Activity Based Costing (ABC) – An Effective Tool for Better Management

Research Journal of Finance and Accounting www.iiste.org
ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)
Vol.6, No.4, 2015
66
Activity-Based Costing (ABC) – An Effective Tool for Better
Management
Ishter Mahal1 Md. Akram Hossain, Ph D2*
1.Assistant Professor, Department of Accounting & Information Systems (AIS), University of Dhaka, Dhaka,
Bangladesh
2.Associate Professor, Department of Management Information Systems (MIS), University of Dhaka, Dhaka -
1000, Bangladesh
*[e-mail]
ABSTRACT
Activity-based Costing (ABC) is a powerful tool for the an organization to have an accurate and effective cost
for its product avoiding cost distortion that may lead sustainable development and growth which is mandatory to
be competitive in the era of globalization and complex business environment. The article contains some brief
description of international journals on ABC. Author has tried to bring up the main essence of these journals.
The mentioned journals cover a wide range of topics from theoretical aspects of ABC to its application. Author
has discussed some specific cases in different countries. Some of our journals highlight the impact of ABC on
the European firms where as some other has tried to discuss the American context of ABC. Analysis contains
some data on the Nestle Bangladesh Ltd. which maintains the ABC. We have tried to analyze how successful the
company is in implementing ABC. In the analysis of journals, author focused on different era of business like
service sector, technology business, manufacturing sector and many more. Implementing ABC in these different
sectors is a little bit different. ABC has to be implemented considering the characteristics of that sector. In total
ABC has been proved to be successful for almost all the sectors. There have been some modifications in ABC
also. Some other concepts have also been discussed here like theory of constraints, time driven ABC and many
more.
Keywords: ABC, management accounting, manufacturing sector, time driven ABC.
1.0 INTRODUCTION
Management accounting is well recognized as a tool to assist managers to make decisions, formulate plans and
operate controls. Dynamic changes in business environment and vigorous global competition rectified some
shortcomings of traditional management accounting system (MAS) in terms of validity, completeness,
consistency, relevance and understanding creating a demand for modern management accounting tools such as
Activity based Management, Activity based Costing, Activity based Budgeting, Benchmarking, Balance
scorecard, Total Quality Management etc.
Activity-based costing (ABC) was developed and has been advocated as a means of overcoming the
systematic distortions of traditional cost accounting and for bringing relevance back to managerial accounting. A
traditional system reports what money is spent on and by whom, but fails to report the cost of activities and
processes (Miller 1996). Many organizations in the manufacturing industry have adopted the new costing
method. Aranoff et al (1998) said that there are two purposes of activity-based costing. The first purpose is to
prevent cost distortion. Cost distortion occurs because traditional costing combines all indirect costs into a single
cost pool. Cost distortion is prevented in ABC by adopting multiple cost pools (activities) and cost drivers. The
second purpose is to minimize waste or non-value-adding activities by providing a process view.
Activity Based Costing is motivated by a belief that traditional (general ledger) accounting information
is all but useless to managers who are interested in evaluating the effectiveness of resource allocation decisions
in their companies. This traditional information is geared instead toward satisfying auditors or other outsiders
who are interested in some evidence of financial accountability.
2.0 LITERATURE REVIEW
For this article author analyzed related reputed studies and a trial is done to summarize the findings of those
studies under specific head concerning the relationship between ABC & different recent issues such as Total
Quality Management (TQM), Theory of Constrain (TOC), Activity Based Budgeting (ABB), Supply Chain
Costing and the role of ABC as a business tool e.g. as a pricing tool, role in manufacturing concern, role in E-
business, role in preparing financial budget etc.
Analysis of ABC & Theory of Constraints
According to Robert Kee and Charles Schimidt (1997) traditional cost accounting system has two major
alternatives – ABC and theory of constraints (TOC). Theory of constraints is suggested for long run. The paper
has developed a general model between these two extreme approaches. Sometimes neither theory of constraints
nor ABC may lead to an optimal product mix. This general model may be used to modify theory of constraints or

