168

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

A STUDY ON ACTIVITY BASED COSTING Rahja Raajeswary @ Raaji Faculty Business & Law Multimedia University, Malaysia Email: [email protected]

Devinaga Rasiah Faculty of Business and Law Multimedia University (Melaka Campus) Email: [email protected]

Wei Yin, Lim Faculty Business & Law Multimedia University, Malaysia Email:[email protected]

ABSTRACT This paper examines Activity Based Costing. Activity Based Costing generally means the method of allocating overhead costs. The overhead cost is allocated to various activity cost pools and from those cost pools it is then allocated to products or services with the use of cost drivers or more clearly, the factors which has a direct cause and effect relationship with the resources consumed. In the traditional costing system a companywide predetermined overhead rate based on either direct labour cost or machine hours are used to allocate the overhead costs. In recent years due to the advancement in technology and the excessive usage of computerised system using a single allocation base like direct labour cost or machine hours are no longer relevant. Therefore a better approach to allocate overhead costs more accurately is needed. The advantages of using this approach and the limitations will be discussed. In addition, this paper also intends to study on how this approach can produce more accurate cost information. Field of Research: Activity-Based Costing, Traditional costing, cost drivers, cost pools

169

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

1. Introduction According to Jamaliah Abdul Majid and Maliah Sulaiman (2008), stated that activity-based costing (ABC) is a good system because it had been used in different ways, for instance customer profitability analyses (Bellis-Jones, 1989), cost reduction (Brimson, 1991), cost modeling (Cooper, 1994), product-range decisions (Johnson and Kaplan, 1987) and budgeting (Kaplan, 1994). Activity-based costing system allocates costs to cost objects such as products and services. It further calculates the costs of personal activities engaged to produce each product or services. Activity-based costing (ABC) is an approach for allocating overhead costs and it is a system used to measure the cost of activities and provide useful, timely and accurate information to the related management. According to the John C. Lere (2000), stated that activity-based costing is a powerful tool for industrial marketing decision makers because activity-based costing had appeared over the past 20 years.

According to the Jamaliah Abdul Majid and Maliah Sulaiman (2008), the process would entail measuring the cost; performance of cost object and the activity which comprises of activity-based costing. Jamaliah Abdul Majid and Maliah Sulaiman further agreed that in activity based costing the following variables should considered such as jobs, customer, service, and product for costing purposes. Resource drivers and activity drivers respectively measure the consumption of resource and consumption of activity. In addition, they also claimed that activity-based costing had tried to define the cost drivers and charged a cost object for only the overhead it actually consumed.

2. Research Question Can Activity – Based Costing provide a better product and service costing information for firms compared to Traditional Costing System?

3. Research Objective The objective of this research is to do a theoretical review on Activity – Based Costing system in firms and further examine its benefits.

4. Research Purpose The purpose of this study is to provide relevant and accurate costing information to managers to make better decisions with regards to the use of Activity-Based Costing.

170

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

5. Background Research According to the Jesper Thyssen, Poul Israelsen, Brian Jorgensen (2004), they stated that the origin of activity-based costing traced back to1983 – 1984 (Kaplan 1983; 1984a,b; 1985a,b; 1986) although the term of activity-based costing haven’t been created yet. Due to resentful of the traditional costing system, this was disputed to be not relevant to be used in the current manufacturing industry. ActivityBased Costing was an invention brought to existence after several attempts of innovative action research carried out by Robin Cooper and Robert S. Kaplan through the period 1987 to 1992 (Kaplan 1998).Kaplan’s and Cooper’s book on “Cost and Effect” (1998) has significant insight on Activity-Based Costing. The model grew into a more full-fledged costing system for hierarchies of activities and cost objects.

