Activity based costing in manufacturing: two case studies on implementationThe Authors

Amrik S. Sohal, Department of Management, Monash University, Australia

Walter W.C. Chung, Department of Manufacturing Engineering, Hong Kong Polytechnic University, Hong Kong

Acknowledgements

The authors are grateful to the Financial Controller at MelCo and to Mr Richard Siu, now Deputy General Manager of Ciba Specialty Chemicals (China) Ltd. They are also thankful to the Hong Kong Government Industry Department and The Hong Kong Polytechnic University (PolyU) for providing the funding to complete this paper and to Jimmy Ho who worked as a Research Assistant/Student on the ABC project at PolyU.

Abstract

This paper presents two case studies on the implementation of activity based costing (ABC). The first case is a company based in Melbourne, Australia, which manufactures engineering components. The second case study is a specialty chemicals company based in Hong Kong. The case studies discuss the introduction of ABC and the benefits and problems experienced during implementation in each company. Based on the experiences of the two companies, factors critical to successful implementation of ABC systems are identified.

Article Type:

Case study

Keyword(s):

Activity-based costing; Australia; Hong Kong; Implementation.

Journal:

Integrated Manufacturing Systems

Volume:

9

Number:

3

Year:

1998

pp:

137-147

Copyright ©

MCB UP Ltd

ISSN:

0957-6061

Introduction

Manufacturing organisations of today are much more complex than those of the 1960s and earlier years. To manage today’s manufacturing organisations managers require information which is relevant, accurate and readily available. Information is needed to formulate and operationalise functional strategies and to make decisions on product mix and production costs. Although production systems have changed to meet the changing needs of the marketplace, in many organisations the internal management accounting systems and information systems have remained unchanged. Managers and accountants have become dissatisfied with conventional costing systems and have expressed concerns about their suitability in the modern manufacturing environment.

Activity based costing (ABC) has emerged as an alternative to conventional costing systems. It was developed in the USA by Harvard Business School Professors Kaplan and Cooper and is a process of individually listing and measuring the cost of each activity contributing to the production and delivery of a particular product or service. In their executive summary to a report on ABC published by the Chartered Institute of Management Accountants, Innes and Mitchell (1990) differentiate activity based costing from conventional costing as follows:

ABC differs from conventional costing in its treatment of non-volume related overhead costs. Many significant overheads are related to specific activities which are relatively independent of production volume. For example, the purchasing overhead may be related to the number of purchase orders. It is the volume of such activities (not the volume of production) which consume resources and therefore determine the overhead cost. These

activities drive the overhead costs and ABC uses such activities for both production costing and process control.

Based on a critical review of activity based costing, Innes and Mitchell (1990) provide a summary of its benefits:

Provides more accurate product line costing particularly where non-volume related overheads are significant and a diverse product line is manufactured.

Is flexible enough to analyse costs by cost objectives other than products such as processes, area of managerial responsibility and customers.

Provides a reliable indication of long-run variable product cost which is particularly relevant to managerial decision-making at a strategic level.

Provides meaningful financial (period cost driver rates) and non-financial (period cost driver volumes) measures which are relevant for cost management and performance assessment at an operational level.

Aids identification and understanding of cost behaviour and thus has the potential to improve cost estimation.

Provides a more logical, acceptable and comprehensive basis for costing work.

This paper describes the adoption of ABC in two organisations and identifies the factors that are critical to implementation. Implementation is the most difficult stage in adopting new management philosophies and techniques. It is hoped that the experiences of the two companies described in this paper provide useful lessons for managers considering the adoption of ABC systems.

The need for a new approach to cost management and the design and operation of an ABC system have received considerable attention from accounting academics and researchers and it is not intended to cover this here in any detail. The Appendix at the end of this paper provides a brief summary of the need for a new approach and the design and operation of an ABC system.

Extent of implementation of ABC systems

After almost ten years since it was developed, ABC still has a relatively low take-up as shown by the results of a number of surveys conducted in North America, the United Kingdom and Australia.

