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by Brian Rutherford 03 Feb 2001 Diploma in Financial Management Relevant to Paper D2

Activity based costing (ABC) hit the world of financial management with a very large bang in the late 1980s. Within a few years 20% of the UK’s largest companies were using, or at least piloting, ABC systems. By the turn of the millennium, however, the proportion of adopters was no higher, while one third of those adopting the technique earlier had actually abandoned it. Only one third of those companies considering the use of ABC in 1994 had actually adopted the system by 2000.

Why are practising financial managers proving so reluctant to embrace this revolution in one of their key disciplines, when it is so widely praised in the literature and so vigourously marketed by consultants? Are we looking at an example (our critics would say yet another example) of the traditional conservatism of our profession? Certainly that’s the view consultants would urge on our fellow-managers.

A defender of the profession might first point out that ABC is far from guarenteed to work. Indeed, its claim to provide “accurate” costings - truly breathtaking to accountants brought up to believe in different costs for different purposes - are generally exaggerated because in many situations there will be costs (essentially those relating to non-separable resources) that ABC doesn’t handle much better than traditional costing. Appendix A (see over) illustrates the deficiencies of ABC.

Nonetheless, the accusations against traditional (volume-based) costing on the back of which ABC was launched is valid. Where overheads are high and plants produce a range of items with significantly different volumes and complexity, volume-based systems over-cost high volume lines and send the wrong signals about pricing, product choices and resource allocation. But the uselessness of absorption costing for taking decisions in these areas has been understood for years and taught to generations of students - who have, indeed, been examined on the subject in grizzly detail. Are we to believe that once they qualified and hit the streets - or rather the multi-product plants - accountants forget all they have learned and respond like automata to the data emerging from traditional absorption costing systems? It seems more likely that strategic management accountants know that the output of absorption systems must be treated with caution - and look for additional evidence when important decisions have to be taken.

There are, of course, well-documented tendencies for the bare numbers to drive decisions - especially where they are made by groups which include non-accountants, who may not appreciate just how complex are the measurement issues involved. Thus, Johnson and Kaplan’s high profile reinforcement of the need to identify relevant costs correctly was to be welcomed. But was the “invention” of a whole new and apparently revolutionary system equally welcome - or even necessary?

The installation of ABC systems is inevitably a very complex and expensive business. To the direct costs of creating the new system must be added the risk involved in dismantling legacy systems and managing the transfer. Given that traditional systems work well in some situations and ABC doesn’t always give the right answer, managers are right to be cautious.

What should worry our profession is that all the hype surrounding ABC may itself damage good financial management. Companies that feel they must make an “all or nothing” decision, to move to ABC or stay where they are, may miss opportunities to refine their current systems. If they do not make the move to ABC, they may spend a great deal of money for little more benefit than they could obtain from such refinements. Accountants themselves may lose confidence in the fundamentals of their discipline, feeling pressured to adopt the latest fad rather than calmly asking what steps should be taken, based on first principles. Other managers, who rely on the accountants to secure effective financial management, may lose confidence in their ability to deliver it. Companies that have installed the latest systems, at great cost, are, perhaps, more likely to rely uncritically on the numbers emerging from them, rather than encouraging their accountants to scrutinise the output in light of the principles they have been taught.

Further, students will seize on “hot topics” such as ABC and give insufficient attention to the fundamentals of the discipline, resulting on over-reliance on the gurus and reinforcement of the tendencies outlined above.

If these dangers are to be avoided, it is important that we see ABC as a refinement of the approaches to costing the profession well understands rather than a revolution displacing all that has come before.

When ABC doesn't work
Penco manufacturers writing implements. It has 11 products, a “basic” pen and 10 different luxury models which use more expensive materials but take up the same labour time. Each period it manufactures and sells 50,000 of the basic models and 5,000 of each of the luxury models. Direct costs are 50p per basic pen and £1.50 per luxury pen. Basic pens sell for 75p and luxury pens for £1.90. Set-up costs are £1,000 per run. Other costs are ignored for the purpose of this illustration.

