Activity Based Costing Analysis

Accounting has changed over time by recognizing the effects of accounting information on management procedures, on security pricing decisions, or on social accountability and welfare. Thus, interpretations, measures and definitions of costs and benefits presented in accounting reports have changed. When addressing the cost of producing goods and services in accounting, it is usual to distinguish between the following definitions. In their book Relevance Lost: The Rise and Fall of Management Accounting, Johnson and Kaplan propose a new approach to cost accounting and management. This approach allows companies to improve their accounting and management practices and identify cause and effect correlations to assign costs.

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Johnson and Kaplan state that traditional accounting procedures lead to failures and low productivity levels. They found that “Management accounting reports are of little help to operating managers as they attempt to reduce costs and improve productivity” (Johnson and Kaplan 1). Traditional cost accounting deals mainly with cost accumulation, inventory valuation, and product costing. It emphasizes the cost side. Thus, the objective function of the new approach is implicitly perceived to be cost minimization. The activity-based costing is a more accurate management method which helps to identify a true cost of an item. The advantage and strength of this method is that “By linking many separable processes, complex and extensive organizations evolved to handle each of the activities” (Johnson and Kaplan 19). The method of activity-based costing underlines that costs are calculated for each activity, and only for those products that pass through this activity (Cooper & Kaplan 20).

According to this accounting method, the company should follow some steps to introduce this accounting system” to define the process, analyze the activities in the process; establish cost pools: match the cost pools with the activities; identify the cost drivers. “The need for a uniform financial measuring rod compelled managers of integrated multi-activity firms to push management accounting beyond the cost management systems” (Johnson and Kaplan 87). The advantage of this method is that indirect costs which cannot be traced to each product are calculated on the basis of cost drivers. Johnson and Kaplan underlines that cost-based accounting and budgeting deals with the efficient allocation of resources. The objective function may be perceived to be profit maximization. It is also believed that the cost accountant and the management accountant are performing different activities; cost control is in the domain of the cost accountant, while cost reduction is in the domain of the management accountant (Cooper & Kaplan 88).

The activity-based budgeting shows that the emphasis in placed on cost control and planning, which may have reinforced the belief in a difference between both areas. It is advisable, however, not to stress those differences, but rather to conceive of accounting as an attempt to bring techniques from other disciplines into the area of cost accounting. In fact, in recent years, the scope of cost accounting has been enlarged in various ways. The postulate that individuals are acting rationally and are always selecting the optimal alternative can only be maintained when including a cost measure in the comparison of choice alternatives. “The system of internal control is aimed at the more efficient and smooth performance of regular operating activities” (Johnson and Kaplan 161). However, as long as costs are a matter of different individuals’ preferences, based on subjective measures and including concerns, it is difficult to verify such a proposition In general, the cost principle compares different choice alternatives within the framework of rational choice. Depending on the specific problem statement and assumptions that specify a particular problem, various measures of opportunity cost can be defined. “Some costs are fixed over relevant ranges of activity, while others vary in pattern with respect to output, scope of operations, levels of quality, area of market coverage, number” (Johnson and Kaplan 160). In general, this cost accounting method provides cost data for the development of the right strategy necessary to gain competitive advantage.

The main limitation of activity-based costing is its limited scope and additional calculations. The activity-based costing methods have been developed and tested by other researchers. Among them are Lindahl (1997), Albright & Sparr (1994). These researchers broaden understanding of activity-based costing by bringing into the analysis the strategic elements necessary to gain a competitive advantage. However, as long as costs are a matter of different individuals’ preferences, based on subjective measures and including concerns, it is difficult to verify such a proposition In general, the cost principle compares different choice alternatives within the framework of rational choice. It is difficult to apply this method to large production and estimate costs for several production lines at a time.

