"As global competition increases, businesses are being pressured to reach higher levels of productivity to price their products and services competitively." Explain how management accountants can play a role in helping management meet these challenges. 

(b) “As global competition increases, businesses are being pressured to reach higher levels of productivity to price their products and services competitively.” Explain how management accountants can play a role in helping management meet these challenges.

 

Traditional Model/ Absorption method

 

The traditional method, also known as the absorption method, depicts the relationship between the overhead and the volume size of the resources. This method was very much favoured in the 60s and 70s during which that was the peak period when mass production flourished. Back then, it had created employment for many; mass production gave rise to the increasing demand and supply of labour in the market. With this, the intensive labour cost had become one primary cost driver for many of the manufacturing firms.

Therefore, most of them started adopting the traditional method of cost absorption of overhead costs using the predetermined overhead rates. (Dr Philip E Dunn) This rate was ascertained based on the labour hours and the applied overheads calculated,measure the volumeof consumption in proportion to the total units being produced. 

However, the traditional method is skewed toward financial accounting and did not provide much information to determine the product costs. (Polimeni et al 1991: 1119) Managers encountered problems when it comes to making product mix decisions and to assess and evaluate the performance of the plant.

Emergence of Activity-Based Costing Model

 

Historical background of Activity Based Costing

The Activity-Based Costing (ABC) method, a contemporary management accounting tool, was first developed by Kaplan and Cooper. There was a paradigm shift during the late 1980s following the development of advanced manufacturing technology (AMT). (David Russell) With this, the recovery of overheads become redundant as there is seemingly little relationship between the overheads and labour hours. And with the progression of today’s technology, companies are producing a diverse range of products for more sophisticated consumers.

ABC then sees the need to undertake the behaviour of overhead costs and to have a better understanding of the activities that cause overhead costs to change labour input.The traditional method is based on the analysis of the overhead costs which varies with the volume of the production, whereas ABC method focuses on the cost drivers resulting from the volume of activities. The essence of ABC is more on the activities that result in the cost rather than just the cost of the products alone. (David Russell)

Framework of the ABC Approach

There are two phasesto the ABC approach: 1) Identification of significant and “value-adding” activities and allocation of overhead costs to each activity which is based on the proportion of the organisation’s resources and its uses. Managerial accountants allocate the overhead costs into the respective activity which then formed what is called the cost pool. (Babad and Balachand 1993: 564) 2) Identifying the cost drivers in each cost pool; overhead costs are then allocated from each activity cost pool to the respective product linebased on the percentage of consumption by the product line.Cost pools are then applied to the product line using cost driver rates that is with respect to the number of transactions for the cost driver. Cost driver rate is derived by the total cost pool of the activity over the volume of the cost driver. (MetinReyhanoglu)

To determine the value-adding activities, managers would have to examine all activities across the entire chain of the organisational processes following the analysis of the income statement. In this way, managers would then be able to justify the purpose of these activities within the organisation.(Dr Philip E Dunn)

It is important to pick out the most relevant and appropriate cost driver in each activity as this is only then that managers can drill into these significant costs in helping them to make better and informed decisions that will have an impact on the productivity level of the firms.

Applications of ABC

 

Production Line &Manufacturing Industry

As the production processes are getting far more complex in the highly competitive business world, improved informationplay a vital role to support planning, control and decision making as well as evaluation of performance in management accounting.(Mike Tayles)

Implementing the correct use of ABC method would result in better planning and control, in which managers can then make decisions that will reduce costs and increase revenues for the companies.One successful implementation of the ABC approach to accounting can be seen in the case study of Xu Ji Electric Co. Ltd.

Case Study: Xu Ji Electric Co. Ltd (Chartered Institute of Management Accounting)

Xu Ji Electric Company is a large Chinese manufacturing company and it is only in 2001 that they started to implement the ABC method. Prior to that, Xu Ji adopted the traditional costing system, with the overhead costs being allocated based on the direct labour rate. However, this method gave rise to inaccuracy of product costs and during that period, Xu Ji underwent a series of flotation, following the introduction of the free market competition in China. Xu Ji faced pressures from the market competition as their inaccuracy of the traditional costing jeopardised their ability to compete in terms of their pricing.