According to the Rotch (1990);Cooper(1994); King et al(1994)Cooper and Kaplan(1998), they stated that company in USA and UK for instance telecommunication , information service, transportation and marketing of service sectors also using activity-based costing. According to Jamaliah Abdul Majid & Maliah Sulaiman (2008), they stated that traditional costing system allocates overhead to products on the basic of predetermined plant wide allocation based using labor costs and machine hours. Therefore, the relationship between indirect costs and the individual product rarely reflected the real cause and effect on the activities. Activity-based costing has been used by every company because labor hours and machine hours of the traditional costing method did not fulfill the allocation of all the overhead cost. Alternatively, it can be said that activity-based costing system had solved the limitations of the Traditional costing system.

6. Literature Review 6.1 Advantages of Activity-Based Costing According to Carles Griful (2001), several authors had described the main advantages and benefits of using ABC costing such as Innes and Mitchell, (1990); Bellis-Jones and Develin, (1995); Malmi, (1997). According to them Activity-Based Costing reduces the risk of the company and provides more useful decisions in the future. Therefore, it not only depended on the analysis but also depended on its ability to use the correct diagnosis for successful outcomes. Activity-Based Costing also focuses on the value-added activities, which are those activities that create value to customers. Non value adding activities could influence activities to generate value adding activities. In addition to these, the product and service costing was more accurate, especially the non-volume -related overhead in the organization. It is the cost behavior that captured the interest of the managers. Activity-Based Costing looked into the costs of complexity, variety and change related to the service provided and to the customized customer requirements.

171

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

Activity-Based Costing is said to help analyze customer profitability. It enabled costs by areas such as in terms of managerial responsibility and customers to be examined, by which the customers directly were influenced on cost structure of the cost. It also helped to recognize the way in which customers directly influenced the cost structure of the business. Practical capacity is used in order to execute capacity analysis. In order to have the right capacity, costs of resources used needed to be measured instead of the costs of resources supplied to close the excess capacity gap.

6.2 Limitations of Activity-Based Costing Activity-based costing is a system to solve the limitation of traditional costing system but did not represent to be the perfect one. Below are the limitations of the activity-based costing:The limitations of activity-based costing are the difficulty in collecting the accurate data of the amount of work because several activities cross department bonder. Besides that, executing activity-based costing was a multi-step process and it required not only collecting and processing of data, but also needed interpretation of the result. Too much time, effort and money on gathering and going over the data collected are also associated with Activity-Based Costing by some companies besides its benefits (Peter F. Druker, 1999). Normally, the managers were not pleased to handle too many details that involved in ABC. On the other hand, incomplete data had led to lacking of details for decision making. The incomplete data provided would have affected the results when using ABC. This will happen in businesses that had no intention of using ABC costing as their main costing system. Cokins (2000) in his article wrote “Overcoming the obstacles to Implementing Activity – Based Costing, noted that the managers ignored the cardinal rule so the activity based costing usually led to a failure. Moreover, the advantages of average cost rates, andoverly detailed information and the failure to connect information to actions interfered with ABC projects. CPA business partners and consultants could improve their performance by having knowledge on these concepts of Activity – Based Costing, with its only limitation being costly software to implement, Cokins (2000). A special purpose Activity – Based Costing software tailored to the specific firm is required to make the activities in the firm more manageable and easier to handle in the organization. Moreover, time can also be a factor for businesses seeking a quick fix which means that ABC costing can be successful in a short run .Relating to Henricks (1999) although some companies had instant results, it typically took a longer time to experience the benefits of ABC. According to Peter (1999), some overhead costs, such as chief executive salary, are difficult to be assigned to products and customers. 'Business sustaining' which are termed by the costs and were not assigned to products and customers because it was not meaningful to an organization. The main motif of Activity – Based Costing was to provide accurate costing information to management but some argued that there were also chances of allocating costs arbitrarily, which meant that the cost drivers did

172

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

not match the cost pools or activities of the company. Hence, it cannot be denied that any cost of using ABC approach, could be assigned in an arbitrary manner.

