CHAPTER4 ACTIVITY-BASED COSTING (ABC)
Cooper and Kaplan (1988) introduced activity-based costing as a more refined and relevant approach for allocating overhead expenses and calculate product costs (Drury 1992:273; Dugdale 1990:40).
This chapter deals with the basic principles of activity-based costing and provides the background for Chapter 5 which focuses on the implementation of a product costing methodology in a banking environment through the application of a hybrid of standard costing and activity-based costing methodologies ..
Definition of activity~based costing
Drury (1992:275) explains that activity-based costing emphasises the importance of understanding the cost structure of an organisation. This understanding will facilitate the identification of the causes of overhead expenses as well as how they behave when there is a change in product volumes. Activity-based costing also recognises that in the long run most overhead expenses show a variable cost behavioural pattern. It is, therefore, necessary to understand and identify the forces (drivers) that cause overhead expenses to change over time.
Turney (1993 :315) defines activity-based costing as follows: ‘A method ofmeasuring the cost and performance of activities and cost objects. Assigns cost to activities based on their use ofresources, and assigns costs to cost objects based on their use ofactivities’.
According to Clarke ( 1994: 16) ‘activity-based costing assigns transaction overheads to products using various activities’.
Cooper (1988:41) agrees that: ‘Activity-based costing systems by focusing on activities instead of products, overcomes the distorted product costs inherent to traditional volume-based cost systems’.
FSA (1993: 18) argues that the objective of activity-based costing is to find out more about the costs and the activities in the organisation.
The introduction of an activity-based costing system (ABC)
Traditional costing systems focus on specific products and traditional overhead allocation methodologies are used to assign overhead expenses to products (Luck 1989:16-17). According to Drury (1989:60), ‘activity-based costing emphasises the need to obtain a better understanding of cost behaviour and thus ascertain what causes the overhead costs ‘.
Beischel (1990:53) points out that many companies with a diverse range of products fmd it difficult to accurately assess the profitability of products. The indiscriminate application of overhead allocation rates could distort the cost allocation to products. This process of incorrect cost allocation will distort profitability analyses as well as pricing decisions because there is cross-subsidisation between products. The inability of management to assess the true profitability of products has been identified as one of the main problem areas within organisations (Luck 1989: 16-17; Sephton & Ward 1990:29,32).
Costs are a critical variable in the decision-making process. Cooper and Kaplan (1988:96) concluded in their article ‘Measure costs right: Take the right decisions’ that: ‘Bad information on product costs leads to bad competitive strategy’. The article concludes that managers in companies with a diversity of products may base their decisions on distorted information.
Sheridan (1989:20) suggests that ‘costing needs to be regarded as an area of strategic management’. The purpose of costing is to facilitate better decision making and therefore, it should reflect business realities. Turney (1993:49-51) in his book ‘Common Cents’ argues that costing information should play an important role in value added management. Cost information is used to highlight problem areas as well as business opportunities.
Ostrenga (1990:42-49) emphasises the importance of total cost management (TCM). It is important to understand that costs are not merely incurred, they are caused. The underlying principle of total cost management is the focus on activities that cause operating expenses to be incurred by an organisation. Sephton and Ward (1990:29) agree that the ‘implementation of activity-based costing involves identifying activities and the events which cause activities’.
Any sustainable reduction in operating expenses can only be achieved if those activities that cause costs, are reduced. The term cost drivers explains the cause-and-effect relationship referred to under the activity-based costing methodology.
Blumberg (1993:51) and Cooper (1990a:86-88) agree that it is not possible to understand a product without analysing the underlying activities. Blumberg (1993 :51) illustrates the inter-relationship between activities, costs and products by means of a graphic illustration of the ‘activity-based costing rule ‘ (Figure 4- 1).
An accurate allocation of overhead costs requrres the identification of responsibility areas, the activities performed within the responsibility areas and a detailed analysis of the way in which products consume activiti~s. Drury (1992:35) refers to responsibility centres as a segment of an organisation where an individual manager is held responsible for the segments performance. The accurate allocation of overhead costs in terms of the activity-based costing methodology generally involves the identification of multiple cost drivers to calculate accurate product costs. Drury (1989:61) defines cost drivers as ‘those activities or transactions that are significant determinants of costs’.
Sheridan (1989:24) argues that the cost driver approach is to ‘look where the ‘ » decisions are made or the factors occur that give rise to costs – often somewhere else ‘. The introduction of activity-based costing enable management to understand the cost behavioural patterns of various components of their business. A clear understanding of how costs behave will enable management to control costs and to identifY a variety of cost drivers that facilitate the allocation of overhead costs.
Clarke (1994:16-17) and Cooper (1990b:4-14) classifY the levels of activities utilised in an activity-based costing methodology as follows:
- Unit-level basis
Resources are consumed everytime a unit is produced. These activities are the same as the traditional variable costs, for example machine power.
- Product-level basis
Resources are consumed when different products are produced or developed, for example inspection.
