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Activity Based Costing (ABC) - Sample Research Paper




"Activity based costing (ABC) is the perfect cure for the problem of overhead allocation within organisations." This statement demonstrates the relationship between activity based costing and the process of overhead allocation. Activity based costing is simply an accounting method that identifies all activities and the costs associated with these activities; it then assigns the cost associated with the activity directly to the pricing of the output of that activity, rather than averaging the cost across all outputs. This is obviously not required in organisations that produce only one good or service, but in most organisations there is more than a single good or service produced. The use of activity-based costing reduces the potential for overpricing or underpricing, thus allowing the firm to offer more precise prices to its consumers. However it is much more complex to implement and depends on data that firms may not have access to, which can reduce its utility particularly for smaller firms and those that make less use of information technology. Thus, ABC can be a strong tool for budgeting and costing in some organisations, but is not necessary in others.

Cost Research

Activity-based costing, as noted above, is used to precisely identify cost centres for each product or service offered by a firm and build those costs into the price of the product. For example, in a manufacturing plant that produces two dissimilar products, it is likely that these products will use not only different materials (which can be easily directly costed), but different amounts of worker labour, electricity, machine time, human resources and management efforts, and marketing requirements. If one product requires twice as much marketing effort as the other product, it is clearly fair that the price of the first product reflects this increased cost for marketing. Thus, the use of ABC allows the firm to precisely price its products in reflection of their actual cost of production. The process also allows for elimination of waste by identifying areas where there are excessive expenditures and allowing the firm to limit these expenditures. These all provide compelling reasons why a firm might want to use ABC to control its costs and determine prices.

There are five steps to setting up an activity-based costing system. These include identifying the activities a firm engages in; determining the costs of these activities; identifying activity centres; selecting first-stage cost drivers; and selecting second-stage cost drivers. These activities may be performed in different was depending on the system that is currently in place for tracking and identifying work processes. For example, a firm that uses an online tracking system for its customer service management processes will find it relatively simple to implement activity-based costing for these services, as will a manufacturing firm that uses an ERP system to drive manufacturing processes.

The advantages to ABC include careful control of costing, which can be a strong advantage when there is fierce competition, when the products being produced are already very expensive, or when a firm is attempting to gain or maintain a cost-leader position. It can also help to ensure that a firm with a diverse product line can price its products competitively in all cases, which allows for increased competitiveness within each of these areas (Proctor, 2009). It also provides a good way for service organisations to handle costing. However, there are also some disadvantages to ABC. First, ABC is highly complex and may be difficult for firms to implement with accuracy; for some costs, such as upper management compensation, there is simply no way to identify an appropriate costing method, leaving some portion of expenses in the traditional undifferentiated overhead bucket. Second, ABC does not take into account resource constraints or excess capacity; although it may be possible to identify these issues with careful examination, there is nothing inherent in the methodology that does so, making it difficult for the firm to engage in waste management. Finally, there is some feeling that the activity centres chosen in ABC may be to some extent arbitrary, and that these activity centres do not necessarily apply directly to the products involved. Finally, in some cases, like in cases where firms produce only one product, ABC is simply unnecessary and traditional costing is a more appropriate and simpler approach to overhead allocation.

Research has indicated that a relatively small number of UK firms currently use activity-based costing in their accounting operations (FSN, 2008). Although FSN (2008) indicated this was only 10-12% of US firms, early research had indicated that this may be as high as 15%. The reasons for this lack of adoption are unclear. However, research has indicated that some of the reasons that ABC may not be used by UK firms include lack of product diversity (ABC is not required if only one product, or several very similar products, are produced by a firm); firm size; industry; and use of information technology. Despite the potential usefulness of activity-based costing to manufacturing, only around 20% of manufacturing firms in the UK were found to use ABC, as compared to 68% of financial services firms. Finally, 57% of small firms were found to use either no formal costing at all or only direct costing, and very few small firms used activity-based costing. Thus, the potential usefulness of activity-based costing is not being realised by many firms in the UK.

If an organisation has a specific need for ABC and it has chosen to use the information technology and production management structures required to determine its costing precisely for multiple products or services, ABC can be a highly effective means of development. However, the disadvantages, such as the difficulty of identifying indirect costs and the problem of isolating and calculating indirect costs, should not be overlooked.

