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Activity-Based Costing (ABC) - advantages and disadvantages

How ABC can be applied to institutions of higher education

Seminar Paper 2005 11 Pages

Business economics - Accounting and Taxes

Excerpt

CONTENTS

Introduction and Definition
1.1 Executive Summary
1.2 Introduction
1.3 What is ABC Costing?

ABC Model
2.1 The ABC Model
2.2 ABC in practise

Manufacturing and ABC in relation to University
3.1 Manufacturing
3.2 How can the methods employed & ABC help in relation to University

Example methods
4.1 Example - Absorption Cost system
Example - Activity Based Costing

Advantages and Disadvantages of ABC
5.1 Advantages of ABC
5.2 Disadvantages of ABC

Conclusions and Recommendations
6.1 Conclusion
6.2 Recommendations
6.3 Bibliography

Introduction and Definition

1.1 Executive Summary

In this report I will show how activity-based costing (ABC) can be applied to a department of a major institution such as a University.

Large universities may maintain and follow complex and rigid accounting systems. However, the systems are almost always based on a form of fund accounting and are intended to satisfy legal and donor stipulations rather than to provide information for administrative decisions.

In this report I show how activity-based costing (ABC) can be applied to institutions of higher education and, I believe, can result in improved information of benefit to academic administrators, legislators, voters and consumers. The report also analyses an example related to the degree at the university which follows with the appropriateness of using this system by the university.

The Advantages and Disadvantages of activity-based costing are also investigated in this report and therefore, will provide a disclosure for the University board in terms of the usage of ABC.

1.2 Introduction

The University, like any organisation, has competitors and has limited resources, so it must allocate resources efficiently. This means that Direct and Indirect Costs are assigned and are economically based on each product’s usage, so the university understands how much each product is costing it, and it highlights any area of concern.

Management faculties of any organization have little knowledge of product costs. It is only the finance department who can handle this issue by using the ABC system to solve the problems relating to the products of the department.

In this University all products are treated as homogenous, i.e. same cost and same price for its product, but after all the products have different characteristics, and therefore the cost will generally differ. The University allocates all its indirect cost depending on the number of students or the number of teaching hours on that course (product).

In the long term for the University the target is to survive and prosper; it must charge people correctly based on costs for that course. This is related to the efficient allocation of costs: therefore, similar to manufacturing processes, it has become more complex and the approach of absorption costing may not be efficient, so the ABC Cost system may be more useful.

1.3 What is ABC Costing?

Following the increase in complexity of processes for many organisations, e.g. manufacturing (described below), the traditional approach of “absorption costing”, it is argued1, that it is inappropriate as the approach consists of identifying a direct relation and allocating appropriately, usually on the basis of volume of the product of that company. This means a small change in direct labour (usually cost driver in the traditional approach) lead to a drastic change in allocation of costs2.

In 1988 Cooper and Kaplan of the Harvard Business School devised the Activity Based Cost for product costing in manufacturing industry3 as an alternative to absorption costing, intending to give a greater insight into allocating cost. It has been proven to give significant improvements over the traditional approach.4

They argued that the traditional approach was like “peanut butter spread” approach, leading to distorted cost allocation. Therefore, it found out that there is a cost for activities carried out within the organisation; ABC takes them into account and allocates them based on the product’s use. So consequently, Activity Based Costing has been used as a strategy to price products more accurately.5

ABC System is designed on the following processes:

1. Identifying the major activities that take place in organisations
2. Assigning costs to activities
3. Selecting appropriate cost drivers for assigning costs (how to allocate activities)
4. Assigning cost of activities to products6

It is based not just on a single driver as absorption cost, so it goes more in-depth into each cost that has occurred, and subsequently into how to allocate them more efficiently.

ABC Model

2.1 The ABC Model

The following diagram shows how the ABC System works:

Abbildung in dieser Leseprobe nicht enthalten

7

The Green line is the Traditional Absorption Method that is usually based on a direct cost in relation to the product, thus, this shows how ABC highlights the processes to a greater degree than the traditional approach.

Abbildung in dieser Leseprobe nicht enthalten

2.2 ABC in practise

Abbildung in dieser Leseprobe nicht enthalten

Management Accounting for Non-specialists”, 3rd Edition8

A survey of large businesses in 1999 revealed that, on average, 15 % of businesses fully use an ABC approach to dealing with full costing, and a further 8 % use it partially. The remaining 77 % do not use ABC at all. Even so, there was a surprising range in the level of usage of ABC from industry to industry (see Fig.1).

Manufacturing and ABC in relation to University

3.1 Manufacturing

A prime example of an ABC cost system implementation is in the Manufacturing industry. Within the Manufacturing Industry over the last 50 year period9, the processes have changed drastically, and they become more complex: this has led to a wide range of products with different specifications to meet the needs of the customer. The main contributor to this change is the increased use of technology.10

Technology has also led to manufacturing going from a labour intensive and direct materials model with minimal overhead costs in the 1900’s to a capital intensive and machine based production, which has seen greater emphasis on overhead costs in relation to direct costs in the late 20th and 21st centuries. Due to the effects of globalization there is now greater competition and opportunities through the global market, therefore more details are required for product pricing.

ABC in manufacturing was mainly required to get better insight and price correctly as Kaplan and Cooper stated earlier: this was due to the extra competition in the global marketplace11 and also with the implementation of the automation system it was perceived as a better way of allocating cost12.

3.2 How can the methods employed & ABC help in relation to University

The methods involved in ABC system could help in the following ways:

- It will give management an insight into the product costs, which they did not have any measures in previous times
- An ABC system gives a view into how efficiently resources can be utilized and how all activities contribute to the cost of a product or service, as a result, the university can target profitable products, i.e. profit from undergraduate degree courses, and examine where and how it needs to cutback its costs.
- It may provide more accurate data, which can outline changes that have to be made to certain departments.
- Outline Major Degrees that use more indirect resources, i.e. Biology, due to large experiments required compared to Accounting and Finance that contains no experiments13 that otherwise would not be identified under absorption costing.
- The University ABC system will highlight the cost of all activities and overhead, which are traced to particular product or service rather than spread across all product lines or services. This enables resources and overhead costs to be more accurately assigned to products and services that utilize them; this means that the university will be more efficient and there is no cross subsidization.

[...]


1 http://www.surf.nl/download/5.3-Heginbotham.pdf

2 ACF 262, lecture 7

3 http://www.surf.nl/download/5.3-Heginbotham.pdf

4 http://www.mficonsulting.com/ABC.html

5 http://www.mficonsulting.com/ABC.html

6 Lecture Notes

7 http://www.surf.nl/download/5.3-Heginbotham.pdf

8 “Management Accounting for Non-specialists”, 3rd Edition, Peter Atrill & Eddie McLaney

9 http://www.accaglobal.com/publications/studentaccountant/39820

10 http://www.accaglobal.com/publications/studentaccountant/39820 15/03/05

11 http://news.bbc.co.uk/1/hi/world/south_asia/4294679.stm

12 Managerial Accounting Book

13 University Prospect

Details

Pages
11
Year
2005
ISBN (eBook)
9783638443104
ISBN (Book)
9783638750837
File size
412 KB
Language
English
Catalog Number
v47340
Institution / College
Lancaster University
Grade
1,6
Tags
Activity-Based Costing Management Accounting

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Title: Activity-Based Costing (ABC) - advantages and disadvantages