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ABC systems vs. traditional cost systems essay example
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ABC systems vs. traditional cost systems

Headquartered in Boston, Massachusetts,Great Eastern Industries (GEI) owns three fabrication facilities in the U.S and an assembly test facility in Malaysia designs, manufacturing and selling various products that are used in cell phones and air-bag systems.

In 1999, the company’s profits plummeted, with “operating losses reaching $100 million on sales of approximately $650 million. There was a feeling that the standard cost system could not truly identify which of the company\’s products were profitable. Standard cost system could not effectively capture company’s performance and there was a “lack of an understanding of product profitability, a flawed product mix, and poor marketing and pricing decisions could have contributed to GEI\’s financial problems” (Brewer, Juras & Brownlee, 2003).
Indeed, traditional cost systems are inaccurate and may lead to inadequate decision-making. They rely on an arbitrary allocation of overheads to products, services and customers, based on a simplistic single volume method (3rd). At GEI for example, a labour-based cost system was in place. As described by the product engineer, it created some misperceptions (p.2) as the proportion of overheads continued to increase (by 1999, direct labour represented less than 10% of total manufacturing costs). Within the logic line at GEI, simple, high-volume products were overcosted whereas the more complex, low-volume products were undercosted through the direct manufacturing labour-hour cost-allocation base. (textbook p.327)

ABC systems, however, assign resource costs to activities, use volume and non-volume-related cost drivers to assign activity costs to products (case, p.2). They also reflect the added complexity of the manufacturing process in the cost system for low-volume, specialty orders etc., offering more visibility and product cost accuracy, to help optimize the product mix (case, p.3). Furthermore, they make costly and non-value adding activities more visible, allowing managers to focus these areas to reduce or eliminate them (3rd ref).

At GEI, prior to the ABC implementation, employees such as product engineers intuitively understood the shortcomings of the existing system. As a result, they had a willingness to change and were motivated by their involvement (which is one factor that contributes to a successful implementation of ABC, on a behavioural note). They genuinely believed that it was a better system, and was proving useful to strengthen their relationship with customers (case p.5).
Nonetheless, there are some limitations to the system, of which consultants should be aware.
Indeed, it can be costly to implement, run and manage an ABC system, and collecting the data about activities and cost drivers can be time consuming and difficult (3rd).
As a result, it is vital to provide an adequate training for a successful implementation of ABC.

At GEI, the project team (in charge of building the system, supervising and coordinating its implementation across plants) was given a week of training. However, plant-level employees were given a negligible training, that lacked in-depth explanations and attention to their constructive concerns, while what was asked from them was significant in that they were expected to provide activity definition in addition to resource driver and activity driver information (case, p.5). Because of ABC’s complexity to understand, the lack of thorough training can also have behavioural consequences on top of the technical ones, that translate into a decreased motivation to use the system to make better-informed decisions. As an example, process engineers and operations managers were not accessing the data at GEI, considered ‘too difficult’ for some that used to conduct their queries through other departments such as Finance (case, p.9).

Another limitation is that ABC does not solve all allocation issues. Some overhead costs are unclear and difficult to assign, so the allocation bases will still have to be applied arbitrarily (3rd ref). Also, activity-cost rates need to be updated regularly, which can be difficult to maintain (3rd ref). At GEI for example, revaluations were initially set to a 6-months period, but rapidly increased to 1 year (case, p.5).
Additionally, ABC reports do not conform to generally accepted accounting principles (GAAP). As a result, a company using this system will still have to use two cost systems – one for internal use and another to prepare external reports (ref. 6). However, with two systems available, managers might be encouraged to choose the figures that make their department look best rather than the most accurate ones that would make waste visible (4th ref).
This highlights the importance of adapting performance measurements to the use of ABC, as it impacts employee motivation and behaviour. At GEI, performance measurement systems were not updated. As mentioned by an operations manager, “people do what they are measured on” and they were not being held accountable for using the tool (case p.9), which undermined the successful implementation and utilization of ABC.

There are two broadly defined cost accounting objectives, namely, strategic cost management, choosing the right value-add things to do, while the other objective being operational cost management, opting to perform well via increased efficiency and reduced wastes along the value chain.[ref #5]

Once the need for an alternative costing system has been established and the groundwork for adoption of ABC system has been laid, the design work for ABC is undertaken to meet those specific needs. Among larger organizations, a pilot project may be implemented to obtain ‘proof of concept’ and gain buy-in for ABC. However, a pilot study done on a single process or department carries the danger of overlooking activities and costs from various other departments and costs centers not being studied in the pilot phase. These reservations were shared by GEI in that knowing only half a product’s cost was useless. In general, process consultants ideally prefer activity analysis across multiple departments.(ref-5)

The second step concerns the ownership of the system once it is implemented. For instance, if GEI desires to focus on improving operations, the system would be best placed under the ownership of operating personnel. However, it is often not feasible in practise, thus, the onus to collect, validate, and report financial information has lies with the accounting department.

The third step involves reaching a balanced position on complexity (associated costs) of the system that provide good enough levels of detail and accuracy. That is why the ABC community often echoes, ‘It is better to be approximately correct than precisely wrong’.

Fourth step prompts the question of the extent of ABC integration into the management’s information systems. Long-term, GEI wishes cost accounting to have a greater role in improving business processes and enhancing customers’ satisfaction by understanding the firm’s activities and cost drivers. To achieve this, a completely integrated ABC system is required that leads to usage of information as the basis for activity-based management (ABM).

There are two different ways to view an ABC system (ref 5) –
Cost Assignment View (the What), the predominant view, provides information about resources, activites, and cost objects.
Process View (the Why) provides operational information about business processes and the activities that belong to them.

