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ACTIVITY BASED COSTING

A SURVEY FOR THE GREEK COMPANIES

UNIVERSITY OF MACEDONIA

ECONOMIC AND SOCIAL SCIENCES

Demetrios Ginoglou

Assistant Professor

Department of Accounting and Finance

E-mail: [email protected]

Tel. ++30310-891-688

Fax ++30310-891-688


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CONTENTS

ABSTRACT.

INTRODUCTION...

LITERATURE REVIEW...

DESCRIPTION OF THE METHOD AND ITS DIFFERENCES FROM TRADITIONAL COST

SYSTEMS.....

DESIGNING AN ABC MODEL

1STSTAGE: DETERMINATION OF COSTS.

2NDSTAGE: IDENTIFYING ACTIVITY CENTERS.3RDSTAGE: TRACING COSTS TO ACTIVITY CENTERS.

4THSTAGE: DETERMINATION OF PRODUCTS5THSTAGE: ASSIGNING COSTS TO PRODUCTS .....

CRITERIA FOR ABC IMPLEMENTATION IN MANUFACTURING

INDUSTRIES...

BENEFITS OF ABC

DISADVANTAGES OF ABC.

ABC SOFTWARES...

RESULTS OF THE STUDY.

BIBLIOGRAPHY..


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ABSTRACT

The new manufacturing environment of 21st century create more efforts to

increase efficiency and improve information, new technologies etc. thus it gives

essential elements of survival to business. Examples of new technologies and

techniques are numerous and publicized such as computer aided manufacturing,robotics, EDI, EFT, BBS etc. One of the main goal in manufacturing environment is

to measure accurately not only the unit cost but also the cost of each activity. Many

companies have problems with overhead costs because they want to allocate it more

accurately in order to have more precise measurement of each product unit cost.

In this research study an attempt is made to investigate in a random sample

of Greek companies if they use the Activity Based Costing technique(ABC) or not.

Other reasons that has led to this study were the article of G. Venieris (Prof. in

Accounting ) in the magazine Logistis, Also the study of a researchers team during

the program ADAPT Pigasos, with the study E-Commerce & Enterprises Activity-

Based-Costing and the practical implementation of this method in a pilot-

company(A) in Thessaloniki Greece which has gained a major cost advantage byusing new technologies and ABC.

INTRODUCTION

At the beginning of the 21th century we realize the new large revolution in

new technologies, in computer sciences, in telecommunication etc. New local area

networks arises and the VAN networks, internet etc. growth more quickly.

Technologies like Electronic Data Interchange (EDI), Electronic Funds Transfer

(EFT), Bulletin Board Services (BBS), internet, E-Mail and other Electronic

Commerce applications are commonly used by the companies in order to gain the

target markets and in order to be better in every stage of its value chain.

From the accounting point of view one major goal for many companies in

order to gain a strategic advantage in measuring the unit product cost is to adopt a

new technique called Activity Based Costing. A more accurate measurement of unit

costs may assist managers in many ways.

First of all the ABC system subdivide overhead cost into a number of activity

cost pools. Each cost pool represents an activity such as: machinery repairs, car

repairs etc. The overhead cost in every pool then applied to production separately

using the better cost driver.

Such cost drivers may develop new procedures that may reduce the overhead

costs. The company that use the ABC system first of all determine many different

activities. Then prepare the cost of each activity, collect data for the activities and

finally estimates the cost of production. While the traditional cost system focus on the

division of:

Direct materials

Direct labor

Overhead cost etc.

In order to get total product cost we have to add the direct and indirect cost

of the product. A direct cost is directly related, or traceable to a cost objective. A cost

objective is any grouping to which costs are assigned, such as an individual unit of

inventory, a department, a product line etc. On the other hand, indirect costs relate tomore than one cost objective. If the cost objective is a particular product in a


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multiproduct factory, all manufacturing costs other than direct materials and direct

labour are considered indirect manufacturing costs (manufacturing overhead).

LITERATURE REVIEW

There are different approaches in the task of assigning overhead costs to the

product cost. In the early part of 20th century, when cost systems first began to be

developed, direct labour constituted a major part of total product cost. Therefore,

direct labour was typically chosen as the base for assigning overhead cost to products.