6.3 Steps in implementing Activity Based Costing ABC system involved the following stages as follows: 1

2 Identify Important Activities

3 Create cost pools for each activity

4 Identify cost drivers for each activity

Costs are traced based on products consumption of activities

7. SCENARIO ONE: Young & Young offer two primary services, auditing and taxation. The partners from both the service line are having a different opinion regarding the assignment of overhead. Tax partners want the overhead to be assigned on the basis of 20 % of direct labor dollars, whereas the audit partners wants to implement activity based costing. Both the partners had agreed on doing an analysis and comparison on both the allocation methods.

Activity Cost Pools Employee Training

Direct labor dollars

108,000

900,000

Expected use of cost drivers for Audit Service 525,000

Typing and Secretarial

No of reports/Forms

38,100

1,250

400

850

Computing

Number of minutes

102,000

30,000

12,500

17,500

Facility rental

Number of employees

71,250

20

11

9

Travel

Per expense

40,650

Direct

28,000

12,650

Cost Drivers

Estimated Overhead

Expected use of Cost Drivers

Expected use of cost drivers for Tax Service 375,000

173

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

Assigning Overhead under Traditional Costing Predetermined overhead rate x direct labor dollars

Overhead assigned to audit: 0.20 x RM525, 000 = RM210, 000 Overhead assigned to tax: 0.20 x RM375, 000 = RM150, 000

Assigning Overhead under Activity – based Costing Activity cost Pools

Estimated Overhead

Estimated Use of Cost Drivers per Activity

Activity – Based Overhead Rates

RM108,000

900,000 Direct labor dollars

RM0.12 per direct labor dollar

Typing and Secretarial

38,100

1,250 Reports/Forms

RM30.48 per report/form

Computing

102,000

30,000 Minutes

Facility Rental

71,250

20 Employees

Travel

40,650

Direct

Employee Training

RM3.40 per minute RM3,562.50 per employee Direct

RM360,000

Activity Cost Pools Employee Training

Expected use of cost driver RM525,000

Activity-Based Overhead Rate for Audit Service RM0.12

Cost Assigned for Audit Service RM63,000

Typing and Secretarial

400

RM30.48

RM12,192

Computing

12,500

RM3.40

RM42,500

Facility Rental

11

RM3,562.50

RM39,187.50

Travel

28,000

Direct

RM28,000

Overhead costs assigned Activity Cost Pools

RM184,879.50 Expected Use of Cost Driver

Activity-Based Overhead Rate for Tax Service

Cost Assigned for Tax Service

174

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

Employee Training

RM375,000

RM0.12

RM45,000

Typing and Secretarial

850

RM30.48

RM25,908

Computing

17,500

RM3.40

RM59,500

Facility Rental

9

RM3,562.50

RM32,062.50

Travel

12,650

Direct

RM12,650

Overhead cost assigned

RM175,120.50

Traditional Costing

Activity-Based Costing

Difference

Audit Service

RM210,000

RM184,879.50

RM25,120.50

Tax Service

RM150,000

RM175,120.50

RM25,120.50

For Audit service the difference is 12% lower under ABC costing The difference for Tax Service is 16.7% higher under ABC costing. Therefore Activity-Based Costing should be used to ascertain the profitability of each service.

9. SCENARIO TWO:-ABC and Traditional costing Gabrielle manufactures massaging chairs. The accountant has proposed changing from traditional costing system to Activity-Based Costing system. The vice president of Gabrielle requires an analysis and comparison to be made between the two costing methods. Gabrielle currently received an order of 75 units of massaging units, and the comparison between the two costing methods will be based on this order.

Relevant Information for both costing methods: Direct Materials: RM27, 750 Direct Labor Hours: 410 Direct labor rate per hour: RM9

175

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

Relevant Information to traditional costing system: Predetermined overhead rate is 150% of direct labor cost.