Further, an ABC project requires two types of information: conceptual information, to understand and overall design of the ABC system, while transactional information is needed to simulate the cost flows through the system. [Ref #5]. As done at GEI, several interview sessions were conducted to gather necessary information to [Ref Bhimani textbook]

  • Identify the chosen cost objects, i.e., the final products manufactured in GEI’s case.
  • Identify the direct costs of the products
  • Select the cost-allocation bases to use for allocating indirect costs to the products
  • Identify the indirect costs associated with each cost-allocation base
  • Compute the rate per unit of each cost-allocation base used to allocate indirect costs to the products
  • Compute the indirect costs allocated to the products
  • Compute the total costs of the products by adding all direct and indirect costs assigned to them
  • Finally, through 88 interview sessions, 674 activities and 254 activity drivers, incorporating cause-and-effect relationships, were identified across the firm.

ABC system might lose its lure with the executives if the system’s technical implementation leads to a big system that requires months devoted to building large components. The upfront large scale investments may prompt them to doubt if the results would be worthwhile.
Instead, a rapid ABC prototyping with iterative remodelling approach is usually recommended, which allows for small scaled trial-and-errors and prevents over-designing and excessive details being embedded at first.

A successful implementation of an activity-based costing system requires more than just a solid technical design. One of the key takeaways from the implementation of ABC at Great Eastern Industries is definitely the importance of the support of main stakeholders, including the executives and the rest of employees. Implementation of this approach doesn’t just ask for a behavioural change in the whole organization, but definitely a substantial amount of learning and adjusting for every individual involved in the process. Logically, in the role of the main enforcer, GEI’s project team streamlined the implementation of new costing system by focusing attention on specific units within the model in order to maximise the efforts and implementation resources utilization on what were thought to be main cost drivers for the company. This is easily done by taking a bird’s eye approach while working on the understanding of the company, gradually analyzing the high cost activities and addressing the cost distortions. Once this phase was complete and the team started ABC model-building and data gathering, having the success of this step completely reliant on the input of plant level employees. In retrospective, this stage was definitely critical for the successful implementation of ABC at GEI, as the efforts put in the whole project became dependent on the reception of employees working at the bottom lines where the actual costs were occurring. Having one centralized project team dealing with every aspect of the implementation did help maintain approach consistency. However, the plant-level employee’s knowledge of the system was very limited and since training was insufficient, this developed into an acute problem for the future of the system and only 1.6% of the staff was actually familiar with the ABC. On one hand the lack of effective communication between the project team and plant workers, meant that the workers were unable to understand what exactly the ABC system asked from them and how to best utilize it for their own and company’s benefit, as the ABC information was not made available to them. On the other hand, despite being the group which is the most familiar with the actual costs and how they occur daily, they did not get a proper chance to express their opinion and concerns about this model. Hence, this miscommunication led to a lost opportunity of finding the best way to perfectly tailor the new ABC model to the needs of GEI, which could have been a drastic advantage for the success of the model and its goals. Uneven utilization of the system across different organizational units also presented a problem during the implementation. While product engineers and marketing managers frequently used the system to make their business decisions, operation managers and other functions did not use it at all. There are two main reasons for this, lack of incentives to use the system for regular employees and the fact that it wasn’t user-friendly for people with a less financial background.

Even after some implementation issues, the ABC system did result in both improvements in product-cost accuracy and a better cost visibility. Despite the alarming lack of training, they intuitively did a good job recognizing how ABC helped them capture the value of the business. It also provided many benefits at the strategic level enabling a more open and smooth relationship with the customers, as the pricing and costs associated with it were now easily explainable. The long-term objective of ABC implementation was evolving to ABM oriented applications of the system in order to proactively optimize costs. The first prerequisite of both ABC and ABM is having the full support of the executives, which for GEI, lacked when the ABM introduction phase started. While ABC was viewed as an extremely useful tool when there was an urgent need to reduce costs and regain profitability, when business performance increased and it was time for growth, ABM (as an extension of ABC) was perceived as ‘hindering’ to new business and product development. It is in this step of the model’s use, that the issue of people’s adjustment and communication has proved to be critical. Even though ABM is the logical successor of the ABC system and in theory could seem easy to gradually transfer from one to the other, the example of GEI proves that both implementations have to be taken separately in order to achieve desirable results. The lack of sufficient motivation and training of staff for ABM, no sense of urgency in terms of business performance and ill-fitted user interface all contributed to the failure of ABM method at GEI.

Conclusion:

In the light of ineffectiveness of broad-based traditional cost accounting that yielded over $100 million in losses despite $650 million in revenues, GEI naturally gravitated towards ABC system to improve cost accuracy. Adoption of ABC system enabled both improved product-cost accuracy and greater product-cost visibility. In cases where causal relationships are not as easily established, we also observe that ABC is as much an art as it is a science.
The logical next step, i.e., ABM, shares a lot of success factors with ABC system but those aren’t exactly the same. If ABC is utilized by employees across the board, and not just management accountants, then ABC evolves into firm-wide practise of ABM. To reach such a stage, however, an even stronger support from top management is required, that entails greater focus on collaboration rather than top-down imposed decisions to affect systematic and behavioral change. This also requires knowledge sharing and providing necessary information even to the front-line employees.This requires shedding the old-conventions of holding back information under the pretense of confidentiality.

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As products tend to become more standardized, focus is now towards differentiating services. The implication being that customer-related cost-to serve costs may be arguably more critical than product costs.
GEI can apply ABM, in tandem with ABC principles, to gain a competitive advantage in the industry.

It is important, however, to note that cost management should always be done in the broader context of performance management that integrates time, quality, service levels, risks, capacity planning, and costs. It is critical for GEI to understand its cost structure, and thus ABC is instrumental for all of its stakeholders – its employees, its loyal customers, its shareholders, and its community.

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