- Batch-level basis
Resources are consumed in direct proportion to the number of batches of each product.
- Plant- or facility-level basis
Resources are consumed by all products and allocation is done in an arbitrary manner. This basis represents the traditional fixed overhead costs, for example factory rent. However, the application of the activity-based costing analyses will reduce the size of fixed overhead costs.
The objective of the cost driver approach is not to allocate all overhead costs but only to allocate overhead costs to the lowest meaningful level. The objective should be to allocate all costs but the viability of such an allocation is an important factor. According to Sephton and Ward (1990:33) the critical question should always be: ‘Do the benefits ofthe enhanced cost allocation outweigh the cost ofobtaining it?’ Some costs can only be allocated at product group levels, i.e. the costs of an advertising campaign to promote a range of products should be included in the calculation of the profitability of that product group. However, if the aim of the advertising campaign is to promote a personal cheque account, then the advertising costs should be included in calculating the profitability of that product.
Establishing an activity~based costing methodology
Cooper (1988:41) and Jeans and Morrow (1989:42) list some of the characteristics of an organisation in a manufacturing environment where the successful application of activity-based costing could enhance the int~grity of cost information of an organisation:
- Highly competitive markets;
- Diversity of products, processes and customers;
A significant portion of overhead costs IS not assigned to individual products;
The demands on overhead resources placed by individual products and customers are not proportional to volume;Cross·subsidisation between products; High cost of errors due to poor decision·making in relation to product design, marketing focus etc.
An analysis of the cost structure of a bank as well as the diversity of products and customers shows that banks are perfectly suited for the implementation of the activity-based costing methodology. Sephton and Ward (1990:29) concur with this statement: ‘The main characteristics of a retail financial service institution are very similar to those required for the successful application of activity-based-costing in a manufacturing industry’.
Basic structure of an activity-based costing system
Glad and Becker (1994:12-25), Morrow and Ashworth (1994:32-36) and Turney (1993:81-92) describe the basic structure of an activity-based costing system as a two dimensional modeL The following illustration (Figure 4-2) shows how operating costs and non-financial information should be applied to provide management with the cost information to formulate business strategies.
FORMULATING A PRODUCT COSTING METHODOLOGY
FOR A COMMERCIAL BANK
1.1 Background to the study
1.2 Statement ofproblem
1.3 The importance of the study
1. 4 The purpose of the study
1. 5 Method of research
1. 6 Outline of the study
2. Tllli ROLE OF COSTING IN A BANK
2.2 The features ofbanking products
2.3 Objectives of costing
2.4 Definition of product costing
2. 5 The features of a product costing system
2.6 Understanding the cost structure of an organisation
2. 7 The importance of costing in a bank
2. 8 The need for better costing information
2.9 The uses of costing in a bank
3. EVALUATING TRADITIONAL COSTING IvfETHODOLOGIES IN THE CONTEXT OF THE BANKING SECTOR
3 .1 Introduction
3 .2 The identification of the elements of product costs
3 .3 Different types of product costing systems
3 .4 Actual, normal and estimated or standard costs
3.5 Standard costing
3.6 Overhead cost allocation: An overview
3. 7 Costing techniques
3. 8 Cost accumulation procedures
3.9 Relevance lost
3.10 Problems caused by conventional costing systems
3. 11 Problems with traditional costing systems
3 .12 The application possibilities in a banking environment
4. ACTIVITY-BASED COSTING (ABC)
4. 2 Definition of activity-based costing
4.3 The introduction of an activity-based costing system (ABC)
4.4 Establishing an activity-based costing methodology
4.5 The application possibilities of activity-based costing
4.6 Advantages and disadvantages of activity-based costing
5. FORMULATING A PRODUCT COSTING « METHODOLOGY FOR A BANK
5. 1 Introduction
5.2 Evaluating the existing product costing methodology
5.3 Development and implementation programmes for product costing systems
5.4 Ten stage development and implementation programme for a product costing system in a
5.5 Stage 1:- Obtaining executive approval and presenting a project plan
5.6 Stage 2:- Identify cost objects and the high level costing information requirements
5. 7 Stage 3:- Analysing the cost structure of a bank
5.8 Stage 4:- Formulating a product costing methodology for a bank
5.9 Stage 5:- System configuration and development
5.10 Stage 6:- Structuring the product costing database
5.11 Stage 7:- Categorising activities and establishing product profiles
5.12 Stage 8:- Calculate the product costs
5.13 Stage 9:- Prepare feedback report to general management
5.14 Stage 10:- Implementation, application and on-going maintenance
6. COST OF STATUTORY REQUIRE »MENTS
6.2 Cost ofreserving
6.3 Cost of capital
6.4 Financial services levy
7. SUM:MARY, CONCLUSIONS AND RECOMl\1ENDATIONS
7.2 Further research required
GET THE COMPLETE PROJECT
FORMULATING A PRODUCT COSTING METHODOLOGY FOR A COMMERCIAL BANK