Xu Ji then saw the need to take on the approach of ABC method and through the system, it was able to trace direct labour costs to product and the client contracts and assign manufacturing overheads using the updated direct labour hours pegged to the contracts. This system led to subsequent restructuring of the internal management of the organisation, from testing of labour and design hours to other forms of monitoring front-line performance.

Through the implementation of the ABC system, it was revealed that the main discrepancies of product costs arose not from the use of out-dated material cost information, but the lack of standardised working practices and inventory control.

ABC system then matched the organisational structure according to therespective cost drivers for allocation of facility sustaining costs. Through the implementation, there was an increase in 50% of annual revenue and also an increase in net profit margin of 13% in 2010.

The case study shows ABC’s ability to analyse many aspects of the companies’ operations.Itprovides guidance on repricing products resulting from the effective and accuracy in cost allocation of products.

Service Sector

The country’s economy on a large scale is very much dependent on private and public sectors like the healthcare services, financial institutions, educational institutions, transportation, and the hospitality industries. With much progression in the economic development and increased competitiveness among these service sectors, they are required to provide a quality customer service at a reasonable cost.

By looking at the contemporary economic climate, there is a need for service organisations to learn how to manage cost effectively.To do so, managers have to go through trainings and workshops to enhance their knowledge on the significance of investing in programs aimed at reducing production costs. Most of these courses and workshops on ABC are gaining popularity among managers from the financial industries. (Julie Mabberley)

Taking financial institutions like banks for example, the products ranging from checking accounts to mortgages would incur expenses due to the variations in customers’ preferences. Much time and efforts as well as further transaction costs are incurred in the event when customers demand for different products that are best suited to cater for them.

The use of ABC model therefore analyse the expense structure of the individual operating department and then ascertain the factors that cause the demands for the functions to be performed by the department. The primary aim of this analysis is to retrieve the cost per unit for the processing of transactions from the products and customers.(Hussain and Gunasekaran, 2001)

Theapplication of ABC system in hospital assists managers to better understand the whole operational process and to attain efficiency as such and creates a useful ground of comparison with other hospitals, in terms of financial performance; provides an optimal mix of services catered to patients(King et al., 1994, cited in Adams, 1996).

Managers are able to identify some of the cost savings measurements which will then eventuate an improved budget planning using the information generated by adopting the ABC method. Therefore, this would allow service sectors to form a better understanding on the cost and value of service activities that are importantto prevent operational costs from escalating.

Educational institutions seek to remain highly competitive especially when much advertising was done to create awareness to the public. A case study on the use of the ABC system was established in one of the universities of Malaysia.

Case Study: University in Malaysia

 

 

 

Planning - Once the planned scale of production has been established it is possible to translate this into the number of times that activities are required to be performed. Help define required departmental capacities for machines and for staffing levels. Extending activities by the cost per activity enables financial budgets for each activity centre to be established

Control – ABC is the basis for the control of the efficiency of processes or activities being performed by signalling a number of key measures of performance which should be monitored if costs and the business generally are to be controlled

Decision-making & pricing – Assist in pricing decisions, in decisions on promotion or discontinuing products or new ways of carrying out business. Provides a basis for directing management’s attention to consideration of changes in the composition of the products or services that a company offers. Effective for long run product costing

Management behaviour – Process of evaluation & management discussion.Represents a structured approach to managing the organisation. Costs often become believable to the managers who use them and if handled in the right way, greater cooperation in cost control is obtained.

 

 

 

-          Long term variable costs – do not vary with the volume of production, but do vary with an alternative measure of activity; cost drivers will not be related to the output volume. Costs are related to the transactions undertaken by the support departments where the costs are incurred.