A survey conducted in 1990 on behalf of the British Chartered Institute of Management Accountants (CIMA) ABC Working Group involving organisations in both the manufacturing and financial services sectors found that only 6 per cent of the responding firms had commenced implementation and 9 per cent had rejected ABC (Innes and Mitchell, 1991a). The survey which was mailed to 720 organisations resulted in 187 useable replies, a response rate of 26 per cent. Slightly over 50 per cent of the respondents had not seriously considered ABC and around one-third were vetting it.

In 1995 the Australian Society of CPAs initiated a major survey on ABC amongst Australian manufacturers. This survey, which was conducted by the University of Technology, Sydney, involved 213 firms covering all aspects of Australian manufacturing (Corrigan, 1996; Wood, 1996). This survey showed that 45 per cent of the surveyed firms had never considered adopting ABC (although 88 per cent of those surveyed acknowledged awareness of activity-based costing), 29 per cent were still in the process of considering adopting it, 14 per cent had considered and rejected it and only 12 per cent of the firms surveyed had actually implemented it. The highest adoption rates of ABC were found amongst the food, beverage and tobacco industry with 25 per cent of this group using this method.

Of those companies which had adopted ABC most had implemented it within one to two years after making their decision to adopt it and the majority of these companies believed that they had achieved five goals:

more accurate product costing; better cost management; better cost control; better allocation of overheads; and more accurate cost information.

The Australian survey found that those companies which rejected ABC claimed that the uncertainty of benefits and the high cost relative to perceived benefits were the main reasons for rejecting activity based costing. Some companies believed that they already hade an effective costing system in place or that they hade more important priorities.

Corrigan (1996) refers to a similar survey conducted in the USA by the Institute of Management Accountants which showed a much higher level of implementation amongst American firms. Forty-one per cent of the American respondents were already using ABC as their cost management system and 33 per cent believed that they should be using activity based costing systems.

Another Australian survey conducted by Chenhall and Langfield-Smith (1996) examined the extent to which large firms had adopted certain traditional and contemporary management accounting practices; the benefits received from these practices; the intentions to emphasise certain management accounting practices in the future; and the extent to which benefits received from particular practices were related to the effective implementation of certain management innovations such as TQM, JIT, team work and supplier partnerships. The survey, which resulted in 78 useable responses, was mailed to 140 manufacturing firms selected from the 1994 Business Review Weekly list of Australia’s top 200 companies.

Amongst the 42 management accounting practices listed in the Chenhall and Langfield-Smith survey, activity based costing was ranked 24th in order of the percentage of respondents who indicated their business had adopted the practice during the past three years, indicating very low adoption of the method. In terms of the relative benefits

received from using each practice, ABC was ranked 38th, however, it ranked slightly higher, at 29, in terms of future emphasis to be given to each item .

In terms of the association of management accounting practices with the effective application of management innovations, the study showed that “activity based costing provided relatively higher benefits for the high benefit groups in all of the management innovations (although, while still in the low to moderate benefit categories” (Chenhall and Langfield-Smith, 1996). Overall, the results of the survey indicated “a preference for traditional management accounting techniques that emphasise financial information.” ABC was one of the areas where respondents indicated there would be greater future emphasis. Other areas identified were strategic planning, product profitability analysis and benchmarking.

Earlier experiences of implementing ABC

Cobb et al. (1992) used the results of the 1990 CIMA survey mentioned earlier and followed up certain of the respondents to investigate the problems which they experienced or perceived with ABC. They conducted telephone interviews with 30 of the 62 respondents who one year ago were considering ABC and had identified potential problems in its implementation. They also made visits to 12 companies which had implemented ABC including two companies which had implemented and then rejected it. This project was specifically designed to investigate problems and issues involved in adopting ABC.

Of the 30 companies interviewed by telephone, 20 were still considering its adoption one year later. The five major problems perceived by this group were:

amount of work involved in installing an ABC system, particularly for small companies. This problem was perceived by 15 out of the 20 companies;

competing uses for resources which were given a higher priority than ABC; of suitable accounting staff resources to install an ABC system; computer resources; and of selecting suitable cost drivers.

In this group of 20 companies, making major changes and innovations to the management accounting system was seen as a highly sensitive issue due to a combination of the following factors:

the perceived importance of the management accounting system; the difficulty of accepting that it has been wrong; management accountant’s lack of innovative experience; or simply continuing doubts about the value of ABC.