Relevant Information to Activity-Based Costing system:

Activity Cost Pools

Cost Drivers

Activity-Based Overhead Rate

Expected use of Cost Drivers for Massaging Chair Order

Engineering design

Engineering Hours

RM15 per hour

165

Machine setup

Setups

RM100 per setup

11

Machining

Machine Hours

RM12.5 per hour

366

Assembly

Number of subassemblies

RM4 per subassembly

750

Packing and Shipping

Packaging/shipping Hours

RM7.5 per hour

76

Building occupancy

Machine Hours

RM3 per hour

366

Traditional Costing System:

Direct Materials

RM27,750

Direct Labor

(410 x RM9)

RM3,690

Overhead Assigned

(RM3, 690 X 150%)

RM5,535

Total costs assigned to the order Number of massaging machines Cost per unit

Activity-Based Costing

RM36,975 75 RM493

176

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

Direct Materials Direct labor

RM27,750 (410 x RM9)

RM3,690

Engineering design

(165 hours X RM15)

RM2,475

Machine setup

(11 setups x RM100

RM1,100

Machining

(366 machine hours x RM25)

RM9,150

Assembly

(750 subassemblies x RM4)

RM3,000

Packaging and shipping

(76 hours x RM7.50)

Building Occupancy

(366 hours x RM3)

Overhead activities costs :

Total costs assigned to the order Number of massaging order Cost per unit

RM570 RM1,098 RM48,833 75 RM651.11

The cost per unit obtained through Activity-Based Costing was better than the cost per unit obtained from the traditional costing system because Activity – Based costing related to the sources and causes of the cost per unit. Due to this Activity – Based Costing enables Gabrielle to derive a better product costing and with this it will have better control over its profitability.

8. Analyses and Discussion Apart from the ABC costing system, there is another system called traditional costing system. Traditional costing system allocates overhead through a very direct way that is based on the basic of predetermined such as machine hours or the labor costs. Activity-based costing (ABC) provided more accurate information than traditional costing system, because it assigned overhead costs using the steps that had been mentioned at section 3. Traditional costing system allocates overhead to products on the basis of predetermined plant wide overhead rate using direct cost and machine hours. In this rapidly developing environment, the total overhead cost such as depreciation on plant, property and equipment, maintenance had increased. On the other hand, the amount of direct labor used in industries had reduced. In this situation, it was inappropriate to use the basic predetermined overhead rates based on direct labor because direct labor and overhead had no correlation.

177

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

This had led to product cost distortions because the companies were using overhead rates based on direct labor, where companies were no longer labor intensive. Companies can prevent the distortion by using the machine hours as the basis to allocate overhead in an automated manufacturing industry. Manufacturing process were involutes and complex, and therefore using only machine hours was not sufficient to allocate all the overhead cost. In this situation, managers had decided to use “activity based costing”.

10. Conclusion Activity-Based Costing system provides accurate costing information to managers in an organization. These information leads to better decision making in terms of product and service costing. Traditional Costing system uses a single plant wide overhead rate, using activity base such as labor and machine hours to assign all the overhead to the processes or departments, whereas Activity-Based Costing allocates overhead costs to activity cost pools, which it later assigns using cost drivers to products based on the level of the products consumption of activities. Under the Traditional Costing system, importance is given to single cost objects such as products and services, whereas Activity-Based Costing focuses on many cost objects or activities of the businesses. In addition, Traditional Costing system leads the business to experience over or under costing problem. This was due to the firm’s inability to match the activities with the correct allocation base. Activity-Based Costing on the other hand provided accurate information to support the decision made by the organization. Accurate information was the key to improve cost management efforts.

Therefore, with all the analysis done above, it can be concluded that Activity-Based Costing provides more accurate costing information compared to the Traditional Costing system.

11. References Akyol, D.E., Tuncel, G., &Bayhan, G.M. (2005). A comparative analysis of activity- based costing and traditional costing. World Academy of Science, Engineering and Technology 3 2005, pp, 4447. Bordovsky, T., VanZante,N.R., &Wagman, G.R. (2005). Activity-Based Costing System Required For Successful Customer Relationship Management. Journal of Business & Economics Research – March 2005, Vol. 3, No. 3, pp, 35-37 Brown, I.R. (2003). Pricing and profit management [Electronic Version], pp 1-3. Burch, J, (1994), Cost and Management Accounting. Modern approach. West Publishing Company, ST Pual, MN.