-          Give examples on the support department costs and their possible cost drivers (Grouped into cost pools)

 

-          Therefore, misallocations can lead management effort to place the wrong products

ABC Approach

-          As a consequence associate more closely to the derivation of overhead and serve to provide more accurate product costs

-          Insight to long-term variable costs and non-volume based cost drivers:

-          Diversity of volume, where some products in manufacture, or some customer’s requirements apply to a large proportion of business and others apply to small value orders

-          Diversity of complexity, products or services ranging from those which are very simple to execute, to more detailed and complex customer requirements

-          Diversity of size; both large and small products are handled and they require different amounts of resources

-          ABC does not model the cash flows, it has been pointed out that ABC is a resource allocation model not a spending model (Economic Concept)

-          Reveals the links between performing particular activities and the demands of those activities make on the organisation’s resources, it can give managers a clear picture of how products, brands, customers, facilities, regions, or distribution channels both generate revenues and consume resources

-          Helps managers to focus their attention and energy on improving activities that will have the biggest impact on the bottom line

-          The search for profits – Managers need to understand patterns of resource consumption at the micro level and not the macro by just looking at the financial statements

-          Used by managers to monitor and predict the changes in demands for activities as a function of changes in output volume and mix, process changes and improvements, introduction of new technology, and changes in product and process design

Application of ABC involves a set of procedure:

-          Separate the expenses and match them to the level of activity that consumes the resources

-          To put it simply, managers should separate the expenses incurred to produce individual units of a particular product from the expenses needed to produce different products or to serve different customers, independent of how many units are produced or sold

-          Recovery and charging of overhead to product/ service based upon the demand for the activity

-          ABC hierarchy – ABC segregates the expenses of indirect and support resources by activities

-          Assigns those expenses based on the drivers of the activities

-          Brand analysis could look at all the expenses incurred with sustaining a brand

-          Managers can judge the brand’s profitability by matching the revenues earned from the products against the expenses associated with promoting, advertising, and maintaining the brand in the marketplace

-          Managers should not use the information naively to close plants or eliminate products. Need to cut costs and do repricing

Context of 1990s (Mike Tayles)

-          High levels of competition, (some say global competition) for which an accurate indication of the cost of resources consumed in meeting that competition is required

-          Increasing costs especially indirect, support costs or overheads. Examples are developed using the AMT environments as a basis. Appropriate as it is here where some of the early ideas originated. *Many service industries for instance the banks and others in financial services are adopting ABC approaches to deal with the high proportion of their costs which are overheads

-          Demands for more information to help manage the costs of support departments. Managers have found that the overhead costs of support departments can have a tendency to grow and they have little direct idea or information to help them manage and control these costs. It is claimed by some that traditional methods simple “allocate” the overhead costs but do not provide any basis to “manage” or control them

-          Increasing calls by management for information on the profitability by product/ service, customer and market segment. The MA cost objects which traditionally were products, often manufactured products, can be widened to embrace individual customers or groups of like customers

 

Contrast between Activity Based Costing & Absorption Costing (Inclusion of overheads into the product cost)

-          Volume based absorption costing results in the following:

1.      Over allocates overhead to high volume products and under allocates overhead to low volume products

2.      Over allocates overhead to products which require more hours of work on and under allocates overhead to product which require less hours of work on

ABC approach acknowledges that some activities are unrelated to volume by using allocations bases that are not related to production volume for the inclusion of overhead into the product cost. This increase in the sophistication of allocation bases recognises the relative consumption of the overhead and attempts to trace the same to each product.

Advantages of ABC

-          ABC product cost are as a consequence likely to be more reliable than those produced by conventional costing system

-          Provided an opportunity for cost management for overhead by coupling the costs to the activities that cause them

-          Process of establishing cost drivers provide an opportunity of a reappraisal of operations carried out in the business

-          Where companies use cost plus as the basis of pricing decisions, ABC provides more reliable data on which to base selling prices

-          Generates improved or more accurate product costs – however, recent research suggests that by improving the quality of cost and management accounting information, it also provides managers with a wider understanding of the economies of production and those resource consuming activities which when linked to labour and capital provide the wealth we know as “value added”

-          ABC helps managers understand precisely where to take actions that will drive profits

-          Hierarchy gives managers a structured way of thinking about the relationship between activities and the resources they consume

