Activity Based Costing and Activity Based Budgeting

Introduction

Accounting has changed over time by recognizing the effects of accounting information on management procedures, 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.

We will write a custom Activity Based Costing and Activity Based Budgeting specifically for you
for only $14.00 $11,90/page
308 certified writers online
Learn More

Main text

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 1991, p. 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. Activity-based costing is a more accurate management method that 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 1991, p. 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 1997).

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 1991, p. 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 underline 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 1997).

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 1991, p. 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.

Get your
100% original paper on any topic done
in as little as 3 hours
Learn More

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, the scope of operations, levels of quality, area of market coverage, the number” (Johnson and Kaplan 1991, p. 160). In general, this cost accounting method provides cost data for the development of the right strategy necessary to gain a competitive advantage.

The activity-based costing methods have been developed and tested by other researchers. Among them are Hussein & Tam (2004), Lindahl (1997), Albright & Sparr (1994), Maiga & Jacobs (2003). These researchers broaden their understanding of activity-based costing by bringing into the analysis the strategic elements necessary to gain a competitive advantage. As a result, accounting information gains an expanded role in the stages of the strategic process:

  1. formulation of strategies and stages,
  2. communication of strategies,
  3. development of tactics, and
  4. implementation.

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 so that management can focus its attention on the products and processes with the most leverage for increasing profits. It helps managers make better decisions about product design, pricing, marketing, and mix, and encourages continual operating improvements” (Johnson and Kaplan cited Barnes 1992, p. 21).

Using these examples, Barnes underlines that activity-based costing and budgeting allow improving 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 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.

“ABC thinking” calls into question performance measurement. If the new “activity” insights call for a different emphasis, then performance measurements should direct the manager’s efforts toward that emphasis (Lindahl 1997, p. 62).

We will write a custom
Activity Based Costing and Activity Based Budgeting
specifically for you!
Get your first paper with 15% OFF
Learn More

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. Since decisions are future-related, this involves the concept of environmental stability.

Krumwiede & Roth (1997) broaden the concept and suggest that 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. Krumwiede & Roth (1997) claim that:

the 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” (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.

Albright & Sparr (1994) and Maiga & Jacobs (2003) find that the approach proposed by Johnson and Kaplan (1991) optimally balances potential information conflicts among the various social constituents of a firm. Activity-based costing and budgeting include formalized procedures for cost accumulation, product costing, budgeting, performance evaluation, and resource allocation. Business strategies define how a firm decides to compete in a given business and positions itself among its competitors.

They underline that the strategy style adopted needs to be supported by adequate and appropriate accounting techniques. Therefore, the strategic style chosen is an important determinant of the principles, techniques, and systems of accounting techniques adopted.

The determination of the appropriate method is important to both internal and external users of management accounting information of a given firm as it may show the nature of the “fit” between the strategic style and the management accounting system supporting its enactment, formulation, and implementation. Albright & Sparr (1994) find that “The cost analysis performed by TPG suggests that even in a labor-intensive manufacturing environment, ABC can produce cost estimates that differ and are superior to those provided by a labor-driven overhead rate” (p. 215).

Not sure if you can write
Activity Based Costing and Activity Based Budgeting by yourself?
We can help you
for only $14.00 $11,90/page
Learn More

These activities require sometimes subjective interpretations and involve personal interactions. Management control involves both top management and middle managers who will approach problems following a definite pattern and timetable to ensure efficient and effective results. Maiga & Jacobs (2003) expend the theory of activity-based costing and suppose that the performance of these tasks or transactions is accomplished according to rules and procedures derived from management control and planning. Also, they test the interaction effect of Balanced Scorecard (BSC) and activity-based costing on manufacturing unit performance. They find that:

BSC systems and management accounting systems can have complementarity or synergistic effects on performance. Thus, inferences from this research are that (1) researchers need to be aware of the important role BSC and ABC can play in determining the effectiveness of any “intervention” in contemporary manufacturing environments and (2) companies seeking substantial improvements in their programs should modify their manufacturing initiatives to complement the new performance standards” (385).

It is possible to say that the process by which accounting principles have evolved has changed over time, and that management has full control over the methods by which accounting information is collected and the type of information that was reported. As a consequence, modern organizations adopted activity-based costing and activity-based budgeting techniques to accomplish their strategic objectives.