Three of the 30 companies interviewed by telephone had considered and then rejected ABC without implementing it. They also viewed data collection difficulties, other priorities and the time involved for the accountants as major problems. The cost of

implementing and running an ABC system was considered to far exceed the benefits which would be generated. This was also the view of the two small companies which had implemented ABC and then rejected it (Cobb et al., 1992).

The most common problems identified during the first year of implementing an ABC system were (in total there were 17 companies in this group, seven were interviewed by telephone and ten companies were visited by the research team) the amount of time spent on ABC and the retraining needed both by the accountants and the computer staff. As with any other major organisational change project, ABC also requires a change to the organisational structure. This was found to be a continuing problem in the companies in this group. The choice of activities, the selection of cost drivers, the uncertainty over using ABC for stock valuation for external financial reporting and the linking of cost drivers with individual product lines were also problems experienced by many companies during the initial stage of implementation (Cobb et al., 1992).

Recognising the potential of ABC, the Chartered Institute of Management Accountants initiated case study research in the United Kingdom. Initially three case studies were prepared. Two of the cases were manufacturers (High-Tech Electronics and Traditional Engineering) having one year’s experiences of organising and implementation of ABC. The third case was a retail distribution company with two years of experience with ABC. These three case studies are presented in Innes and Mitchell, (1990).

The three case studies demonstrated the deficiencies of the cost information produced by the conventional costing systems used. This was well recognised by accountants and managers in the three companies and ABC was viewed as a means of overcoming many of the disadvantages associated with the conventional costing system. The credibility of the cost information, its perceived utility and its comprehension by management were all enhanced by ABC in the three companies.

Innes and Mitchell identified a number of similarities in the approach adopted by the three companies in implementing ABC. These included:

up of a small team to design and implement the system. In each case this team was headed by a very senior accountant.

consultation with all the relevant managers in the organisation. This ensured that managers had the opportunity to make an input to the design of the system and to ensure that proposals were acceptable and sensible.

the system as simple as possible by limiting the number of cost pools and cost drivers. This ensured that a workable system was up and running in a reasonable amount of time.

Based on the experiences of the three companies, Innes and Mitchell concluded that an organisation can achieve a range of benefits reasonably quickly from the design and implementation of ABC. In two of the companies a substantially different pattern of product line costs was apparent and in all three cases ABC increased the “visibility of overhead cost”. Improved product line cost would be invaluable for organisations where

price may be cost sensitive and where product promotion strategies and product range/mix decisions need to be made frequently. An improved visibility of overhead cost enhances the process control of costs by linking costs to the series of activities (cost pools) which cause them (Innes and Mitchell, 1990).

Furthermore, in one of the companies cost driver rates provided a basis for a detailed cost comparison between its manufacturing plants and enabled management to make better location decisions for certain processing work. The design of new products or modifications to existing products can also be improved by the designers as they have a better understanding of the characteristics of the product which cause overhead cost.

The three case studies also highlighted a number of problems with adopting ABC. The major problem was the high set-up costs associated with the initial design of the ABC system, which involved a considerable amount of management’s and accountant’s time. Two of the companies considered the time and effort needed to identify cost drivers and their association with product lines a costly exercise and one of these companies thought that the amount of information generated by the ABC system would require additional staff in the accounting function.

Innes and Mitchell (1991) also present a much more detailed longitudinal case study of ABC implementation at the Daventry (UK) plant of Cummins Engine Company. Organisation-wide consultation and acceptance and board level support throughout the period of implementation were considered to be the major success factors in this case. The new information produced by the ABC system was used to make a range of managerial decisions which reduced costs in several areas.

It is clear from the above review that managers need to understand better the processes involved in adopting ABC and recognise the factors that are critical to implementation. In order to add to the body of literature in this area, the authors investigated the adoption of ABC in two quite different organisations. The companies were chosen because they were know to the authors to have adopted ABC with some success. Permission was obtained from each company to document their experiences with ABC and subsequently a number of in-company interviews were conducted with company staff who had led the implementation in their organisation. A structured interview questionnaire was developed and used by the authors to record the data collected.

The next section presents the two case studies on the implementation of ABC. These case studies demonstrate the many benefits that are achievable from a successful implementation as well as some of the associated problems. The final section of the paper identifies the key ingredients for successful implementation of ABC.