In the article, Management’s Stake in Improved Decision Making with Activity-Based Costing Barnes (1992) analyzes the role and importance of activity-based costing in decision-making. He cites Johnson and Kaplan: activity-based costing is not designed to trigger automatic decisions. It is designed to provide more accurate information about production and support activities and product costs” (Johnson and Kaplan cited Barnes 21). Using these examples, Barnes underlines that the activity-based costing and budgeting allows to improve decision-making and problem solving methods. The opportunity of this approach in practical decision making provides a method to evaluate problem situations that occur because of nonoptimal conditions. These problem areas may not be restricted to measures of accounting profits and explicit costs, but may relate to implicit costs and psychic values. In this sense, decision-making may relate to much broader concepts than those defined for rational economic behavior based on explicit market values.

Lindahl (1997) broadens the scope of a problem analysis, and suggests that it is possible to discover interrelationships and complex adjustment processes that in time may eliminate current problem situations. Such dynamic processes are not “obvious” in traditional analytic, static, and simplified models. Lindahl (1997) underlines that activity-based costing can be successfully applied to marketing and strategic management spheres. The cost principle also provides criteria for the selection of relevant information for economic decision making. Depending on the particular decision problem, this may include accounting data besides measures of intrinsic and opportunity costs. Inasmuch as decisions are future-related, this involves the concept of environmental stability.

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Activity-based costing can be applied to information technology. On a micro-level, decision alternatives relate to individual economic agents such as firms or individuals. Their individual actions will not affect price levels, so that decision alternatives relate to different uses of resources when market prices are fixed. Researchers claim that activity-based approach is expanded beyond improved product cost information to a broader cost management philosophy that focuses on identifying and eliminating nonvalue-added activities relating to design, procurement, distribution, selling, and even administration functions” (Cooper & Kaplan 98). An objective of activity-based costing and account is to make available in an optimal manner, to all social constituents, relevant information on a firm’s goals, policies, programs, performance and contributions to strategic goals. Relevant information is that which provides for public accountability and also facilitates public decision making regarding social choices and social resource allocation.

The new ideas and accounting procedures have a great impact on companies and their strategic management. The method proposed by Johnson and Kaplan allows flexibility and adaptability. It refers to the degree to which data may be the basis for several types of information and reports. It depends on both the classification used for the data base into definite categories and the level of aggregation used in each of the categories. Activity-based method allows companies to adapt to new environments and calculate real product costs. The benefit for companies is that information is derived from the data base may be tailored to, or harmonized with, the decision processes of the firm.

The adaptability of an accounting system requires not only the presence of flexibility, but also an explicit process of harmonizing it with the decision process. This is especially important eithin the concept of a market equilibrium, where any individual would be just indifferent between different choice alternatives presented by the market. This implies that all individuals have preference structures defined in terms of money value and prefer more money to less. By applying this argument to the aggregate market environment, we can postulate that in equilibrium all market opportunity costs are just equal to zero. The activity-based costing and activity-based costing budgeting include the elements of organizational structure most prevalent and essential to a proper functioning of a management accounting system and the theories of organization essential to an identification of the significant elements that approximate the patterning and order in organizations. They define the role and scope of management in the organization and the techniques, approaches, and philosophies it may espouse in order to provide adequate services to the organization.

Works Cited

Albright, Th., Sparr, L. Activity-Based Management for the Labor Intensive Manufacturer: A Field Study. Journal of Managerial Issues, 6 (1994). 213-215.

Barnes, F.C. Management’s Stake in Improved Decision Making with Activity-Based Costing. SAM Advanced Management Journal, 57 (1992), 20-22.

Cooper, R., Kaplan, R. Cost and Effect. McGraw-Hill Ryerson Agency, 1997.

Johnson, Th. H., Kaplan, R. Relevance Lost: The Rise and Fall of Management Accounting. Harvard Business School Press, 1991.

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Lindahl, F. W. Activity-Based Costing Implementation and Adaptation. Human Resource Planning, 20 (1997), 62-65.

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