Data relating to direct labour were readily available and convenient to use, and there

was a high correlation in most companies between direct labour and the incurrence of

overhead cost.

However, events of the past two decades have made drastic changes in the

manufacturing environment. Automation has greatly decreased the amount of directlabour required, product diversity has increased in those companies that manufacture

a wider range of products, and these products differ substantially in volume, lot size

and complexity of design; and total overhead costs has increased in some companies

to the point that a correlation no longer exists between it and direct labour. Wherever

these changes have prevailed, companies that have continued to use plant wide

overhead rates and direct labour as a basis for overhead assignment have experienced

major distortions in unit costs. In order to overcome these distortions, some

companies used a two-stage allocation process. In the first stage, overhead costs are

assigned to cost pools, such as individual departments or operations. In the secondstage, costs are applied from the cost pools (departments) to individual jobs. These

second-stage applications are made on various bases according to the nature of the

work performed in the department.

Unfortunately, even departmental overhead rates will not correctly assign

overhead costs in situations where a company has a range of products that differ in

volume, lot size or complexity of production. The reason is that the departmental

approach relies on volume as the key factor in allocating overhead cost to products.

Studies have shown that where diversity exists between products, volume alone is not

adequate for overhead costing. These studies show that overhead costing based on

volume will systematically over cost high-volume products and under cost low-volume products. In order to overcome these problems some companies use Activity

Based Costing. ABC involves a two-stage allocation process, as described earlier,

with the first stage again assigning overhead costs to cost pools. However, more pools

are used under this approach, and they are defined differently. Rather than being

defined as departments, the pools represent activities, such as set-ups required,

purchase orders issued, and number of inspections completed. In the second stage,

costs are assigned to jobs according to the number of these activities required in their

completion. According to Noreen and Garrison ABC is considered to belong to a

third stage of cost systems.

ABC systems require a new kind of thinking. Traditional cost systems are the

answer to the question, How can a organization allocate costs for financial reporting


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and for departmental cost control? ABC systems address an entirely different set of

questions:

1. What activities are being performed by the organizational resources?

2. How much does it cost to perform organizational activities and business

processes?3. Why does the organization need to perform activities and business

processes?

4. How much of each activity is required for the organizations products,

services and customers?

In 1984 two respected accounting professors, Dr. Robert Kaplan of Harvard

Business School began to expound the shortcomings of traditional cost accounting

systems. Concurrently, Dr. Robin Cooper of the Harvard Business School developed

the new cost system ABC. From these beginnings, ABC gained attention and spread.

Today ABC systems are widely used in USA, Great Britain and Germany. In Greece

activity-based costing systems are still rarely used by companies.

METHOD DESCRIPTION AND ITS DIFFERENCES FROM TRADITIONAL

COST SYSTEMS

An activity-based system can paint a picture of product costs radically

different from data generated by traditional systems. These differences arise because

of the systems more sophisticated approach to attributing factory overhead, corporate

overhead and other organizational resources, first to activities and then to the products

that create demand for these indirect resourses.

Companies need cost system to perform three primary functions:

Valuation of inventory and measurement of the cost of goods sold for

financial reporting

Estimation of the costs of activities, products, services and customers

Providing economic feedback to managers and operators about process

efficiency

The first need is driven by the needs of constituencies external to the

organization: investors, creditors, regulators, and tax authorities. The second and thirdfunctions arise from the need of internal managers to understand and improve the

economics of their operations. Managers need accurate and timely cost information to

make both strategic decisions and operational improvements. Traditional standard

cost systems are still fine for financial reporting. Some companies, even today, have

systems that use simplistic direct labor overhead costing systems, perhaps with only a

single rate, despite operating with diverse processes, which might include both

manual assembly and highly automated machining.

But such aggregate methods for allocating factory overhead costs to products

provide managers with poor information. And the costs of many organizational

resources, especially those of marketing, sales and distribution, are not assigned tocost objects at all since such costs are not in financial statements. Although these


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recourses clearly help an organization meet the demands of individual customers,

channels and markets, the financial system does not assign their costs to users. Such a

calculation is neither necessary nor allowable for financial reporting purposes.