ABC implementation case studies

Case study one: MelCo

Note that the name of the company has been disguised to protect confidentiality.

The company, referred to here as “MelCo”, is based in Melbourne and manufactures engineering components. It is the only manufacturer of these products in Australia but has recently experienced considerable competition from overseas producers. MelCo is part of a larger group of companies and currently employs just over 100 people. Six staff are employed in its accounting function, including a financial controller who was specifically appointed to introduce ABC into the company. His previous appointment was with another Melbourne-based company which manufactured automotive components. His attempts to introduce ABC there had failed because top management was not convinced of the benefits of activity based costing.

Within the group there had been no previous attempts to introduce ABC. MelCo was the first company in the group to have done so successfully. Its previous costing system was a conventional costing system where overheads were allocated to products based on labour hours utilised. The company manufactured a very wide product range for a large customer base using a large variety of processes and methods ranging from highly sophisticated and automated processes to highly manual processes. Orders were typically for a small number of items produced to customers’ specific requirements. A high level of flexibility and responsiveness was demanded by the marketplace.

In order to provide the required level of flexibility and responsiveness MelCo had five years earlier made substantial investments in new manufacturing technologies including a robotics welding cell. The result of this was that the cost structure of the products manufactured by MelCo had changed quite dramatically, with labour costs now only accounting for a proportion of what they were previously. The savings made from the technology upgrade were not passed on to the customers and eventually a clear price disadvantage emerged in the marketplace. Many of the company’s buyers wanted to source from overseas, however they preferred to stay with MelCo.

Although the company’s overall profit margins were increasing, it was slowly losing many of its customers to overseas suppliers. The company was not aware of the areas which contributed to the improved profit margins. It was clear to senior management that the existing accounting system was not adequate and appropriate decisions could not be made on pricing, etc. due to insufficient information.

Awareness about ABC came from senior executives within the group; however, they had no experience themselves about how the system worked or how to develop and implement it. They recognised that ABC would provide a solution to the problems experienced by MelCo. Hence, the financial controller was appointed specifically to implement ABC within MelCo. On taking up his new appointment at MelCo, the financial controller established a small project team consisting of himself, an engineer from the manufacturing area and the cost/systems accountant to develop and implement ABC. Over a period of three months the project team held many informal discussions with other personnel in the company. Both the engineer and the financial controller worked full-time while the cost/systems accountant spent about two-thirds of his time on the ABC project.

The team established 25 cost pools for the whole of the company and spent a considerable amount of time agreeing on the cost drivers. Some of the cost drivers identified were:

frequency of set-ups for the new machines, this included programming the NC machines;

number of manufacturing orders - this was driving many activities from the original quoting stage to dispatch of the finished products;

number of purchase order lines - this was driving the workload in the purchasing department;

number of store issues to the production departments - this was driving the workload in the stores;

number of inspections made - sampling inspection was carried out in many areas; area allocation to processes and machines; service personnel costs.

Many of the cost drivers were common to several cost pools and the project team did not experience any major difficulties in allocating cost drivers to activities. The system implemented at MelCo is PC-based, largely consisting of spread sheets developed in-house by the financial controller. Only $1,000 was spent on purchasing software but a substantial amount of effort was made in tailoring the software for the specific needs of the company. Collecting and inputting data was also very time consuming.

The ABC system was initially piloted on a sample of 40-50 products which covered the whole range of products manufactured by the company. The level of detail reduced to 25 products once their homogeneity was established. The old costing system is still used, primarily for stock valuation, variance analysis and labour efficiencies.

The ABC system can generate true costing and pricing, automatically give performance measures and product profitability and provide a variety of information for management decision-making. The current year’s budget is being prepared using data and models developed from the ABC system.

Management expectations of the ABC system

At the time of introducing the ABC system at MelCo the general manager was fully supportive and recognised the full potential of its outputs. However, he was not aware of the amount of time and effort required to set up the system. After only one month of starting the implementation the general manager demanded results. He was told politely by the financial controller that this was not possible with the existing resources allocated to the project and that if he wanted the project to be implemented quickly then he would have to allocate additional resources. The general manager was also under pressure from head office to show results from the ABC system. To convince himself, he made his own enquiries to validate the claims of the financial controller and established that the time frame required was reasonable given the resources allocated to the project. However,

further resources were not allocated and the implementation proceeded as originally planned by the financial controller.

