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Introduction:
The paper has been formulated in order to determine the basic differences that are
present between the activity based costing (ABC) and conventional methods of costing
that are used around the world. A large number of companies have converted to the ABC
system since as far back as 1980 as the system has shown its usability in the appropriate
product mix decision, overheads management etc. (Roztocki 2000) (Reyhanoglu 2004)
The work of many renowned authors have proven to be the crux of the
formulation of this research with sources being as diverse as textbooks and article portals
to renowned journals like the Journal of Accountancy etc. This point is further elucidated
by a scenario study based on the motor vehicle industry which has helped to put things
into numbers and provide a different perspective on the matter. (Reyhanoglu 2004)
Objective:
The objective of this paper is simple to try and uncover whether ABC system is
the best practice in accounting for manufacturing concerns like motor vehicle and parts
industry and whether it is able to cater to problems that are faced by industries employing
conventional costing systems. To achieve this objective, I need to first review the
shortcomings of traditional absorption costing and how ABC can help overcome those
expect to find these concepts through literature review. Some papers and articles with
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case studies would be a good source for the empirical side. And I aim to mathematically
absorption costing and how ABC can help overcome those shortcomings, which can be
derived from a conceptual and empirical perspective. We expect to find these concepts
through literature review. Some papers and articles with case studies would be a good
source for the empirical side. We shall come to a conclusion that ABC generally yields a
costing, better represent the consumption of shared resources by the firm’s products,
customers and service offerings. Evaluated in light of these new activity-based costs,
making when calculated under traditional absorption costing. This information may
enable a firm to change the mix of products produced. The firm may divest the loss-
evaluating the results under the traditional costing method and ABC. In order to make
feasibility of introduction, pricing strategy should not be ignored. Discussion will also be
spent in this area, the details of which can be derived from the site visits, management
interviews and study of accounting system and cycle. We aim to obtain some raw data
inputs for applying the concepts we found previously from literature review.
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Background:
In the People’s Republic of China, the demand for motor vehicles and related
products such as tyre has been increasing over the last few years. However, the profit
Traditionally in the United States or in the United Kingdom, all the expenses were
allocated to the product based on the volume, such as working hours, machine hours, or
number of units produced. ABC was first introduced in the works of John Deere (March
and Kaplan, 1987). In this newly distribution system, costs, products and components
will be allocated by the use of activities, such as set-up time and the number of load
distribution relating to the establishment and material handling. The new system proved
that products cost less in the mass production of small batch processing, compared with
that is required to produce individual units in order to process batch of a product design
or maintenance and maintain a manufacturing facility up and running. Robin Cooper and
Robert Kaplan have presented their views in the ABC system design and implementation.
They also outlined the potential benefits of ABC system in their studies (Cooper and
wish to ascertain if it is a good approach for Tyre Manufacturing Industry. For example,
the profitability of Sumitomo Rubber Industry (SRI), a tyre manufacturing company and
one of the famous giants in the industry, has been reducing over the past decade. A recent
case study concluded that apart from the pricing strategy, SRI should focus and adopt a
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more positive accounting approach, such as ABC, in order to maintain sales and
profitability.
Variable overhead includes such elements as supplies, minor parts, and a portion
supervisory labor, rent, insurance, and a portion of electricity or other power sources.
There is no problem with identifying the variable elements (direct materials, direct labor,
and variable overhead) with the product. In fact, when we produce another unit, we incur
addition variable costs. The problem is in the application of the fixed overhead to the
product. However, financial accounting rules require us to include a portion of that fixed
cost in each unit of product. This process is called unitizing fixed costs.
This is a dumb and stupid rule. The unitization of fixed costs treats these costs as
variable even though they are fixed. Thus, when we make decisions concerning products
when fixed costs have been unitized, we are assuming that total fixed costs will change as
the activity level changes and, in fact, those costs do not change. This makes contribution
Now, let's look at how traditional fixed overhead is added to the product. In the
slide presentation below, the variable costs (direct materials, direct labor, and variable
overhead) have already been assigned to the product. The costs incurred refer only to the
fixed costs that must be allocated to the product. Note the three steps. In the first step, we
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must decide which costs are to be allocated and to which product. This is the definition of
the cost pool. Next the fixed costs are identified and assigned to the cost pool.
