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Contemporary Management Research
Pages 75-90,Vol.2, No.2, September 2006
An Application of Activity Based Costing in Higher Learning
Institution: A Local Case Study
Anbalagan Krishnan
Curtin University of Technology
E-Mail: [email protected]
ABSTRACT
The widespread environmental change has forced many organizations to change and
rethink their business and competitive strategies, particularly cost management system, in
order to achieve the competitive edge in the marketplace. Successful organizations are
those that are able to improve quality, lower costs and efficiency of operations and
eliminate products and services that incur losses. This explains why some organizations
are successful while others fail. An organization costing system is a system that helps the
management with the strategy planning while the system plays an important role in
providing accurate cost information about the products and customers. In other words, the
costing management system is important to provide timely and quality information to
help managers in their decision making process. To achieve this, many organizations shift
their focus from conventional or traditional costing system to an increasingly popular cost
methodology system that is Activity- Based Costing (ABC). This system simply collects
cost in functional activity cost pools and then applies costs to products/services using
individual cost drivers (Brignall, 1997). Initially when this system was introduced, it was
only popular among the manufacturing context; however, now it also pulls attention of
the service sectors. Kock (1995) noted that it is now more important than ever to have
access good information in decision-making in the management of service firms. A
number of research and studies reveal how the ABC system in the service sectors has
effectively kept the operational cost at marginal level and still be able to provide better
customer service at the same time. Thus, this case study analyses how an ABC costing
system that improves operations and to better meet the needs of University customers in a
more cost – effective manner.
Keywords: Conventional Costing System, Activity – Based Costing, Quality of
Information
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INTRODUCTION
A country’s economy in large depends on industries particularly service sectors such
as insurance company, financial institutions, health service, transportation. As more
corporate sectors venturing into service industries create competition, they are required to
provide a quality customer service at reasonable cost. A number of service firms have
gone into bankruptcy as a result of poor control over escalating overhead cost. Thus, the
survival of a firm in service industry is largely depending on the availability of timely
and quality information for decision-making and the ability to keep the operation cost at
marginal level.
Consequently, cost and management accounting concepts and techniques are not
only used in manufacturing sectors but also in service sectors to provide cost information
for decision-making. A study by Horngren (1995) found that the focus of cost
management should be on decisions and the various cost management techniques,
systems and measurements that spur and help managers to make wiser economic
decisions. Of the many available cost management systems, research reveals that a
bigger number of companies’ uses Activity- based costing (ABC) method in comparison
with the traditional costing system in providing timely and quality cost information
(Adams, 1996; Brignall, 1997; Cagwin & Bouwman, 2002; Innes & Mitchell, 1997).
However, the implementation of such system is costly and often the idea of implementing
the system is drop as a result of time consumption and lack of expertise. In some cases,
the cost for carrying out the ABC analysis is higher than the returns. Nevertheless, there
is a growing body of literature, which argues that, compared to the traditional costing
systems, Activity- Based costing (ABC) offers important advantages to organizations
(Adams, 1996).
LITERATURE REVIEW
In 1923, J. Maurice Clark coined the phrase ‘different costs for different purposes’,
but most companies only have one costing system, which is used for all purposes: stock
valuation, planning, control and decision-making (Brignall, 1997). Prior to the
introduction of ABC costing system, a number of companies, particularly manufacturing
sectors, used a traditional costing system called volume- based costing system, which is
volume-based cost driver such as direct-labour hours, direct labour cost, or machine
hours. At most the cost are classified into two main parts that are Product cost which is a
cost assigned to goods that were either purchased or manufactured for resale and Period
cost where administration and selling are recognized as expenses during the period in
which they are incurred. If inventories are manufactured, the product cost is relatively
Contemporary Management Research 77
easy to trace to production job but manufacturing overhead is not easily traced to jobs as
these costs often bear no direct relationship with individual jobs or units of product
(Hilton, 2005). The conventional or traditional accounting system allocates the
manufacturing overhead to the products either plantwide overhead rate or on two-stage
allocation system. The former allocates cost on a single activity base for the entire factory
but the latter assigns manufacturing overhead cost based on departmental activities.
Under this system, at the first stage, the manufacturing cost is collected into cost pools
and then attached to products by a method based on unit volume of production such as
direct labour hours (Brignall, 1997). Thus, the allocation of manufacturing cost depends
on the types of resources that the products consume. The greater the products consume
the resource, the higher the overhead attached to the products based on one particular
activity base such as direct labour hour, machine hour or direct labour cost. Furthermore,
this system allows for cost distortions, which will be greater in business units with a
higher proportion of overhead costs (Baird, Harrison, & Reeve, 2004).
While this approach has the advantage of simplicity, it will result in systematic
miscosting where overheads are not volume driven (Innes & Mitchell, 1997).
Researchers noted that this system failed to reflect other resource or cost of activities that
added value to the production (Adams, 1996; Innes & Mitchell 1997; Johnson & Kaplan,
1987). Other than that, Copper and Kaplan (1987, cited in Adams, 1996) assert that
traditional cost and management accounting systems such as those based on standard
costing and absorption costing have measured company performance imperfectly because
they have not kept up with the developments in production technology and consumerism.
Therefore, to avoid biased cost reporting, the allocation of overheads to cost objects
should not be based on a common volume-related measure, such as direct labour hour but
on the groups of activities which generate those overheads (Kaplan, 1987, cited in
Adams, 1996).
An overhead allocation based on activity centers avoids a common consequence of
traditional output-based costing system particularly under cost low volume products. A
study conducted by Innes and Mictchell (1997) found that overheads based on activity
centers facilitate the targeting of unnecessary, wasteful, resource usage and the costly
effects of over-complex ways of running a business process. This technique, which is
popularly known as Activity-Based costing (ABC), is a ‘system that focuses attention on
the costs of various activities required to produce a product or service’ (Baird et al., 2004:
384). This system is in favor of many organizations in order to provide “true” cost
information for their strategic decision-making.
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The ABC, first developed by Cooper and Kaplan (e.g. Cooper, 1988; Cooper and
Kaplan, 1988), is a system that will reduce the level of arbitrary cost allocations
associated with “traditional” costing systems and result in more accurate product cost
(Baird et al., 2004). Many authors have advocated the benefits of ABC, and a number of
studies have provided empirical evidence to support those benefits (Anderson, 1995;
Foster and Swenson, 1997; McGowan and Klammer, 1997; Norris, 1994; Swenson, 1995
all cited in Baird et al., 2004). Spicer (1993, cited in Adams, 1996) noted that besides
providing more accurate product costing, ABC also improves the basis upon which
strategic decisions, involving resource allocation, product mix, pricing and marketing, are
made. Cagwin and Bouwman (2002) further listed authors who are in the opinion that,
the application of ABC is more effective in specific environmental conditions (enabling
conditions) such as manufacturing complexity (Jones, 1991), environments with specialty
product costs (Srinidhi, 1992) and diverse (multiple different) business environments
(Cooper & Kaplan, 1988). Furthermore, the refined treatment of overhead cost by using
ABC system can facilitate the identification of how individual customer influences the
cost of supply (Innes & Mitchell, 1997). Bellis-Jones (1989) found that when ABC is
used in this way, customer profitability profiles and analysis are possible and market
strategy is enhanced by this intelligence (cited in Innes & Mitchell, 1997).
In the beginning, ABC cost management system was common in the manufacturing
environment where the identification of activities associated with the products was still
less complex and in some instances the...