Problems during implementation

Lack of resources was a continuing problem during implementation, particularly when the general manager was expecting fast results. Lack of available skills in-house meant that a considerable amount of education and training had to be undertaken. This was largely undertaken by the financial controller on an informal, as needed, basis with some formal education of senior management to inform them of what ABC was all about and how it was being implemented in the company. The training of the cost/systems accountant was on-going throughout the project planning and implementation stages.

As part of the communication and data gathering exercise the financial controller had to deal with the unions on the shop-floor. A number of union officials were interviewed to determine how they spent their time during the day. In many cases there was a reluctance on the part of the union officials to answer questions and they indirectly resisted the implementation of the ABC system. They were somewhat wary of why ABC was being implemented and particularly its implications for their jobs. They were told that this was simply a costing exercise. Generally, they recognised the usefulness of the system for the long-term survival of the company.

The results of the ABC system

According to the financial controller, the ABC system implemented at MelCo has delivered many benefits. The benefits include:

more accurate information on costs and pricing and hence competitive positioning of the company in the marketplace;

identification of appropriate benchmarks which can be used against imported competitive products;

better information has enabled the company to outsource many products which were inefficiently manufactured in-house;

more appropriate capital investment decisions being made as a result of better weighting being determined on various aspects of this exercise;

many problem areas identified where costs were excessive. This includes the NC section where utilisation has been low;

performance measures have been developed which are used to identify improvement initiatives;

validation of annual budgets for specific expenses.

Although 12 months man-time was necessary for implementation, the benefits clearly outweigh the costs. The overall benefit has been the much more accurate and relevant information which can be effectively used by management. ABC provides a tool for management for commercial decision-making.

Current status of the ABC system

Lack of appropriate resources to run the ABC system remains a problem at MelCo. This may emerge as a major problem in the very near future because of the recent change in senior management in the company. The general manager who initiated the ABC system at MelCo recently departed and has been replaced by a new general manager who is not familiar with the ABC system and does not appreciate fully its benefits. The resources needed to further develop and run the ABC system may not be allocated in the future by the new general manager.

Overall, the group’s top management recognise the high potential of ABC. The financial controller sees the ABC system as a good tool for the group to develop further and implement fully in other companies.

Having been involved in implementing two ABC systems in two different companies the financial controller regards activity based costing as “a necessary system; it is common sense and answers many of the questions facing manufacturers currently. The quality of information provided by the system is high and enables informed decisions to be undertaken.”

Case study two: Ciba Specialty Chemicals

Ciba Specialty Chemicals is a leading manufacturer of chemicals and is part of the newly formed global life sciences group Novartis which was formed in 1996 as a result of the merger between Ciba-Geigy and the pharmaceuticals company Sandoz. Ciba Specialty Chemicals employs more than 20,000 employees worldwide. It generates sales in 117 countries, operates 58 production sites in 29 countries and conducts research in 12 countries.

This case study is based on Ciba Additives Hong Kong (CAHK) which is part of the Additives Division of Ciba Specialty Chemicals (the other divisions are consumer care chemicals, pigments, performance polymers and textiles dyes). CAHK was charged with marketing and distribution of additives products in the South East Asia region and provided both technical and managerial services. CAHK employs around 120 people in the South East Asia region. Operating costs and expenses were being allocated using common allocation bases - sales value and sales volumes. This approach was far from the realistic situation and in early 1996 questions were being raised as to how operating costs can be fairly allocated to the various cost objects. External pressure from head-quarters in Switzerland and internal pressure from the local operations built up to challenge the status quo. This was an indication for top management to review the current situation and implement a new costing system.

Ciba had earlier experimented with ABC in other divisions and had learnt some important lessons. Human resources support, time availability of the project champion, top management support, cost/benefit analysis, detailed project planning, user participation and external expertise had all been identified as critical success factors. At

the time CAHK was considering the introduction of ABC, The Hong Kong Polytechnic University (Department of Manufacturing Engineering) was initiating a research project focusing on Manufacturing Information Systems. This project, funded by the Hong Kong Government Industry Department, was a unique initiative in which government, industry and academia collaborated to develop and implement new manufacturing information systems in local companies and establish these as reference sites for future projects. Details of this initiative are given in Chung et al., (1997).