Capital Investment Appraisal Methods

Capital investment appraisal is the process of determining which capital investments are appropriate for a firm to make based on its restrictions, resources, and required rate of return (Proctor, 2009).There are a number of different methods of capital investment appraisal available to organisations. Four of the most common capital investment appraisal methods include the payback period, the internal rate of return, the accounting rate of return, and the net present value (Proctor, 2009). However, these methods of appraisal are suitable in different situations, and some of them are not suitable for more than a very shallow estimate. Choosing the right method is key to successful selection of capital investments.

These four methods of capital investment appraisal are widely used in the UK; the table below demonstrates the use of the four types of appraisal techniques for strategic and non-strategic projects. These figures, from a study of major UK firms indicate that the ARR is the least commonly used, with the IRR being the second least commonly used; the NPV, widely acknowledged to be the most robust method of appraisal, is also most commonly used for both strategic and non-strategic projects.

The simplest method of capital investment appraisal is the payback period, which is simply the investment divided by the rate of return per period. For example, if a project is expected to cost $45,000 and return $15,000 per year, the payback period is 3 years. The payback period has some advantages, such as simple calculation and ease of use, and remains a popular method of calculation. However, its disadvantages, which include ignoring the effects of inflation, the time value of money, and its bias toward shorter-term projects, make it unsuitable for sole use in capital investment appraisal and making net present value and other methods preferred.

The accounting rate of return calculates the average percentage return that a firm can expect to realise over the lifetime of the investment (Proctor, 2009). In order to do this, it calculates the average rate of return over the expected lifetime, and then divides this by the expected investment in order to determine the average expected rate of return for the project. For example, a project that cost £10,000 and had annual cash flows of £3,000 would have an ARR of 20% over four years ( ). This can be used comparatively in order to determine which approach would be best (Proctor, 2009).However, as with the PP, the ARR ignores the time value of money and the structure of earnings, making it less suitable for capital investment appraisal than the NPV or IRR methods.

The most insightful, but also the most complex, method of capital investment appraisal is the net present value method (NPV) (Proctor, 2009). This method takes into account the time value of money by calculating the investment's present cash flows; that is, if all the cash flows were realised at their discounted rate depending on the rate being paid for financing and inflation, what would be the resulting value of the investment in today's money? This takes into account the potential for risk involved in the project, as well as positioning the business objectives involved in the operation in a primary position. The NPV is calculated using the present value (PV) minus the investment (I). The equation below demonstrates how to calculate NPV. In this case, C represents cash flows (with C0 representing initial cash flows and Cn indicating cash flows during period n), while r indicates the interest rate).

A final method of capital investment appraisal is the IRR method. The IRR method is simply the percentage return at which the NPV of the project will be precise 0. This can be calculated using the equation.

The IRR is useful because it shows how much the project can expect to achieve at a rate at which the firm is not making any money (NPV = 0), thus taking into account the issue of risk. A general use for the IRR rule is that if it is below the interest rate required for capital investment, the project should not be funded. For example, if a project has an IRR of 8% and a finance rate of 6%, this would be a positive investment for the firm. Alternatively, firms may have specific rates; for example, a firm may only accept projects with IRR 10% or over.

The four methods of capital investment appraisal can be used to directly compare the desirability of two or more investment projects in order to identify which should be chosen. The table below demonstrates the outcomes for two projects. The first project has a required investment of £100,000 and has annual cash flows over four years of £10,000, £40,000, £50,000 and £20,000. The second project has a required investment of £40,000 and expected cash flows of £15,000 per year for four years. Assuming that the firm pays 10% p.a. for financing for the two projects, the rates are below.

Project / ARR / PP / IRR / NPV
Project 1 (£10,000)20%3 years7%(£6,022.94)
Project 2 (£40,000)50%2 years, 8.6 months18%£6,861.80

As can be seen from this comparison, even though the first project has higher overall earnings, it actually is a poorer investment. With a lower ARR and a longer PP, the most elementary processes of analysis indicate that project #2 is better. These results are held up by the IRR, where the firm would not be able to cover its funding rate, and the NPV, which indicates that the NPV would be negative for the first project. This demonstrates the utility of the capital investment appraisal process, which allows a firm to choose a seemingly more modest, but also more lucrative, investment strategy. However, it also demonstrates that some methods are considerably more useful than others, and care should be taken in the choice of methods.

Budgeting Planning and Control

"Budgeting is as much about people as it is about money." In the planning and control aspects of budgeting, the involvement of people in these activities is key to understanding how the budgeting process and the people that form budgets interact in order to determine how understanding people is key to the budgeting process. The type of budgeting process in use in the organisation varies widely, as does the responsibility for budgetary planning and control. However, by integrating many people into the budget planning and control process, there are many advantages to be had, including gaining access to information regarding the needs of the business that might not be immediately obvious and providing immediate oversight for expenditures and income. The use of some budgetary process should be considered to be essential for firms of all sizes, although the complexity of this process can vary greatly.

