Activity-Based Costing: Review
Activity-based costing is a modern method of allocating overhead costs to activity cost centers where cost drivers are used as the basis of allocation. This paper focuses on the difference between activity-based costing in large and small firms. The comparison is broken down into several parts such as; sophistication of the system, reasons to use activity-based costing, implementation of the system, cost and limitation of activity-based system. The future of activity-based system is also analyzed, and a recommendation given based on the conclusions about the system.
Activity-based costing which is commonly referred to as ABC costing was developed in the 1980s in a bid to get a costing system which makes up for the inefficiencies identified with the traditional costing systems (Hicks, 2002). This new system of costing had been widely publicized in many organizations and appreciated because it allocates the overhead costs to activities, not to cost centers as the case is with the traditional costing systems. The costing system uses cost pools and identifies the cost drivers for each of the cost pools so that the costs are assigned based on a cause-and-effect criterion (Drury, 2009).
Organizations of all sizes have embraced activity-based costing system in order to gain from the benefits accruing from its application. This research paper aims at bringing out the differences between activity-based costing in small and medium firms, e.g. Lowes Company, and in large firms, e.g. The Coca Cola Company. The differences have been discussed under different subheadings as below.
Level of Sophistication of the Systems
Activity-based costing systems are developed and customized by their manufacturers in order to suit the specific needs of an organization (Röthlin, 2010). Large organizations usually have many activities and diverse mix of products and services which result to a wide range of indirect costs. The number of activities that generate indirect costs is usually directly proportional to the number of cost drivers that cause them. This means that the larger the firm, the more the cost drivers and activity cost centers to be incorporated into the activity-based costing package, hence more sophistication (Röthlin, 2010).
On the other hand, small firms are likely to have fewer activities than large firms, which translate to less cost drivers and, by extension, less indirect costs. The activity-based costing systems they adopt will capture only the activity cost centers and cost drivers unique to their undertaking, which are usually less than those for larger firms. Activity-based costing systems for smaller firms are thus less sophisticated than those for larger firms. Therefore, in adopting activity-based costing systems, smaller firms may be more advantaged as compared to bigger firms because their infrastructure is not as complex and inflexible as that of larger firms (Drury, 2009).
Reasons for Using Activity-Based Costing
The main reason why organizations use activity-based costing is for precise pricing purposes in order to fix the prices of products and services in a scientific way (Hicks, 2002). This is because the method ascertains the costs of activities more accurately as compared to the traditional costing systems. It also helped in the reduction of costs by organizations through elimination of non-value adding activities (Hansen, Mowen, & Guan, 2009). Inefficient departments, products and activities, are identified, and action taken to improve them or do away with them altogether. Financial and human resources are allocated to profitable products, activities and departments in order to maximize on the returns from the activities of the organization. Appropriate product mix which maximize on the value of the firm can be determined accurately through the use of activity-based costing (Drury, 2009). This costing system is effective due to its use of cost drivers as opposed to the traditional costing systems which used labor hours as the main basis for overhead cost allocation. It thus makes it possible to allocate non-labor related costs to activity cost centers, information which places the organizations competitively in the marketing environment.
These reasons for using activity-based costing systems are common to both large and small firms. The main difference between the application of activity-based costing in large and small firms lies in product-mix decisions. In most cases, small firms deal with a small range of products whereas larger organizations are involved in a wide range of products. Larger organizations are normally capital-intensive; thus most of their cost drivers are not related to labor hours (Hansen, Mowen, & Guan, 2009). The cost drivers are usually machine hours and other machine related drivers such as number of production runs, set-up hours and number of inspection times. On the other hand, small organizations are labor-intensive, hence their cost drivers are usual labor hours and labor related drivers, which means that traditional costing systems are still applicable to smaller organizations to a large extent. Larger organizations thus get more value from their application of activity-based costing than smaller firms.