Developing the prototype ABC system

The introduction of ABC in CAHK started with the establishment of a multi-disciplinary project team charged with the design and implementation of an ABC system, including the development of the ABC software. The team members consisted of two parties; a practitioner team made up of a project leader with an accounting and finance background, a project champion from information engineering, and user staff members from information technology who would take over the information system prototype for maintenance. Second, the development team from The Hong Kong Polytechnic University consisted of experts from the computing, accounting and engineering departments.

At the beginning, over a period of two months, the project team spent 15 man-days interviewing various people in CAHK to collect relevant data. Each month the project team met twice to discuss various issues relating to the design of the ABC system, the prototype ABC software, and other technological and organisational aspects. Developing a flexible system which could accommodate on-going structural and managerial changes was a key requirement. This was especially necessary given the dramatic changes that were taking place in CAHK and Ciba Specialty Chemicals as a result of the recent merger.

In developing the ABC system, the project team identified budgetary line items from the account lines held in the general ledger. This information was easily extracted and categorised into the following six budgetary line items in the form of a database: planning and control, sales and marketing, general administration, customer services, information and communication and project management. The project team identified over 30 activities (e.g. transportation, accommodation, product promotion) and used a direct method of allocating expenses to these activities. Indirect expenses such as rent and equipment depreciation were allocated using a weighted factor method.

The cost drivers identified included sales value, sales budget, number of orders, number of samples, number of complaints, etc. The activities and cost drivers were continually monitored by the project team because of the structural and managerial changes taking place within the organisation. The development and implementation of the ABC system took approximately 18 months. An experienced programmer worked for six months on developing the prototype ABC software. This was trialed and tested by the CAHK practitioner team and many changes were made along the way.

The top management team from Ciba Specialty Chemicals was very supportive throughout the project and allowed local Hong Kong management to be fully involved in the project. The ABC system developed and implemented assists CAHK in a number of ways. The system provides realistic cost information on selected cost objects and much more accurate information is now available for business analysis. Currently both the traditional accounting system and the ABC system are being used to provide different cost information for various purposes.

Problems during implementation

Key staff involved in the ABC project were at times under considerable pressure as they were also involved in a number of other major structural changes taking place within CAHK. Hence, time availability was a problem. It is recognised that full-time availability of key people is a pre-requisite to success.

There was some resistance from a number of the staff members. This may have resulted from the overall structural and managerial changes that were taking place at the time of the ABC project and to some extent the uncertainty in the future. The support and involvement of the top management was vital in overcoming resistance and fear amongst some employees.

Benefits of the ABC system at CAHK

The ABC system developed at CAHK provides more accurate costs, enabling management to analyse better the customer base and provide better services. The ABC system has also enabled CAHK to promote more appropriately relevant product lines and make better business decisions, particularly those relating to outsourcing.

As a result of the ABC project and the collaboration with The Hong Kong Polytechnic University, CAHK has developed a number of capabilities:

superior project planning expertise; better leadership and managerial skills amongst its people; ability to learn together; learning to be patient; and learning to delegate responsibility and trust others to be responsible.

CAHK is currently extending the ABC system to cover its manufacturing area which is being established in Southern China. The Hong Kong ABC implementation experience has taught the company to understand the different culture that exists in China and to integrate the different values that each part of the organisation holds. Respect for the individual, open communication, education, training, career advancement and team working are absolutely essential and professional/personal development is vital in creating a harmonious working environment.

Discussion and conclusions

This paper has described the adoption of activity based costing in two organisations. It is clear from the literature reviewed and the two case studies presented in the previous section that ABC offers substantial benefits over conventional accounting systems; however, it has a relatively low up-take amongst organisations. Many of the problems and difficulties associated with introducing ABC are related to managerial aspects rather than the technical aspects of the ABC system. Based on the case study experiences presented above, the following are identified as key ingredients for successful implementation of ABC:

Total commitment from top management. They must understand the benefits that ABC offers the organisation and must get involved in setting realistic and achievable objectives. The objectives must be clear and simple so that everyone in the organisation can understand them. The objectives must be regularly reviewed and revised as changes take place within the organisation and in the marketplace.