Drucker, Peter F. Management Challenges of the 21st Century. New York:Harper Business, 1999.

178

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

Eden, Y. & Ronen, B. (2002).The same things in a different guise? Activity-based costing and activity-based management, pp, 47-57. Granof, M.H., Platt, D.E., & Vaysman, I. (2000). Using Activity-Based Costing to Manage More Effectively .The PricewaterhouseCoopers Endowment for The Business of Government , pp. 1-31.

GRÍFUL.C. (2001), Activity-Based Costing Methodology for Third-Party Logistics Companies. IAER: FEBRUARY 2001, Vol. 7, No. 1, pp. 133-146.

Heaney, M. (2004), Easy as ABC? Activity-based costing in Oxford University Library Services. Managing Library Finances Vol 17 · No 3, pp. 93-97

Jamaliah Abdul Majid & Maliah Sulaiman. (2008). Implementation of activity based costing in Malaysia, Asian Review of Accounting Vol. 16 No. 1, 2008 pp. 39-55.

Jerry, W. (1995). Activity based costing for financial institutions. The journal of Bank Cost and Management Accounting, Jan 1, 1995, Vol 8, No 3 Kaplan, R.S. (1994), “Flexible budgeting in an activity based costing framework”, Accounting Horizons, June, pp. 104-9. Kocakulah, M.C., Kelley, A.G., Ruggieri, M., & Aquilina, N.D. (2007), Utilizing Activity-Based Costing To Manage The Maintenance Function In A Manufacturing Company. Journal of Business Case Studies – First Quarter 2007, Vol. 3, No. 1, pp. 57-64

Krishnan, A. (2006), An Application of Activity Based Costing in Higher Learning Institution: A Local Case Study, Contemporary Management Research Pages 75-90,Vol.2, No.2, September 2006, pp,76-87.

Latshaw, C.A., & Danile, T.M.C. (2002), Activity-based costing: usage and pitfalls. Review of Business, Winter, 2002, pp.2-3.

Lere, J.C. (2000). Activity-based costing: a powerful tool for pricing. Journal of Business & Industrial Marketing, Vol.15, pp.23-33.

179

4TH INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (4TH ICBER 2013) PROCEEDING 04 - 05 MARCH 2013. GOLDEN FLOWER HOTEL, BANDUNG, INDONESIA ISBN: 978-967-5705-10-6. WEBSITE: www.internationalconference.com.my

Monir Zaman. (2009). The Impact Of Activity Based Costing On Firm Performance: The Australian Experience. International Review of Business Research Papers, Vol. 5 No. 4 June 2009, pp. 200208, 200.

Roztocki, N., & Weistroffer, H.R. (2006). Stock Price Reaction to Investments in Information Technology: the Relevance of Cost Management Systems. The Electronic Journal Information Systems Evaluation Volume 9 Issue 1, pp. 27-30.

Son, R.L.S., & Williamo (2009), Activity-based costing: It is still relevant. Management Accounting Quarterly 32 , Spring 2009, Vol.12, No.3, pp. 31-39. Stevenson, T.H., Barnes, F.C. and Stevenson, S.A. (1993), ``Activity-based costing: an emerging tool for industrial marketing decision makers'', Journal of Business and Industrial Marketing, Vol. 8 No. 2, pp. 40-52. Thyssen, J., Israelsen, P., &Jorgensen.B. (2004). Activity Based Costing as a method for assessing the economics of modularization – a case study and beyond [Electronic Version], pp. 1-28

Yazdifar, H. & Askarany, D. (2007), Why ABC is not widely implemented? International Journal of Business Research, pp, 1-8.

Weygandt, Kimmel, Kieso (2012), Activity-Based Costing : Managerial Accounting (Sixth Edition)