Budgeting is the process of allocating funds to projects and processes in order to distribute resources most efficiently within the organisation. The budgeting process is a basic part of the business management process. In the planning portion of the budget construction, the budget needs are identified and the available resources are allocated among various cost centres. This can include both operational expenses (such as salaries and wages) and capital expenses or investment expenses (such as information technology investment or buying new plant equipment). The budget is then communicated to those that will be responsible for managing the expenditures identified in the budget. The specific type of accounting practice varies depending on the firm's environment and characteristics, with some firms choosing a centralised responsibly structure and others choosing a responsibility accounting approach in which each area manager (even including floor managers and line managers) are responsible for their own expenditures. However, regardless of the accounting practices in use this communication must occur in order for the budgeting to be effective.

Following the process of planning and the communication of the budget plan, the process of control begins. Who controls a given budget and how this control is exacted depends on the type of budget that has been prepared and what type of accounting practices are in use by the firm. There are a large number of different types of budgets that can be used. Master budgets are budgets that control income and outflow from all assets of the organisation; this may be used in isolation and is often the only budget prepared for use within a small firm. On the other hand, a large number of functional budgets may also be prepared, which focus on various aspects such as operational budgets, capital investment budgets, cash budgets and so on. These budgets allow for more careful control of the specific areas of the organisation targeted for expenditures. Another difference in budgeting is the use of fixed budgets, which assume a fixed level of demand for production of goods or services, or a flexible budget, which calculates the expenditures and income required at several different levels of business. The flexible budget has several advantages, including the ability to reflect actual conditions and not needing to be adjusted as often.

However, there is little evidence of its adoption in the UK, which tends to focus on more top-down and traditional approaches to budgeting in many instances. Thus, although the accounting practices of the flexible budget may be more efficient, as with the activity-based costing practice discussed above the use of flexible budgeting has lagged behind in the UK.

The control of budgets is also a place where strong communication and people are required to make budgeting effective. The budgetary control process is the process by which a budget is applied to a business and resources are spent accordingly (Proctor, 2009). For example, the budgetary control process for a sales manager may include ensuring that his salespeople make the required level of sales while ensuring that the correct level of expenses is also being utilised. In some cases, the responsibility accounting or empowerment may even be used, with each floor supervisor or even individual worker being responsible for maintaining specific levels of performance and expenditures, Research has indicated that the use of this level of managerial responsibility for the budget control and planning process is highly effective in some cases, with managers reporting higher levels of satisfaction and empowerment within the process of budget planning and control. However, this process is also more complex and may offer more potential for failure, and thus should be considered carefully.

Budgeting is highly advantageous within an organisation, as without the budgeting process the organisation is likely to be inefficient and may even out-spend its resources or be vulnerable to deliberate fraud or exploitation. However, the strictness of budgeting is also difficult for organisations because they may come up against unexpected circumstances that were not accounted for in the budget, which commonly requires some difficult management of resources in order to overcome. For example, a firm that experiences equipment failure and cannot have the equipment repaired may be forced to make a significant unplanned equipment expenditure, which may be difficult to manage depending on their provision for such items. The firm may also experience different levels of business; under flexible budgeting this is anticipated, but fixed budgeting, used by many firms in the UK, does not take this possibility into account, which may make it difficult for the firm to operate in conditions of either increased or decreased business. Ultimately, it is important for the level of budgeting in use in the organisation to meet the needs of the organisation in terms of both control and flexibility.

Bibliography

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Alkaraan, F., & Northcott, D. (2006). Strategic capital investment decision-making: A role for emergent analysis tools?: A study of practice in large UK manufacturing companies. The British Accounting Review , 38 (2), 149-173.

Al-Omiri, M., & Drury, C. (2007). A survey of factors influencing the choice of product costing systems in UK organisations. Management Accounting Research , 18 (3), 399-424. FSN. (2008). Activity based costing (ABC) and activity based management (ABM)m

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Investopedia. (2009). Payback period. Retrieved November 25, 2009 from Investopedia.

Jones, T. A. (2008). Changes in hotel industry budgetary practice. International Journal of Contemporary Hospitality Management , 20 (4), 428-444.

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Proctor, R. (2009). Managerial accounting for business decisions (3rd ed.). London: Financial Times/Prentice Hall.

Written by Kathryn Forest