall 
Saeid Bazrafshan; Behnam Karamshahi, (2017). Examining the Disadvantages of Activity Based Costing (ABC) System and Introducing the Modern (Behaviour Based Costing) (BBC) System. International Journal of Management, Accounting and Economics 
Management Accounting, CPA Australia, 2012 
Robert S. Kaplan, Steven R. Anderson. (2007). Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits 
Steven C. Schnoebelen, (1993). “Integrating an Advanced Cost Management System into Operating Systems (Part 1),” Journal of Cost Management 
Cooper, R,. & Kaplan, R,. (1991). Profit priorities from activity based costing, Harvard Business Review 
Hayden, A. (2017). Activity-Based vs. Traditional Costing, Intuit QuickBooks 
Drury, C. (2015) Management and Cost Accounting. 9th Edition. Cengage Learning. 


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