Research Journal of Finance and Accounting www.iiste.org
ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)
Vol.6, No.4, 2015
67
ABC.
TQM as easy as ABC
According to Steve R. Letza & Ken Gadd (1994), fundamental to TQM is the continuous improvement of
business processes and activity based costing (ABC) is essentially an accounting system that measures the use of
resources by activities. ABC therefore can generate the accounting information that is needed for TQM to
evaluate costs.
Supply Chain Costing & Activity-Based Perspective
The purpose of the research paper “Supply Chain Costing: an Activity Based Perspective“ by Binshan, Collins,
Robert (2001) is to help managers to improve their understanding of logistics costs and the accounting for those
costs in order to optimize use of the total cost approach to managing logistics processes. This paper discusses the
history and evolution of logistics management and ABC, the driving cost factors affecting the key logistics
activities, and the use of ABC system to help improve the allocations of logistics costs to specific cost objects. It
also includes managerial implications and implementation techniques for an ABC system.
ABC, A Powerful Tool for Pricing
In his journal, John C Lere (2000) told that ABC is a powerful tool for pricing than traditional costing system.
The reason is under ABC, for each unit, batch or product level activity, a cost driver is identified which
determines cost per unit. According to him, when the resource consumption for an order is typical of total
expected company resource, both traditional cost system and ABC system estimates will be same. They will
differ if orders are not typical of total expected company resource usage.
Strategic Cost Management: ABM Approach
Trussel & Biter (1998) describes the design and implementation of an ABM system which has two stages: first;
resource costs are assigned to total activities and second; activity costs are assigned to cost objects. According to
Chen F. Frank (1996), a journey to cost-effective approach to advanced factory management through ABC
approach can be as follows –
Step 1: Identify / define factory activities
Step 2: Obliterate unnecessary activities as much as possible
Step 3: Identify cost driver for each activity
Step 4: Select necessary control/management functions to minimize/automate cost drivers
Step 5: Cost-effective advanced factory management system
Hughes Andrew (2005) mentioned in his study that ABC/ABM enables firms to focus on its activities and
products; it traces cost-to-cost drivers. ABC information, by itself, does not invoke actions and decisions leading
to improved profits and operating performance. Management must institute a conscious process of organizational
change and implementation if the organization is to receive benefits from the improved insights resulting from
an ABC analysis.
ABC for planning & decision making
Kelline et al (1999) has done a research showing how ABC can be applied in the academic institution, i.e.,
colleges, universities. According to ABC approach, activities of the universities are categorized into four main
parts- instruction (teaching), research, public service and administrative activity and thus costs related to these
activities are allocated on the basis of time spent for each activity. Sheu et al (2003) is enclosed the traditional
standard costing systems are irrelevant in most cases for management decisions because they are “too late to
aggregated and too distorted”. Moreover the measures fail to consider especially the presence of committed costs
and related capacity limitations that lead to bottlenecks. Two alternative philosophies, TOC and ABC have been
offered to overcome some of the failures of standard costing for improving managerial decision making and
provide more relevant information for evaluating the economic consequences of resource allocation decisions.
Application of ABC in logistic business
Stapleton et al (2004) said that how ABC can be used as a tool for determining true costs of marketing and
logistics activities and help firms make better decisions based on more accurate costing information. Thomas J.
Goldsby & Darid J. Closs (2000) in their research has found that activity based costing (ABC) has become an
analytical method of interest to many logistics organizations throughout the world.
ABC for E-Business
Roztocki Narcyz(2001) emphasizes on the implementation of ABC in technology or e-business sector. Since
overhead cost is very high in this sector ABC is considered to be very useful here. To consider the decision of
implementing ABC a new ratio has been introduced which is called overhead to total cost (OT) ratio.
OT Ratio = Overhead Cost / Total Cost
Simulating ABC
Beck & Nowak (2000) in their journal tried to merge discrete event simulation with ABC to provide an
improved costing, planning and forecasting tool. In simulation, physical items flow through the sequence of
manufacturing operations and in ABC costs flow through the model driven by define activity drivers. Thus the
combination of these two can be figured out as follows;

Research Journal of Finance and Accounting www.iiste.org
ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)
Vol.6, No.4, 2015
68
Figure: Interaction of ABC and Simulation Model Flow Adapted from Ostrenga et al (1992)
The research work has shown that the combination of ABC concepts and discrete-event simulation model may
obtain the range of expected product costs.
Activity Based Life Cycle Costing
Emblemsvag Jan (2001) has introduced a new method for life cycle costing called activity based life cycle
costing (LCC). The paper discusses Activity based life cycle assessment analysis method which has several
major advantages and then states the steps of implementing the activity based life span model.
Time driven ABC
Kaplan et al (2003) enclosed since the traditional ABC model had many limitations, time driven activity based
costing model was proposed which is simple and accurate. Time driven ABC is easy and fast to implement.
3.0 OBJECTIVES
The report is prepared with an objective to have a gross idea about Activity Based Costing. Although this is the
main objective of the report, it can be detailed as follows:
1. To develop a clear concept about the theoretical aspects of ABC.
2. To know the applications of ABC in different countries.
3. To know the problems and benefits of implementing ABC in any organization.
4. To find out the reasons of denying to implement ABC.
5. To know about the implementation of ABC in manufacturing sector.
6. To know about its benefits in public sector organizations.
7. To have knowledge about the relationship between ABC and other management accounting concepts such
as Activity Based Budgeting, Theory of Constraints, Supply Chain Costing, Total Quality Management,
Life Cycle Costing etc.
8. To know about the implementation of ABC in Bangladesh.
9. To recommend some steps for the development of ABC implementation.
3.1 Limitation of Our Study
Author faced the following problems when studied the Nestle Bangladesh Limited:

Lack of cooperation.

The firm was very restricted to disclose some necessary required information because of confidentiality
principle.
3.2 Methodology
For the purpose of preparing this report both primary and secondary data are used. Primary data have been
collected by interviewing key personnel of Nestle Bangladesh Ltd. and the secondary data have been collected
by logging on to website, studying different journal related to Activity-based Costing (ABC) and different books.
4.0 IMPLEMENTATION OF ACTIVITY-BASED COSTING
Experts agree on several essential characteristics of any successful implementation of Activity-Based costing.
First, the initiative to implement activity-based costing must be strongly supported by top management. Second,
the design and implementation of an ABC system should be the responsibility of a cross-functional team rather
Activities/ EventsRaw Materials End products
End Products
Resources
Resource
Driver
Final objective of
both is the end
product
Activity
Driver
Simulation Flow
ABC Flow