As competition increased and as the basis of competition shifted away from

the efficient use of direct labor and machines, managers needed more accurate

information about the costs of processes, products and customers than they could

obtain from the system used for external financial reporting. Activity-based cost

(ABC) systems emerged to meet the needs for accurate information about the cost of

recourse demands by individual products, services, customers and channels. ABC

systems enabled indirect and support expenses to be driven, first to activities and

processes and then to products, services and customers. The system gave managers a

clearer picture of their business. The clearer picture from ABC cost system led

naturally to ABM (activity-based management) which is the set of actions that can be

taken, with activity-based cost information.

DESIGNING AN ABC MODEL

In order to implement an Activity-Based Costing system we have to follow the

stages of the following exhibit:

e erm na on o

costs

...Identifying Activity

Centers 60% 30% 10%

rac ng osts to

Activity Centers ... ...

Determination of

Products

50% 20% 30%

ss gn ng os s o

Products

!"#$%&1Cost 1 Cost 2 Cost n

Total Cost of

Activity

Center 1

Total Cost of

Activity

Center 2

Total Cost of

Activity Center m

Total Cost of

Activity Center '

Product 1 Product 2 Product 3 Product 4 Product p


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1ststage: Determination of Costs

The term Cost is defined as the sacrifice made to obtain the objectives of the

company. We can classify cost into the following categories:

1. Materials Costs2. Labor Costs

3. Taxes

4. Interests

5. Depreciations

6. Several Costs

2nd

stage: Identifying Activity Centers

A well-designed activity-based costing system starts with process value

analysis (PVA). PVA consists of systematically analyzing the activities required to

make a product or perform a service. It identifies all activities involved in

manufacturing a product or serving a customer and labels these activities as being

either value-added or non-value-added in nature. Only the actual processing of goods

is a value-added activity, all other steps in the manufacturing process, including

moving goods from station to station, inspection and waiting for processing are non-

value-added activities in that they consume resources without adding value to the

product. The company should find ways to reduce or eliminate the non-value-added

activities.

After a PVA has been completed, the activities involved with the production

of each product will be clearly documented on a process flowchart. Since there may

be dozens of activities identified, a decision must be made at this point as to howmany of these activities to treat as separate activity center. An activity center can be

defined as a part of the production process for which management wants a separate

reporting of the cost of the activity involved. For most companies, it would not be

economically feasible to treat every single activity as a separate activity center.

Rather, companies frequently combine several related activities into one activity

center to reduce the amount of detail and data-keeping cost involved. For example,

several actions may be involved in the handling and movement of raw materials, but

these are typically combined into a single activity center titled material handling.

Perhaps the greatest accuracy in costing is achieved by recognizing four

general levels of activities, with various of these levels then subdivided into specificactivity centers. These four general levels can be described as follows:

Unit-level activities are those that arise as a result of the total volume ofproduction going through a facility. The consumption of power, for

example, is a function of the number of hours of machine time required

to complete all units of product and would therefore be considered a unit-

level activity. Some companies combine activities at the unit-level into a

single activity center, while others recognize at least two unit-level

activity centers-one related to machine activity and the other to labor

activity.

Batch-level activitieswould include tasks such as placement of purchaseorders, setups of equipment, shipment to customers and receipts of


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material. Costs at the batch level are generated according to the number

of batches processed rather than according to the number of units

produced, the number of units sold or other measures of volume. In

addition, cost at the batch level are generally independent of the size of

the batch.

Product-level activities are those that relate to specific productsmanufactured by a company. These activities are performed as needed to

support production of each different type of product, thus, product-level

activities will relate to some products but not to others. For example,

doing quality inspections is a product-level activity, since some products

require inspections while others do not. Typically, a separate activity

center is needed for each product-level activity that can be identified.

Facility-level activities are typically combined into a single activitycenter, since they relate to overall production and not to any specific

product manufactured. Facility-level costs include such items as factory

management, insurance, property taxes and worker recreational facilities.Theoretically, facility-level costs should not be added to products since

doing so involves the use of volume-based measures such as direct labor-

hours or machine-hours. However, virtually all companies do add

facility-level costs to products.

