ABC Technique: Advantages and Disadvantages

This report discusses the ABC technique of costing, its advantages and disadvantages. It analyses two journal articles on ABC technique and highlights how cost reduction can be achieved using this technique. The report also explains the purpose of the studies and the research questions set out to be explored. The subject is Managerial Accounting and the course code is not mentioned. The college/university is not mentioned.

Managerial
Accounting
Assignment

1
By student name
Professor
University
Date: 20th Sep, 2018.
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Executive Summary
This assignment report is basically a discussion on and an analysis of the ABC technique, i.e.
activity bases costing. The use and importance of ABC is not restricted to a particular class of
companies. It is equally beneficial for small and large companies. For the purpose of this
assignment, two journal articles have been studied. With the help of these articles we would get a
real, fair and reliable idea about the merits and demerits of this technique of costing. A thorough
analysis of the chosen journal articles also highlights how cost reduction or cost control can be
achieved so that the firms get a competitive advantage over others. Besides the study on the two
research journals, the similarities and the differences in the 2 studies have also ben highlighted.
Towards the end, the key learnings from the 2 journal articles has also been mentioned which
will be helpful for the management accountants in Australia and over the world in managing the
costs better.
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Contents
Executive Summary.....................................................................................................................................2
Introduction.................................................................................................................................................4
Advantages of ABC costing technique.........................................................................................................4
Disadvantages of ABC costing technique.....................................................................................................5
Discussion on the two journals....................................................................................................................6
Explanation of the Selected Management Accounting Topic......................................................................6
Purpose of the studies and the research questions set out to be explored............................................6
Similarities and differences between the findings of the 2 studies.............................................................8
Specific outcomes and relevant learnings from the research findings..................................................10
References.................................................................................................................................................12
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Introduction
Activity based costing is a technique of whereby overheads are allocated to those items that
actually use it. It is primarily used by entities that are engaged in the manufacturing industry to
improve the credibility of cost data and to give a better picture about the real costing of a
particular product or service. By general practice, entities allocate the indirect costs to the
product and direct costs to the activities. In ABC system of costing, any event, task or activity is
considered a cost driver and indirect expenses are allocated accordingly. In this system of costing
there is a total pool of cost that is divided among different tasks. Thereafter, these tasks are being
allocated to the cost centres to which they relate to (Chron, 2017).
Finally these costs are then further divided on the basis of cost drivers. These cost drivers are
nothing but basis of allocation. There exists a direct and proportional relation between cost driver
and the total of indirect cost. The higher the number of cost drivers, higher will be the total cost.
Under the ABC technique of costing, activity measurement is divided into two categories,
Transaction drivers and Duration drivers. Transaction drivers counts the number of times an
activity is done, on the other hand, duration drivers measure the time taken to complete an
activity. (Dan, 1995).
Merits of ABC costing technique
Following are the merits of ABC costing technique:
1. It helps in understanding the real nature of cost behaviour. It helps in the identification of
activities or tasks that do not add any value to the product or service. This in turn helps in
achieving overall cost reduction. Controls can easily be established over the fixed
overheads costs when managers become aware of the activities that caused those costs
(Belton, 2017).
2. The task of determining the cost of a particular product or service becomes more reliable
and accurate, by the implementation of ABC technique. It enables the management to
understand that costs are incurred by an activity and not by a product. It is also to be noted
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that products consume these activities. In case of an organisation, which is highly
diversified, ABC technique reduces the possibility of errors (Dichev, 2017).
3. It traces all the activities concerned with making the product or service available to the
end users. This also includes activities that aver occurred outside the factory premises.
Therefore, it gives a clear and more accurate picture of all the overheads concerned with
all the activities.
4. ABC facilitates better decision making. When management is aware of the actual cost of a
product they can determine its selling price without any confusion. Therefore the decisions
result in profits and the management gets a boost up.
5. ABC involves the process of pooling the cost of various activities. While doing so, areas
where spare capacity exists gets highlighted. Once the excess capacity is identified
management can increase profitability either by utilizing this capacity or by reducing or
eliminating the costs incurred by the particular set of activities. Apart from this, segments
that are inefficient tor are loss making, are also identified. Even non-value adding
activities can be identified and the company can chose to outsource it to reduce cost or to
increase profitability (Fay & Negangard, 2017).
6. ABC is especially beneficial to entities engaged in the service industry. Service
organizations such as banks, movie halls, hospitals and salon services have negligible
direct costs. Majority of the costs are in the nature of overheads and traditional methods of
costing fail to cater to these specific needs. (Alexander, 2016).
Demerits of ABC costing technique
Like any costing technique, ABC also suffers from some limitations. These drawbacks are
discussed below:
1. It is an expensive and a complex costing technique. ABC has a large number of cost
pools and cost drivers. When put together, they can be more complex to manage than the
tradition methods of costing. It is also very time consuming. Difficulties like
determination of cost drivers, allocation of costs and the varying rate of cost drivers exist
in the execution of ABC technique.