Now comes the controversial part. Assume that we have examined the costs and we
decide that direct labor hours (DHL) is to be used for the allocation. Further, assume that
we incurred $120,000 of fixed costs and we estimate we will use 10,000 DHL for the
period. Therefore, we arbitrarily decide to apply (allocate) fixed overhead to the product
at the rate of $12 per DHL. This is the process of unitizing these fixed costs.
activities instead of cost pools. There is a careful analysis of the process to define the
appropriate activities and then a cost driver (allocation method) is selected to allocate
these costs to the product. Now, consider the impact of this change. By defining these
fixed costs within activities, the behavior of the cost has been redefined. Costs that were
previously defined as fixed now are actually treated as variable. In fact, the previous
classification of fixed was inappropriate and the costs are now properly treated as
variable costs. This is the primary (but frequently unrecognized) value of ABC inventory
valuation.
It is important to note that all of the costs previously classified as fixed will be
identified with such an activity. A portion (sometimes a major portion) of costs will
remain in the fixed category and will be treated in the traditional method. The advantage
of ABC is that a portion of costs previously classified as fixed are, in reality, variable and
In this illustration we have the same costs and products as in the traditional
illustration. In step 1, we identify three activities for which costs can be segregated - the
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ordering, cutting, and painting activities. In step 2, we identify that portion of the
previous cost pool costs that are associated with each of these activities. In step 3, we
develop individual cost drivers for each activity and assign the costs based on the activity
incurred by each product. The result is that a significant portion of the costs are now
allocated to the products on the basis of the activities generated by those products.
• The first and most important advantage is the accuracy in the process of costing
with regards to the product line, the end-users of the product, the stock-keeping
units employed by the management and the channel and category which
streamline the flow of the product from the producer to the end user.
• This system better assists in the process of understanding the concept of overhead
costs i.e. the allocation of common business resources as they are used by
• This process uses unitary cost, or marginal cost as the computation base in
contrast to the traditional cost accounting methods which employ total cost.
• The system works exceptionally well will quality improvement and up gradation
matters business activities which are a burden or stress on the business i.e.
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• The system also works exceptionally with performance management systems
businesses.
diagonal of the firm as business processes, supply chains and value addition
• This system mimics the actual business process as the appropriation of common
pool resources takes place in the same way as common resources are used in the
business.
• The capital expenditure on the activity based system and its subsequent running
• The system is very transparent which some managers would not approve of as
they would like to keep some things out of the view of the owners of the
company.
Technical Limitations:
The major technical limitation that will be faced is testing the hypothesis in the
real world. Testing the hypothesis whether ABC is a more appropriate accounting
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solution is certainly possible on paper but its desirable effects in the real world cannot be
today and the analysis is conducted in a kinetic time mechanism. This is a major
stumbling block for most organizations who are remain transfixed to their current
accounting mechanism and don’t want to change over to this new system, which despite
its obvious benefits, seems to come a great switching or even multi-homing cost.
communications group with leading positions in the mobile and digital segments.
CommQuest provides a wide variety of marketing and communication choices for its
diverse and impressive portfolio of clients such as Telstra, News Limited, NEC, Ford,
An Activity-based costing system follows two steps. The first step identifies
major activities and appropriates overhead costs to each activity depending on the
proportion of the resources that are employed in that activity. The overhead costs that are
assigned to each activity form an activity cost pool. After the assigning of overhead costs
is complete, identification of cost drivers relevant each cost pool ensues. Then in step
two, division of overhead costs from each cost pool to each product line in proportion to
Now, as we move onto our own case, we have decided to specifically target the
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Here, we will look at perhaps the most important aspect of activity based costing:
the ascertainment of cost drivers. When we look at the cost head of consulting fees, it is
clear to note that this cost is not restricted to a section of the organization. Suffice to say,
the most pertinent cost driver that can be employed in this condition is to trace the
whereabouts of cost with regards to the department or area of their inception in this
organization. So, in principle, the organization is basically being demarcated into smaller
units each of whom provide different services to the customer, and each of whom in
collaboration form CommQuest Limited. From here on, the cost of consulting are
attributed to each section of the organization from where it arises and is duly noted
CommQuest Limited is activity based costing but the structure of their operating
statements certainly seem to make the job of an activity based accountant easy as the
statement is created for the entire organization as well as the operating units of the
company. Therefore, the financial statements take a sort of a grid-like structure whereby
costs associated to a single area head e.g. depreciation, is also displayed in entirety with
regards to the firm’s activities and also broken down in line with the smaller sections that
Now, when we look at the segmented version of the operating statement, the
usefulness of the mechanism of activity based costing is made strikingly obvious by the
results that are produced. We can see with clear distinction that which sections of the
organization contribute towards the total expenditure with regards to the consultancy fees
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and which section are not as heavily directed towards consultancy expenses as other. Our
point becomes very clear simply from the results of the 2005 operating statement, where
we see that the 94.5% of the total cost of consultancy is charged by the Smart Ply Limited
sub-entity of CommQuest Limited and out of the eight sub-sections of the company, only
two contribute towards the total consultancy fees that were accumulated in the entirety of
allowed us to better determine the genesis of all the costs that are incurred in an
organization which allows for better decision making vis-à-vis the determination and
control and subsequent minimization of the costs that are incurred by the organization.