Traditional volume-based costing treats set-up costs as an overhead. Overheads are allocated by a volume-based measure such as units produced or labour hours. In this example, both methods will yield the same rate, £11,000/100,000 = 11p per unit. Thus basic pens show a profit of 14p per unit (£0.75 - £0.50 - £0.11) and luxury pens show a profit of 29p per unit (£1.90 - £1.50 - £0.11). Total profit is £21,500 (see column A in Table).

Activity based costing assigns costs to activities and traces activity costs on the basis of what drives them. In this case set-up costs are driven by the number of times the activity is required. The basic pen requires one set-up per 50,000 pens, so set-up costs per unit are 2p; luxury pens require one set-up per 5,000 pens and cost per unit is thus 20p. Basic pens show a profit of 23p each (£0.75 - £0.50 - £0.02) while for luxury pens the profit is 20p each (£1.90 - £1.50 - £0.20). Total profit remains as before but is now regarded as comprising:
Basic: 50,000 @ 23p = £11,500
Luxury: 50,000 @ 20p = £10,000

The revised profit figures reflect the relatively high requirements for set-up activity by luxury pens. They may encourage managers to seek opportunities to expand production of basic pens rather than multiplying the number of types of luxury pens manufactured, thereby increasing profits. (The traditional volume-based, measure made it look better to take on more luxury pen lines.) If production of basic pens can be expanded to 60,000 while two lines of luxury pens are dropped, the set-up cost per basic pen falls to 1.667p (£1,000 / 60,000), the profit per unit raises to 23.333p (£0.75 - £0.50 - £0.01667) and total profits will rise to £22,000 (column B).

However, a much more profitable strategy would be to double the output of each line of the apparently less profitable luxury pens, abandoning basic pens altogether (column C). Changing the length of the run affects the number of set-ups required per unit of output and thus the profitability of the product. (Even more profit can be earned if the first production run in the second period is devoted to the same line as the last production run in the first period, thereby reducing set-up costs still further.)

Appendix 1: how to manage costs strategically

• Whatever cost allocation methods are used, ensure that the cost assignment basis corresponds as closely as possible to cause and effect.
• Regularly review cost levels involving senior management and those who can influence the level of each category of cost under review. Look for costs omitted from the formal costing system as well as those within the system. Ask, for all categories of costs identified by the system, whether they are really caused by the activity under review.
• Whenever major decisions about pricing, production levels and resource allocations have to be taken ask whether a special relevant costing exercise should be undertaken.
• Regularly review all cost allocations - including ABC-based schemes.
• Have courage to manage costs rather than expecting the system to do it.

Table A

			A £	B £	C £
Sales	Basic	50,000 @ £0.75	37,500
		60,000 @ £0.75		45,000
	Luxury	50,000 @ £1.90	95,000
		40,000 @ £1.90		76,000
		100,000 @ 1.90			190,000
	TOTAL		132,500	121,000	190,000
Direct costs	Basic	50,000 @ £0.50	25,000
		60,000 @ £0.50		30,000
	Luxury	50,000 @ £1.50	75,000
		40,000 @ £1.50		60,000
		100,000 @ £1.50			150,000
	TOTAL		100,000	90,000	150,000
Set-up costs	11 @ £1,000		11,000
	9 @ £1,000			9,000
	10 @ £1,000				10,000
PROFIT			21,500	22,000	30,000
Comprising	Basic		7,000	14,000
	Luxury		14,500	8,000	30,000

References 1. Chartered Institute of Management Accountants, Research Update, Spring/Summer 2000 2. For the claim of the proponents of ABC that it yields “accurate” product costs, see Kaplan, R.S. and Cooper, R., Cost and Effect: Using Integrated Cost Systems to Drive Profitibility and Performance, Boston, Mass: Harvard Business School Press, 1998, p19. 3. Johnson, H.T. and Kaplan, R.S., Relevance Lost: The Rise and Fall of Management Accounting, Boston, Mass.: Harvard Business School Press, 1987. 4. Bromwich, M. Accounting for Overheads: Critique and Reforms, Uppsala, Sweden: Uppsala University, 1997.

Brian Rutherford is Professor of Accountancy at Canterbury Business School, University of Kent. He is also an ACCA Council member.

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