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2. The main problem with ABC is the measurement of cost of activity pools. Determination
of basis of cost allocation is also tough to decide on. These measurements are difficult to
measure and involve a sea of calculations. Apart from this, measured costs are to be
updated regularly, in the light of changes in the market.
3. Large companies are more likely to benefit from ABC than smaller firms, comparatively.
Smaller firms are not in a position to give in the required time, effort and resources.
Moreover, the benefits derived would be very less than the resources utilised. Entities
who price their products on the basis of market price would reap nothing out of it. On the
other hand, entities that use a cost plus pricing method will benefit immensely.
4. ABC system is infamous for the difficulty associated with their implementation. The
general norm is to go for multiyear installations, where all the products and services are
expected to fall in line, within the decided time frame. It becomes tough to maintain
management control and budgetary control over these installations, given the long time
period.
5. There may arise a conflict between the results obtained by ABC and traditional method.
These conflicting data for the same issue under consideration may bring doubts and
confusion in managerial decision making. Such conflicting results can also be seen when
managerial performance is to be evaluated.
Discussion on the two journals
The two journal articles that have been analysed here are The Value of Activity-Based Costing in
Competitive Pricing Decisions” by Eddy Cardinals; Filip Roodhooft, and Warlop Luk and “The
Measurement and Management of Unused Capacity in a Time Driven Activity Based Costing
System” by Veyis Naci Tanis and Hasan Özyapici (Eddy, Filip,R, & Warlop, 2004). These
journal articles are studied to get a fair idea about the application and use of Activity based
costing technique, in real world organizations or entities.
Explanation of the Selected Management Accounting Topic
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The first journal article helps to understand and assess the qualities of the ABC technique that
enables to make an effective pricing decision. This article chiefly refers to entities from the
manufacturing sector, where pricing is competitive and prices are highly elastic. From the
thorough analysis of this article it becomes evident that when compared to other methodologies
of costing, such as volume based costing or standard costing, the ABC technique is more
advantageous. ABC helps to eliminate the immaterial competitor response and supports effective
and efficient decision making (Gooley, 2016). It also enables improved product and customer
profitability analysis.
Purpose of the studies and the research questions set out to be explored
The objective of analysing this paper is to gauge the importance of this method of cost
allocation, especially in situation when all the relevant information with respect to price
determination is not available. In today’s business environment where market reviews and
feedback surpasses the accounting statistics, it becomes difficult to decide a price on the basis of
conditions prevailing in the market. On the other head fixing a price, for a product or service, by
implementing traditional methods of costing will yield prejudiced results. The expected cost thus
derive will suffer from certain drawbacks and will not be close to reality. Such a cost may be
overvalued or undervalued, or give an illusion about a particular market being profitable whereas
in reality it is not favourable for the entity (Raiborn, Butler, & Martin, 2016). The diversified
product market when studied by Briers et al. in 1999 revealed that influenced cost data led to
better pricing choices. These cost data were based on the market response and the standard of
excellence set by the entities. However, the most important feature here was the lack of
competition in the market. Later on, these tests were re-conducted to know the actual results.
Two significant hypotheses were applied to these tests and they generated a result, which was
totally different form the previous one. The 1st hypotheses assumed that the prices and returns are
at the prime when the business entity obtains positive feedback from the market as oppose to
negative market feedback, when the profits become the least. The 2nd hypothesis was that the
higher the information generated by the market feedback, the lower the performance of ABC
system of coting. This was mainly attributed to the presence of biased cost information in the
form of those reviews. To scrutinize the impact more evidently, one more test was conducted,
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whereby two groups were formed out of 131 participants. These participants were qualified
management accountants and cost accountants. They were given a set of cost information and
were asked allocate the two costs under the traditional costing systems and the ABC costing
system (Bromwich & Scapens, 2016). The sub categories under the ABC system was ordering,
delivery and software handling. Then the specific cost of associated activities was allocated in
accordance with the ABC system on the basis of 2 different market segments. The cost drivers in
the chosen segments number of orders, deliveries and software handling (Goldmann, 2016).
Thereafter the outcomes of these were observed over ten different time frames so that the direct
effect on the profit can be established. The method adopted was to take the average of the first
five results to evaluate the interface between market view and the accounting. This proved to be
less reliable (Siano, Vollero, Conte, & Amabile, 2017). Thus, the 2nd hypotheses were
ascertained incorrect. It reached a conclusion that the either opponents operate in the competitive
market or that the available information is insufficient and unreliable. However if the companies
allocate cost on the basis of a wise cost driver, better pricing can be reached, which will be
competitive, effective and profitable.
The main question that the second paper intends to answer is how to measure the spare and
underutilized production capacity of the operational process of an entity. This is done by using
time driven activity based costing. In situation where the companies operate in dual shift basis,
determination of unutilized and spare capacity becomes a tedious task. To study thaw complexity
of this specific case, two novice and unconventional concepts should be studied, namely, real
unused capacity and compulsory unused capacities (Choy, 2018). The principal goal of this
research is to lift up the efficiency of ABC and TDABC system. For the specified goal, the real
and compulsory unused capacities per shift are properly defined... The final outcome of this idea
was to transfer and redirect the workforce to areas where they can prove to be productive.