The establishment of a multi-disciplinary project team to introduce and implement the ABC system in the organisation. The team members must be co-operative and share similar values and attitudes. A knowledgeable project leader or champion can be vital to the overall success of the project. This person must have adequate experience in project implementation. The project team has the responsibility for clearly defining time frames, actions and responsibilities. It continuously monitors the progress of the project and makes the necessary changes so that targets are being achieved.

Education and training of all people in the organisation to understand the complexity of the project and its impact on the organisation.

Adequate resource allocation to the ABC project. Sufficient time must be allowed for data gathering and analysis during working hours. Time allowed to gain confidence with the new system is absolutely necessary.

Access to outside expertise, particularly when new concepts and software are being developed. The expertise available at the local university can be invaluable.

On-going feedback to top management and lower level employees on the progress of the ABC project.

Keeping the implementation as simple as possible, perhaps introducing it as a pilot project initially.

A number of potential reasons for failure are also identified from the two case studies:

Employee resistance/scepticism, particularly where education and training has been inadequate or where other major organisational changes are also taking place.

The ABC project seen as an “accounting” project by other functional managers. Underestimating the cost of data gathering. Shortage of appropriate resources, particularly people skills.

Other reasons for failure include too much reliance on outside consultants, politics within the organisation and letting the project drag on.

To overcome the above problems, thorough planning must be carried out and the right person must be appointed to act as the “champion” of the project. This is not to say that top management has no hands-on involvement in the planning and implementation of the ABC system.

Based on their extensive case study based research on ABC implementtion, Innes and Mitchell (1991) concluded that the change process involved in implementing ABC is an on-going one and that there are three factor types which interact together to promote the cost accounting change. These are;

and (see Table I).

Many of the factors listed in this table are identifiable in the two cases.

Furthermore, Innes and Mitchell say that “the effective operation is, however, ultimately a function of the individuals who work for the firm. Managers and accountants must be prepared to question the status quo. The accountants must then be prepared to respond to the changing needs and demands of managers”. These authors identify five key conditions which they say must be met to foster a dynamic management accounting function which will be responsive to management requirements. Accounting staff should:

kept familiar with business strategy and changes therein and be continually assessing the information demands which this implies;

familiar with the operational aspects of the business and changes therein and be continually assessing the information demands which this implies;

and be responsive to management criticisms of information which they provide and indeed be critically assessing outputs regularly themselves;

aware of current developments in their own discipline; and and development role acknowledged, provided for, reported on and assessed by

top management (Innes and Mitchell, 1991).

In this respect, manufacturing and operations managers can assist accounting staff in their orgnisations to understand better the information needs of the manufacturing/ operations function and play a key role in the adoption of ABC.

Table IProduct cost and management decisions

Table AIThe structure of factors influencing the change to ABC

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Appendix

The need for a new approach to cost management

See Table AI. The costing systems used in many organisations today were designed around the turn of the century to produce a small range of products which consumed similar amounts of production support services and when non-volume related costs were relatively small (Johnson and Kaplan, 1987). Direct costs consisting of direct material and direct labour usage are easily identified to product lines. Indirect costs or overhead costs associated with production support services (i.e. procurement, set-up, maintenance and engineering and quality control and quality assurance) are allocated on the basis of production volume. An overhead rate or series of overhead rates based on individual departments are attached to product lines in proportion to a common product characteristic which bears a close causal relationship to overhead cost (Innes and Mitchell, 1990). Direct labour based overhead cost allocations are most commonly used and, since the direct labour content is dependent on production levels attained, these overhead costs are ultimately driven by production volume.