3rd

stage: Tracing Costs to Activity Centers

We said earlier that ABC uses a two-stage costing process. In the first stage,

costs are assigned to the activity centers where they are accumulated while waiting to

be applied to products. Costs can either be assigned directly to activity centers in thisfirst stage or they can be assigned by using first-stage cost drivers.

Where possible, companies prefer to assign costs directly to activity centers

in order to avoid distortions. For example, if a company has an activity center titled

material handling, then it would identify all costs directly associated with material

handling and assign the costs to that center. Such costs may include salaries,

depreciation, etc. Other costs associated with material handling might arise from some

resource that is shared by two or more activity centers, these costs would need to be

assigned to the centers according to some first-stage cost driver that controls

utilization of the costs involved. Plant space, for example, might be shared by several

activity centers, including material handling. The costs associated with plant space

would be assigned to the centers according to the amount of space occupied by each.

4th

stage: Determination of Products

In this stage we determine the products, servicesor customers in which we

will later assign the cost of the activity centers.

5th

stage: Assigning Costs to Products

The fifth stage of activity-based costing system involves tracing costs from

the activity centers to products. This is accomplished through the use of second-stagecost drivers. Two factors must be considered when selecting a cost driver for use:


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First, the ease of obtaining data relating to the cost driver and second, the degree to

which the cost driver measures actual consumption by products of the activity

involved.

The ease of obtaining data strikes at the very heart of activity-based costing,

since detailed information relating to a particular cost driver may be difficult to find.

Assume again that a company wants to establish an activity center titled material

handling. After careful analysis, management has determined that number of times

handled would be the appropriate cost driver to use in assigning material-handling

cost to products. In choosing a cost driver for an activity center, managers must be

sure that it accurately measures the actual consumption of the activity by the

companys various products. If a high degree of correlation does not exist between the

cost driver and the actual consumption, then inaccurate costing will result.

High-tech companies have a distinct edge in the matter of gathering data

relating to cost drivers, since the computers controlling their system routinely gather a

wide range of information relating to each step in the manufacturing process. This fact

probably explains in part why highly automated companies have been the leaders inadopting the activity-based approach.

In the following exhibit we have the cost drivers that are used in ABC

costing systems and also the cost drivers that are used in traditional costing sytems:

ACTIVITIES TRADITIONAL

COSTING

ABC COSTING

Materials orders Labour-Hours Number of orders

Transportation of materials Labour-Hours Number of batches

Production Planning Labour-Hours Number of batches

Machine Adjustment Labour-Hours Product Change

Production Control Labour-Hours Number of checked pieces

CRITERIA FOR ABC IMPLEMENTATION IN MANUFACTURING

INDUSTRIES

Companies that have some of the following characteristics are likely to

benefit from activity-based costing:1. Products differ in volume, size and complexity of manufacturing process.

2. Products differ in their need for various activities such as setups,

inspections etc that are involved in the manufacturing process.

3. High overhead costs.

4. Top management people largely ignore the cost data provided by the

existing system when setting prices or other significant product decisions.

5. The variety of products being manufactured has increased since the

existing cost system was established.


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BENEFITS OF ABC

Activity-based costing improves the costing system of organizations in the

following ways, thereby leading to more accurate product costs:

Activity-based costing increases the number of cost pools used to

accumulate overhead costs. Rather than accumulating all overhead costs

in a single, company wide pool, or accumulating them in departmental

pools, costs are accumulated by activity. As a result, many pools are

created according to the number of cost-driving activities that can be

identified.

ABC changes the base used to assign overhead costs to products. Rather

than assigning costs on a basis of direct labor or some other inaccurate

measure of volume, costs are assigned on a basis of the portion of cost-

driving activities that can be traced to the products.

ABC changes also a managers perception of many overhead costs in thatcosts that were formerly thought to be indirect (such as power,

inspections and machine setup) are identified with specific activities and

therefore are recognized as being traceable to individual products.