-          Advanced information and manufacturing technologies reduce the demands made on batch and product-sustaining resources; when successfully implemented, ABC helps managers justify their commitment to these approaches and quantify the financial benefits

-          Reduce demands for resources by focusing the product line

-          Modify existing product mixes; help managers anticipate the effects of planned changes

-          Eg. of how the new product mix would affect fixed costs. ABC analysis showed that batch and product-sustaining operating expenses would soar as company moved from making one product to many more different products. Co expanded the product mix but immediately initiated programs to reduce resource consumption at the batch and product levels

-          Help management better improve on redesigning of the manufacturing processes

Actions to be taken after an ABC analysis

-          Managers should attempt to reprice the products; raise prices for products that make heavy demands on support resources and lower prices to more competitive levels for the high-volume products that had been subsidising the others

-          Should the repricing strategy becomes successful, company should arrive at a new product mix that either makes fewer demands on its resources or generates more revenues for the same consumption of resources

-          Managers should search for ways to reduce resource consumption. Requires either decreasing the number of times activities were performed for the same output – such as by changing product and customer mix or reducing the resources consumed to produce and serve the existing mix of products and customers

-          Might mean designing products with fewer and more common parts or customizing products at the last possible production stage

-          Mean implementing continuous-improvement programs to enhance quality, reduce setup times, and improve factory layouts, or adopting information technology to facilitate the processing of batches, products, and customer orders

Criticisms of ABC

-          Difficulties exist in determining the most appropriate cost drivers

-          Agreeing all of the costs associated with a particular cost driver for grouping into a cost pool can be problematic

-          The ability of a single cost driver to fully explain the cost behaviour of all items in its associated cost pool is questionable

-          The increase in the sophistication of the allocation method inevitably has a cost associated with it. If management are not prepared to make use of the information in the decision making process it may be more appropriate to remain with a traditional volume based absorption based system

-          ABC does not resolve all of the problems associated with the overhead allocation for example should setup costs in switching from one product to another and back be allocated to both products equally

-          ABC may be a distraction from other vital issues. The number of purchase orders may be identified as a cost driver and the more crucial negotiation ability of the different purchasing officers may be ignored

-          ABC is not widely used for it is far too expensive an exercise to implement

-          Perceive the cost to outweigh the value added i.e. benefit from the system

-          Cost drivers are not perfect predictors of cost behaviour within any cost pool

-          Trade-off between accuracy of cost information and number of drivers is required – management must strike a balance to suit their organisational needs

-          Most ABC systems are historical analyses i.e. they are based on analysis of costs and activities currently being undertaken. They are invalidated when systems or methods of doing business change. Exercise must be revisited and the periodic revaluation of data on cost and activities must take place. Important as this is to ensure the system reflects the current situations; must consider the likely effect of inflation or system changes

-          Not a regular reporting routine, only occurs when management has a question that needs to be addressed from an ABC perspective. Therefore, based on the perceived need to track activity levels in a particular area, generate performance measures or make some budget predictions in a key area

Alternatives to ABC

-          Activity analysis information – on selective basis on the overhead cost of support departments.  Stop analysis after the identification of activity cost drivers and activity cost pools; obtaining benefit from the activity analysis and the activity rates rather than using them in the costing of products and services

Service Line

-          Estimation of amount of time spent on performing activities (Based on percentage)

-          Principal activities that were performed

 

Conclusion

-          Some companies benefit significantly from ABC.

-          Others might reject this approach

-          In order to be effective, cost management must be based on a sound knowledge of an organisation’s cost structure, the proportion of its overheads, the degree of competition, its information needs and within the organisation, an appreciation of how costs are determined and how they may be influenced

References:

http://www.cimaglobal.com/Documents/Thought_leadership_docs/6Activity-based-costing-China.pdf

http://www.ncbi.nlm.nih.gov/pmc/articles/PMC3601252/

http://www.globalfsconsulting.com/display.php?page=1040

file:///D:/My%20Documents/Downloads/11103-38886-1-PB.pdf

file:///D:/My%20Documents/Downloads/652-2836-1-PB.pdf

 

 

Attachments:

• 1513754987-Management Accounting Outline.xlsx