In today’s manufacturing environment an increasing proportion of total costs do not vary with volume (Drury, 1990) and the continued use of conventional costing procedures can have serious dysfunctional consequences for the cost information which is generated and used within firms (Innes and Mitchell, 1990). Drury (1990) refers to a survey of management accounting in advanced manufacturing technology environments which found the method of charging overheads to products a major area of concern for managers. The survey also found that direct labour hours or direct labour wage costs were widely used as a basis for allocating cost centre costs to products, even though direct labour averaged only 12 per cent of total manufacturing cost. Drury concluded that in an advanced manufacturing environment, direct labour-based allocation methods are unlikely to represent a reasonable basis for approximating the overhead resources demanded by products and that output is determined by machines and workers are, in effect, machine tenders. The survey respondents identified the development of alternative bases for assigning overhead costs to products as the most important area for improving product costing systems.

Design and operation of an ABC system

The allocation of overhead costs purely on the basis of volume produced, as is the case with the traditional management accounting systems, is no longer appropriate. In the modern, high technology industries many of the most important contemporary overheads

are largely unaffected by alterations to production volume and can be viewed as resulting from specific transactions or activities which are relatively independent of production volume (Innes and Mitchell, 1990). The costs of these overhead transactions and activities have risen dramatically in recent years. Consider for example the costs associated with product development, product testing, quality control/assurance, procurement and marketing which nowadays can be several times the direct cost of some products. It is the volume of these activities which consumes resources and hence determines the level of overhead cost. ABC attempts to obtain a greater understanding of cost behaviour by trying to understand the forces behind these costs, which are described as cost drivers. Examples of some of the activity based cost drivers which have been recommended by various writers include the number of receiving orders for the receiving department, the number of production runs undertaken for scheduling and set-up costs, the number of purchase orders for the purchasing department, and the number of dispatch orders for the dispatch department (Drury, 1990):

Therefore if products are to be costed in a manner which reflects their actual consumption of resources then their share of overhead must be absorbed by them on the basis of these activities. If this is done then overhead is absorbed in proportion to activities (and hence cost) caused by each individual product, batch of products or product line (Innes and Mitchell, 1990).

Table AI, taken from Innes and Mitchell (1990), illustrates and contrasts this ABC approach with the conventional approach.

Operating an ABC system involves two steps (Innes and Mitchell, 1990):

overhead cost to activity based cost pools. and using a series of cost driver based rates to attach the pooled costs to product

lines.

There are three key factors which influence the design and operation of an ABC system:

the choice of cost pools; the selection of means of distributing overhead costs to the cost pools; and the choice of cost driver for each cost pool.

These are important factors to consider which require that sufficient consultation takes place between management accountants and departmental managers. The establishment of homogeneous overhead cost pools in step one requires the identification of all major activities which cause overhead costs. Initially a very large list may emerge and some of these activities may turn out to be insignificant. A balance needs to be achieved between the accuracy of the output from the ABC system and the costs and difficulties associated with operating a more complex ABC system. Innes and Mitchell (1990) suggest that the activities must be reduced to ensure a practical and cost effective ABC system is finally designed. They suggest that to effect this reduction the accountant will require to know:

the significance of the cost of each activity listed (in order to judge if it is material enough to justify a separate cost pool) and

the factor or factors which influence the cost of each activity (namely the cost driver) in order to judge whether there is homogeneity in the cost behaviour of separate activities (which may be combined into one cost pool, at least for product cost purposes).

The cost of some activities may not have specific cost drivers and in this case these must be reapportioned to the other activities. In addition, a number of the cost drivers may be closely related. In this situation a detailed analysis of the factors should be carried out, as outlined by Cooper (1988) in Innes and Mitchell (1990):

Product diversity should be analysed to understand the extent to which final products consume the overhead activities in different proportions. If product diversity is high then costing accuracy is lost by merging cost pools and eliminating cost drivers.

The relative cost of the activities aggregated should be analysed to understand the significance of the cost of pooled activities in relation to the total pooled cost.

Volume diversity should be analysed: where products are produced in different batch sizes and the demand for activities (and hence for overhead cost) relates to batches rather than units of output. Thus, if one product is made in ten batches of ten units and each batch has a specific delivery of material associated with it, while another product is made in two batches of 50 requiring two deliveries then the use of “number of suppliers’ orders” (assuming each lot of 100 units requires only one supplier order) would result in an undercosting of the former product (which required ten deliveries) and an overcosting of the latter (which required only two)”.

From the above it is clear that a considerable amount of data will need to be collected and analysed in order to operate an ABC system. Many organisations do not have in place the mechani