As a result of having more accurate product costs, managers are in

position to make better decisions relating to product retention, marketing

strategy, product profitability and so forth. For example, with ABC

margins vary significantly from product to product and increased profitsbecome the focal point of decision making-not revenue. So with ABC,

management has better information to measure marketing and sales

performance. Also ABC information helps set discount and servicepolicies. The company now knows how much a consolidated order, to

one shipping destination, saves.

Moreover ABC leads to better-cost control because it eliminates

distortions that are caused by the labor-based costing systems and also

helps investment decisions. Labor-based cost systems under cost capital

intense processes, while over costing labor intense processes. ABC

provides more accurate process cost information, which lays the

foundation for better capital justification. Using activity-based costing,

companies not only know what each process real overhead amounts to,

but what it consists of. The system tells management how much tooling,maintenance and utilities each process consumes. These costs can be

used in capital justifications or as targets in cost reduction programs.

DISADVANTAGES OF ABC

ABC improves the costing systems of organizations but also has some

limitations such as:

Critics of activity-based costing argue that even though some overhead

costs can be traced directly to products through the use of activity


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DATA COLLECTION AND RESULTS OF THE STUDY

The sample of this study consists of more than 500 random large companies

from all over the Greek State. The data collection were made through a questionnaire

(by the students) of the department of Accounting and Finance, University ofMacedonia

ABC is a recent system that can used for more accurate measurement of unit

cost. It can also encourage the management of the company in process activity based

approach versus functional operational based approach. It also meets the need for

accurate information about the cost of resource demands by individual products,

services, customers and channels. This system gave managers a clearer picture of the

economics of their operations.

An activity-based system can paint a picture of product costs radically

different from data generated by traditional systems. These differences arise because

of the systems more sophisticated approach to attributing factory overhead, and otherorganizational resources, first to activities and then to the products that create demand

for these indirect resources.

Results from this research in the Greek companies shows that, even though the

number of companies that has adopted the ABC system remains relatively low (8

companies according to 1999 data), the conditions in Greece nowadays make the use

of ABC system necessary.

The results also show that:

The majority of the companies (84,86%) believe that their cost system cantotally meet the needs of the company.

A small percentage of companies (appr.10%) have adopted ISO and B.P.R

techniques.

In most of the companies (67,18%) there is a major demand for reduction

of cost, while in the 65,30% of the companies indirect costs is increased

by the same analogy with in the total costs. Finally, the 16,44% of the

companies are aware of the cost of their basic activities and the cost of

each of their units.

Only 18,01% of the companies knows ABC system, of whom 53,85%have thorough knowledge about the system, while 49,61% of the

companies would like to be informed.

ABC system has been adopted only by 4,66% of the Greek companies,

half of which use the system precisely. 29,07% of the rest of the

companies are going to adopt ABC system in the future.

The implementation of ABC system in the companies influences mainly

the decisions which are related to the cost and price of the product, while

the decisions which are related to profitability and productivity are less

influenced.

A minor percentage of companies (only 2,99%) assign the process of ABC

system implementation to an external organization. As well, only 1,85% ofthe companies uses special software for the implementation of ABC


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system. Finally, 14,77% of the companies collects ABC system with their

information systems.


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BIBLIOGRAPHY

Venieris Georgios Sandra !"en : #ctivity Based Costing (ABC). :Logistis #pril-

$%y 1999 p. 480-5.

A survey of 70 manufacturing companies in the USA, in a range of industries, for the

identification of the allocation of the overhead costs, Emore & Ness, Chartered

Institute of Management Accountants, 1991.

Cooper R., Kaplan R.S., Measure Costs Right: Make the Right Decisions, Harvard

Business Review, September-October 1988.

Garrison R.H.,Noreen E.W., Managerial Accounting, McGraw-Hill, 8th edition,

1997.

The ABC experience in the UKs top 1000 companies, Chartered Institute ofManagement Accountants, p. 4-7, 1994.

Kaplan R.S., One Cost System isnt enough, Harvard Business Review, January-

February 1988.

How much does quality cost?, Papoutsis G.., Hellenews, Newspaper !erdos, $ay

1995.

Activity Based Costing in Service Industries, Rotch W., Journal of Cost

Management, 1990.

R.S. Kaplan-R. Cooper, Cost & Effect, Harvard Business School Press, 1998

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