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 database into definite categories and the level of aggregation used in each of the categories. For example, purchase data may be classified under the following categories:

  1. by individual product or service,
  2. by the individual purchaser,
  3. by the supplier, and so on.

These data may be aggregated under the following categories:

  1. by transaction,
  2. by day,
  3. by month, and so on.

The concern is with the conduct of managerial activities within the framework established by strategic planning (Cooper & Kaplan 1997).

The 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 database 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 within 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.

When considering costs, benefits, profits, and losses, people commonly think about cash flows or accounting definitions. Since accounting information is primarily concerned with the measurement of income based on explicit costs and benefits of objectively determinable transactions during a specified reporting period, implicit costs and opportunity costs are not recognized. Thus, accounting income does not represent economic income. This special characteristic of accounting data must be recognized when such data are used in any economic analysis. Following Johnson and Kaplan (1991) “within a multiperson organizational setting, the benefit and cost of installing a managerial accounting procedure depend upon how people react to and use its output” (p. 174).

The lack of an adequate activity-based costing structure is mainly due to the failure to recognize the conceptual foundations of management accounting as a guide for the development and evaluation of management accounting techniques. The main advantage for companies is that activity-based costing rests on accounting, problem and decisional, organizational, behavioral, and strategic foundations. The incorporation of these five foundations in management accounting will provide the adequate structure that will enable the gathering of enough pertinent managerial data for internal problem-solving.

Summary

In sum, the literature analysis shows that activity-based costing and activity-based costing budgeting are effective systems that allow organizations to estimate the real cost of products and improve their operations. The activity-based costing and activity-based costing budgeting include the elements of organizational structure most prevalent and essential to the 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 to provide adequate services to the organization. These conclusions point to the possibility of formulating a model of the nature, elements, and determinants of the conceptual foundations of management accounting. Such a model would represent a first step toward the development of a combinatorial theory.

More explicitly, the scope and conduct of activity-based costing and activity-based costing budgeting rest on the new structure of accounting. The activity-based costing and activity-based costing budgeting may will differ in different spheres of business of the extent of appreciation and the incorporation of these foundations, their determinants, and their elements in the design of the system. The research studies and critics reviews of the theory show that the original criticism of activity-based costing is irrelevant. The prove that each of the determinants depends on the set of variables or elements of the foundations, which will characterize by their implementation the resulting management accounting system.

This model provides information that reflects the consequences of past decisions, and particular decision-makers. By ignoring opportunity costs and implicit costs, they will likely make the wrong decisions and therefore select nonoptimal alternatives. On the other hand, actual decisions may reflect not only accounting data, but also a whole realm of future projections including risk analysis and cost considerations. In such a scenario, the role of accountants and the value of accounting information may be seen in a different perspective. Consistency, uniformity, and the ensuing comparability are considered desirable criteria for cost-based budgeting. Their relevance to management accounting differs between long-term and short-term decisions.

Bibliography

Albright, Th., Sparr, L. 1994, Activity-Based Management for the Labor Intensive Manufacturer: A Field Study. Journal of Managerial Issues, vol. 6, iss. 2, pp. 213-215.

Barnes, F.C. 1992, Management’s Stake in Improved Decision Making with Activity-Based Costing. SAM Advanced Management Journal, vol. 57, iss. 3, pp. 20-22.

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

Hussein, M. E. A., Tam, K. 2004, Pilgrims Manufacturing, Inc.: Activity-Based Costing versus Volume-Based Costing. Issues in Accounting Education, vol 19, iss. pp. 539-548.

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

Krumwiede, K.R., Roth, H.P. 1997, Implementing Information Technology Innovations: The Activity-Based Costing Example, SAM Advanced Management Journal, vol. 62, iss. 4, pp. 97-98.

Lindahl, F. W. 1997, Activity-Based Costing Implementation and Adaptation. Human Resource Planning, vol. 20, iss. 2., pp. 62-65.

Maiga, A. S., Jacobs, F. A. 2003, Balanced Scorecard, Activity-Based Costing and Company Performance: An Empirical Analysis. Journal of Managerial Issues, vol. 15, iss. 3, pp. 383-385.

Check the price of your paper