However traditional method of costing would fail to achieve this objective, because in the
modern world, the whole basis on which it works has become redundant and ineffective. In
today’s business environment, that is highly competitive, the companies look for advanced
methods of cost management. One of the major constraints of ABC costing system is choosing
the cost drivers for cost allocation is studied in this example (Mun & Shin, 2018).
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The most recent version of ABC system is characterized by the addition of time factor. This time
driven technique came into existence so that the companies can carve an edge for itself, among
the competitors. Here, in this system, the management needs to develop an understanding of the
resources available with the company and the optimum combination necessary to achieve
targeted production (Visinescu, Jones, & Sidorova, 2017). The execution of TDABC technique is
based on two points, firstly, the cost per unit of resources and secondly is quantity of the
consumption of these resources. The prime agenda of this system of costing is to eradicate all the
constraints brought about by the ABC, so that productivity is improved. To put in simpler terms,
it helps to know the amount of time and resource required for a particular activity. In this system
cost is calculated on the basis of practical capacity in place of cost of per unit (Naci & Hasan,
2012). For example, a given machine that practically works for 60 hours per weeks will
effectively work for about 80-85% of total hours that would effectively be 48 hours. Attention is
to be given to practical and effective capacity or else the cost allocation would not be exact. To
know the unit of resource being strategies like discussion with employees, interviews,
observation can be adopted.
The major help which is yielded using the time driven activity based costing is the efficiency of
the operations of the entity as the management comes to know about the inefficient as well as the
unproductive activities so either the same can be stopped altogether and the manpower from
there can be routed to the other productive functions based on the shift or the activity can be
outsourced to some agency altogether. Moreover, the processs removes the inconsistency among
the industry and the companies and brings about a consistency in the process of cost allocation
which is comparable as the base point is time only. Furthermore, it also leads to correct pricing
of the product and thereby making the product competitive (Erik & Jan, 2017).
Similarities and differences between the findings of the 2 studies
The common findings between the two studies are mentioned below:
1. Both of the techniques of costing have the objective of making effective and efficient use
of time and inputs. Both of these also aim for cost reduction and enhanced productivity in
the workplace. They facilitate better costing and pricing of the products (Grenier, 2017).
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2. Both these techniques plan to remove the inefficiencies associated with traditional
method of costing. They pinpoint the areas which are unproductive and needs to be
eliminated. This not only helped a number of companies in cutting down on costs but also
on the man hours.
The difference between the two case studies are given below:
1. In the first technique the concept of cost driver is highlighted whereas in the second
technique focus is placed on time management. The weakness which was posed in the
activity based system was made good by the strengths of the time driven activity based
costing (Knechel & Salterio, 2016).
2. Activity based costing works to remove factors that lead to poor management resources,
both in terms of time and money. It allocates the cost under correct cost driver and helps
in determination of an optimum price. To the contrary, Time based costing emphasizes
on decreasing the time required and makes the process smooth. In this generation,
majority of the companies favour to adopt TDABC system over ABC system (Linden &
Freeman, 2017). However both system of costing have their own merits and limitation
which is discussed to reach a conclusion.
Though there are a lot of issues that needs to be addressed for the betterment of selection of
drivers, allocation of cost and time management, both these system perform better than the
traditional method of costing.
Specific outcomes and relevant learnings from the research findings
From the thorough study and exploration of theses research paper, it becomes evident that both
the approaches are immensely advantageous for reliable and correct cost management. These
techniques work towards cost reduction increased productivity and profitability. Some of the key
learnings from the 1st research paper are:
1. The market dynamics have more to do with the firms pricing decision when compared to
the competitor’s pricing decisions. When competitor entities price their products at a
lower price, small competitor will suffer from low demand. (Heminway, 2017).
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2. If a new entity wishes to enter the existing market, he is required to follow the rules and
principle set by existing market participants. For fixing price as they lead to wrong
allocation of costs. Resultantly, it shows accounting profits at a lower level than the
original level. This in turn casts a bad effect on the sales volume of the product or service
in question (Trieu, 2017).
3. It is also seen that the negative market response could not wrongly impact entities that
adopted the ABC technique, to an extent that they impacted companies which
implemented volume based costing techniques.
The key learnings from the 2nd research paper are:
1. The major problem addressed by TDABC system is choosing the cost drivers. This
system of costing focuses on using the practical capacity of the machine and not the real
capacity.
2. This approach assists in receiving the goal of cost reduction, resulting in decrease in the
price of the product. Thereby the product becomes attractive and arrests a considerable
market share (Bennuona, Meredith, & Marchant, 2010).
3. Also, it brings upon uniformity and comparability among the cost units across the whole
industry. This makes the data comparable globally and thus meeting the objective of
accounting standards as well.
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