Implementation of Activity-Based Costing
Implementation of activity-based costing system depends on the level of sophistication of the system and the size and complexity of the organization. For large firms with many transactions and many cost drivers, implementation can be slow and in phases. The adoption of the system may involve convincing at least 30 people in the organization (Institute of Management Accountants, 2006). However, for small organizations, implementation of the ABC system may involve convincing one or two key people and implementation of the system can be so fast as to be implemented in one single phase.
Cost of Using Activity-Based Costing
In the 1980s when activity-based costing was developed, the cost of purchase and implementation of such system was very high (as much as $175,000), so the system could only be afforded by large companies then. To install the system and keep it functioning could take about six months with the assistance from a major accounting firm (Pincus, 1999). However, with technological advancement, the cost of such software acquisition and installation has reduced, thus making it affordable and within reach to many small firms.
However, the cost of the software package and installation is dependent on its level of sophistication as defined by the features of the package. Most of the packages are custom-made to suit the needs of the organization. For small firms with lesser activity cost centers and cost drivers, the cost of purchasing and installation is normally less compared to that of larger organizations. The task of overseeing the implementation of activity-based costing system in a large organization is normally assigned to full accounting department due to the level of attention needed. For smaller organizations, managers can oversee the systems and are usually open to new ideas from other members of staff. For growing organizations, it is not uncommon to purchase the more sophisticated packages so as to avoid the costs of upgrading later as the organizations become larger.
Limitations of Using Activity-Based Costing
Despite the many advantages of activity-based costing systems over the traditional costing systems, there are several limitations of the system. Even in activity-based costing systems, some cost drivers cannot be identified for some overhead costs, e.g. salaries for the C.E.O. (Drury, 2009). Another limitation is the fact that Activity-based costing is an accounting methodology which is relatively costly (Garrison & Noreen, 1997). For small organizations, overheads in the form of management emoluments are relatively low compared to those in large organizations. This means that this limitation is more pronounced in large organizations than in small organizations. However, based on the current accounting systems, such overheads are not allocated to activity-cost centers since they have no basis on which to allocate them. Rather, they are offset against the contribution from the various profit centers of the organization. Due to this limitation, costing and calculation of selling prices cannot be done exclusively using scientific methods.
The Future of Activity-Based Costing in Firms
When the traditional costing systems were established, the cost accountants of the time recorded a breakthrough in their efforts to have a costing system which accurately allocated overhead costs to products and services. The system was viewed by organizations as a solution to costing systems and no organization could foresee the limitations of the costing systems. After many years, the activity-based costing system was developed in the 1980s and made up for some of the flaws of the traditional costing systems. Most organizations shifted from the use of traditional costing systems and adopted the activity-based costing methods.
Activity-based costing approach is not without its shortcomings as discussed in this report. Research is ongoing by scholars on how to develop a costing system which takes into consideration all costs incurred in an organization setup. Activity-based costing system may, therefore, be improved in order to incorporate all costs incurred in an organization or a new system that meets these objectives may be developed altogether. The future of activity-based costing thus depends on the outcome of research efforts, i.e. improvement of the costing system or replacement by a more advanced system.
It is clear that activity-based costing is fundamental to both smaller and large firms due to the many benefits it has over traditional costing systems in overhead cost ascertainment. It is an improvement to the traditional costing systems and uses cost drivers in addition to labor hours, which was the only base employed by the traditional costing systems. The level of sophistication, reasons for use, implementation, cost and limitations of the system is what varies between the different sizes of organizations. It is also clear that the system is not a perfect package because despite its many advantages over the traditional systems, it also has limitations such as cost of maintenance, especially in large organizations and inability to distribute all costs of the organization to the activity cost centers. The cost of maintenance limitation has fairly been solved with modern technology where automation has made it possible for organizations to perform the costing operations with minimum human input. The major limitation remains allocation of business sustaining costs such as remuneration to organizational heads.
Based on the deficiencies of activity-based costing, it is recommended that current researchers put in more effort in order to seek remedies to the problem of cost allocation for business sustaining costs. However, activity-based costing systems are hereby recommended to all organizations since benefits of its use exceed the limitations.
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