Activity Based Costing
Thursday, June 5th, 2008The purpose of this report is to present the pilot Activity-Based Costing (ABC) for the University. The emergence of ABC systems has been viewed as the means by which management accounting can re-establish its relevance. It became popular towards the 1980′s, because it prevents cost distortion and provides a process view with traditional accounting cannot provide.
The University is considering adopting ABC because the widespread concern about rising costs for higher education and the unique characteristics of universities that make for special challenges.
The report discusses the various changes in the manufacturing sector with regard to the introduction of ABC and shows how this method can be employed in a higher education institution. It also discusses the advantages and disadvantages of using ABC and explains how ABC may, or may not help the university control its costs.
INTRODUCTION
Traditional costing system has been criticized for cost distortion and lack of relevance during the last 20 years (Johnson and Kaplan 1987). A new costing method, known as Activity Based Costing, was developed as a means of overcoming the systematic distortions of traditional costing systems.
ABC was innovated 50 years ago, but its implementation started in the 1980s due to the intense global competition which led to decision errors due to poor cost information provided by the traditional costing system.
Activity Based Costing (ABC) can be defined as “A method of measuring the cost and performance of activities and cost objects. Assigns cost to activities based on their use of resources and assigns cost to cost objects based on their use of activities. ABC recognizes the casual relationship of cost drivers to activities.” (Peter B. B. Turney)
ABC has two main purposes. The first purpose is to prevent cost distortion and the second purpose is to minimize waste or non-value-adding activities by providing a process view.
In the beginning ABC was mostly used by the manufacturing businesses. It was in the 1990s that the universities stated using the ABC system.
Universities are a very complex business organization with many processes and several layers of outputs. In many ways ABC is a natural solution for such complex organizations as universities, where there are a large number of small and diverse elements forming the cost base. Once an ABC system is in place, it allows all those elements to be tracked regularly and simply for highly efficient cost control.
MAIN BODY
Changes in the manufacturing sector with regard to the introduction of ABC
Manufacturing sector undertook many changes in the last few decades. Earlier this sector was characterized of having direct-labor-intensive production, with low level of overheads relative to direct costs, in a relatively uncompetitive market. But, the start of the new millennium has fundamentally altered the world of industrial production. Now the manufacturing sector has been characterized by capital-intensive production, with a high level of overheads relative to direct costs, in a highly competitive international market. It purports to undo many of the flaws of conventional management accounting by providing strategic and operational, financial and non-financial information to an organization. It identifies that a business is a series of linked activities and processes that are undertaken to serve the customer and to deliver product attributes. These processes and activities is the place where all the costs are happening. Managing these will improve the total cost figure and ultimately, profitability and shareholder value. It is an accounting approached primarily at understanding causality and giving decision-makers the potential to manage costs at the root, rather focusing on product costs only. Product mix helps in decision making. The changes in businesses that ABC caused over traditional costing can be seen in Appendix 1.
How ABC may be employed in a higher education institution
In the early years, ABC was primarily used by manufacturing industries. It was later in the 1980′s that, the service industry realized the use of ABC and started adopting it. In fact, ABC is more relevant to service industries because, in the absence of a direct material element, a service business’s total costs are likely to be particularly heavily affected by overheads.
The main steps involved in implementing ABC are:
Step 1: Identifying the major activities that take place in an organization.
Step 2: Assigning costs to cost pools/coat centers for each activity.
Step 3: Determining the cost drivers for each major activity.
Step 4: Assigning the cost of activities to products according to the product’s demand for activities.
Universities being a part of the service sector have very high overheads. Degree courses are the primary output in a higher education institution. Core activities in a university are teaching, research, service and outreach. These are supported by functions such as administration, facilities maintenance, security, library and learning resources, and labs. University department budget are based on several factors such as credit hours produced, sections offered, number of students and size of the teaching staff. Traditional costing at universities assumes that all courses are the same. But ABC allocates differently. Let’s take a hypothetical university called Lancaster University (LU). LU offers courses in two different academic units, assuming the units have equivalent number of faculty, courses and students. How ABC can help determine the cost of a course is shown in Appendix 2. An example of ‘Estimating the cost of a course’ using ABC is shown in Appendix 3.
Advantages of using ABC
ABC is becoming widely used because of several advantages. Firstly, the implementation of ABC is very advantageous in a highly competitive market, because the system would not under-cost complex, low volume products or services and over-cost simple, high-volume products or services. Secondly, it helps in improvement in cost-control: managers can see costs broken out by a number of activities rather that buried in one or two overhead cost pools. The pooling of costs by activities provides information that helps managers to better plan and control costs. ABC system generally improves the ability of an analyst to estimate the cast flows (Hilton 1994:834). By separating costs into activity pools and identifying a cost driver in each cost pool, the analysts are able to determine more accurately, the levels of various costs that will be incurred.
Disadvantages of using ABC
The major problem with ABC system is that the cost of implementing may exceed the benefits. There are three reasons for criticizing ABC. Firstly, it can be difficult to associate a cost with driver and measure the effect of the activity on that cost. Secondly, the calculations are very complex and may not be worthwhile if the information is not used. Lastly, substantial costs might be left for conventional treatment so that they ‘swamp’ the costs treated under them.
How ABC may, or may not help the University control its costs
ABC can help universities control its costs in many ways. Firstly, its cost information provides universities better picture of true costs of different programs. Secondly, by identifying activities associated with different courses helps universities determine are value adding (helping students learn) and which are no value adding (require a dozen approvals for a new course or frequent changes in teaching schedules) and can be eliminated/simplified. Thirdly, it helps in identifying areas that need more resources and those areas that need fewer resources. It also gives knowledge of true costs of courses/products, which helps universities manage there course/product mix well. It helps eliminating course proliferation and obsolete courses/programs, therefore reducing the costs of running these courses.
CONCLUSION
ABC has highlighted true understanding of what it costs to provide products and services along with a tool for better management. It helps to understand better understand and serve as guides in any business process improvement initiatives, and to subject resources to its efficient use. In a nutshell, it helps to make more effective business process improvement at more transparent cost. ABC has been a suitable technique in both manufacturing and service sector in determining more accurate product or service cost, and in improving the activities preformed by the organization.
The analysis made in the report verifies that ABC could be an appropriate technique to measure and manage the costs of the University. ABC would give the University a competitive advantage over other universities. It will help in giving a clear understanding of unit costs and profitability.
But ABC has problems such as difficult implementing, costly, staff resistance, timeless and difficult gathering information and questionable gathered information.
As the University has entered the new millennium, it need to find new ways to manage shrinking revenues, rising costs for campus and increasing enrolment while enduring high quality education.
In conclusion, the University can encompass the cost control by adopting an Activity-Based Costing system. This can be backed up by the working shown in Appendix 3.
APPENDIX
Appendix 1: Difference between ABC and Traditional Costing
Granof M. H., Platt D. E., Vaysman I., “Using Activity-Based Costing to Manage More Effectively”, The PricewaterhouseCoopers Endowment for The Business of Government, Grand Report, Jan. 2000
Appendix 2: Activity-Based Costing: Application to Higher Education
Tatikonda L. U. and Tatikonda R. J., “Activity-Based Costing for higher education institutions”, Management accounting quarterly, winter 2001, pp.22
Appendix 3 : Example on implementation of ABC
Lancaster University-Activity and cost data
Lancaster University-Cost per course-Activity-Based Costing
Lancaster University-Comparison of Cost Per Course
Tatikonda L. U. and Tatikonda R. J., “Activity-Based Costing for higher education institutions”, Management accounting quarterly, winter 2001, pp 23