An Activity-based costing system follows two steps. The first step identifies
major activities and appropriates overhead costs to each activity depending on the
proportion of the resources that are employed in that activity. The overhead costs that are
assigned to each activity form an activity cost pool. After the assigning of overhead costs
is complete, identification of cost drivers relevant each cost pool ensues. Then in step
two, division of overhead costs from each cost pool to each product line in proportion to
the cost driver consumed by the product line. (Diagram 1) (Roztocki, 2000)
This accounting mechanism calculates revenues and costs for each activity. They manage
and control the planned activities of the business. In accordance with the requests of the
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managers of the company, they can organize each activity as a profit centre. The job of an
Diagram 1:
Activity-
Based
Costing
System.
Source:
This accounting mechanism calculates revenues and costs for each activity. They
manage and control the planned activities of the business. In accordance with the requests
of the managers of the company, they can organize each activity as a profit centre. The
job of an activity accountant is broken down into three parts mentioned below:
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As a result, the differentiation of above aids allocation of costs to costs places.
General Motors Company practiced this system in their 50 of 193 factories and
Activity based costing has also been extended into activity-based management (ABM) to
distribution channels, and other management issues. Therefore, activity based costing is
the system that shows the cost and profitability structure of products in a firm, whereas
activity based management explains the actions to improve quality and reduce costs and
To sum up, we can see that activity based costing is not essentially a
from an entirely different perspective. Cost drivers which are determined in accordance
with each organization certainly have their benefits which we have adequately
determined in our paper, but the most important aspect of activity based costing which is
sometimes overlooked is the readily ad-hoc system that comes as part and parcel of
implementing an activity based costing system; the ability to change the entire system at
any step of the way is certainly a benefit which cannot and preferably should not be
ignored whilst one is conducting a cost/benefit analysis of the usage of an activity based
costing system.
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Methodology:
Our analysis will be based on a two pronged approach: primary research which
will help us better understand the notions and impressions that accountants in our
industry of choice i.e. the tyre manufacturing industry have with regards to activity based
costing and its applications. Further, we will move onto a sensitivity analysis of
hypothetical products which will help us determine the greater usability of activity based
ascertain the proclivities and the impressions that accounting departments in our country
have with regards to activity based costing. The sample questionnaire is given here:
1. What is the current accounting method that is being used in your organization?
b. Other methods
2. Are you completely satisfied with the performance of your costing mechanism of
choice?
a. Yes
b. No
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3. What is the general level of variance between your forecasted and actual
expenditures?
a. 0-5%
b. 5-10%
4. What is your opinion regarding the notion that activity based costing is a costing
best practice?
a. Yes
b. No
c. Unsure
a. Yes
b. No
6. Would your transition be affected by the knowledge that your competitors are
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a. Yes
b. No
c. Unsure
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Results
Note: The total number of companies used in this experiment was 100 out of which 91
Activity Based
Costing
14%
Other methods
86%
We were able to determine in this part of my research that activity based costing is
not a popular choice largely due to the fact that people are not receptive to changing a
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Level of Satisfaction
Yes
29%
No
71%
Yes No
practitioners are not increasingly happy with the current methods that are implemented in
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Variance of forecasted and actual incurred costs
5-10% 0-5%
29% 57%
Most of the companies in this part of the questionnaire replied with the 0-5
percent variance levels, which depicts the stable and consistent nature of current methods
of costing. However, with a 43% majority stating that the variance levels are higher than
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ABC as a best practice
Yes
14%
No
14%
Unsure
72%
Yes No Unsure
saying that they were unaware of the inner workings of ABC systems, which shows the
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Conversion to Activity Based Costing
Yes
29%
No
71%
Yes No
A majority of the answers were negative in this part of the question which
corroborated the previously held notions that most organizations are content with their
current costing systems, an impression which has been felt throughout the research
process.
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Change based on rival’s practices
Unsure Yes
14% 0%
No
86%
Yes No Unsure
In the final section of my research process, the results that have been ascertained
in the earlier parts of my research were further amplified by the notion that a was
majority of the respondents were unwilling to change their current costing mechanisms
based on the knowledge that their competitors were using a specific costing method
whereas not even a single respondent answered in a yes, clearly showing that accounting
practices as a value addition proposition is merely that at this point in time: a proposition.
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Secondary Research: Sensitivity Analysis
Company A
company is owned by three people who also manage the company. Company A employs
more than 100 people; however, a large part of the manufacturing process is automated.
The firm is in the area of manufacturing tyres for all manners of publicly used vehicles.
Company A sells its products mainly in the domestic market, however, some
old equipment. A portion of the company’s output is sold directly to customers via retail
outlets, while the remainder is sold with the help of independent distributors and
wholesalers. At the time, Company A was using a traditional cost system and overhead
allocation was on the basis of direct labor hours. This retrieved information was
reliable cost information with regards to their major product lines: Motors and Motor
Parts, Breakers, Control Products, and Miscellaneous Parts. All three costing systems
(Traditional Cost Accounting, Activity Based Costing and Integrated Activity Based
the costs of Company A with the basic objective of these calculations being to obtain and
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compare cost information from all three systems. The results are presented in the
following sections.
All the financial information that is needed for our analysis is obtained from
Company A’s income statement and balance sheet. Table 2 and Table 3 present Company
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Equipment 1704
Other Fixed Assets 100 Owner's Equity
Total Fixed Assets 1804 Common Stock 300
Retained Earnings 1157
Total Owner's Equity 1457
and general expenses such as transport, rental fees, utilities, and maintenance charges.
The largest component of operating expenses was included in the SG&A expense
category on the income statement and a part of the operating expenses was also included
in the cost category of the income statement: cost of goods sold ($120,000,000). The
Company’s capital consists of all money invested in the firm. Company A’s capital was
Accrued expenses) from total assets. The complete calculation is shown below:
Economic Value Added system is initiated with the identification of its major business
activities. Use of overhead resources determined the operating costs for each activity.
These operating expenses are then traced back to products using cost drivers. After
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operating cost drivers were selected, driver volume information (such as material cost
and number of inspections) was collected. Using the previously selected operating cost
drivers and driver volume data, Company A’s overhead was traced to its four product
lines.
The calculation for the Capital Charges for Company Z’s product lines begins
with the estimation of its CCR. Now, a bank interest rate for debt was 11 percent at the
time, therefore, CCRDebt was chosen to be 11 percent. As the expected return on equity for
the managers was 14 percent, the CCREquity was chosen to be 14 percent in accordance.
The company’s applicable tax rate t was obtained from its income statement and the
balance sheet provided the (long and short-term) debt and the value of the owners’ equity.
Using this information and the equation derived earlier, the CCR for Company A
is:
= 5.33% + 7.21%
0.58
= 5.33% 12.43%
= 17.77%
Source: Roztocki, 2000
Therefore, a CCR of 18 percent was chosen for all of Company A’s accounting
categories and product lines. The total capital cost can then be generated once the CCR
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and Capital were determined. This calculation returns total capital charges to be $
= 510000000
5596000000
= 0.091
Source: Roztocki, 2000
We can see that Company A has a high CT-ratio (>0.05) which suggests that
has potential to increase the reliability of Company A’s cost information. Next, the
lines. The relatively high cost of capital for Tyre and Tyre parts as well as Breakers is
was obtained by adding the operating and capital costs to the direct cost. Table 5 shows
these results.
Product Line Direct Cost Cost Capital Charges ABC and EVA
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Total 2866 2334 396 5596
Arbitrary Figures
Results
The product cost information for the four product lines shows notable differences
Value Added System was the only system which to capital cost into account. Table 6 and
Table 7 summarize the product cost information and profitability figures respectively. [14]
Dollars
Product Line TCA ABC ABC and EVA
Dollars
Product Line TCA ABC ABC and EVA
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Arbitrary Figures
Now, given the results shown by the Integrated Activity Based Costing-and-
Economic Value Added system, Company A’s management should show a tendency to
This system is able to uncover facts that other were not able to as we see in the
product line Tyre and Tyre Parts, which were earlier believed to be highly profitable
under the traditional cost accounting calculations does not to create economic value in the
Economic Value Added in this product line was only slightly negative, it is not difficult to
assume that marginal increase in price would make Tyre and Tyre Parts a value creator.
This price increase would only be feasible if Company A had an especially strong market
position with regards to that particular product line. This mechanism is also very different
from the activity based costing profitability which showed a positive profit which
Total per unit cost 1400.0 387.5 750.0 550.0 (650.0) 162.5
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Atlas Electronics, Inc.'s Activity Areas
Conclusion:
Activity based costing is the need of the future. Traditional costing method,
despite being simplistic and easy to handle are continuously becoming too archaic for
them to be of any use to the firms. However, we have seen that even a simple activity
notion of activity based costing and even that of the activity based costing mechanism in
addition to the economic value added system in order to better ascertain their costs as we
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have seen in the pilot study of Company A: a tyre manufacturing company in the People’s
Republic of China, so they can increase their profitability and maintain their competitive
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