Activity-Based-Costing (ABC) | Brief Background, Criticisms, Problems, Weaknesses, Benefits and Strengths

I was going through my archives when I stumbled upon this academic thesis which attempts to throw light on: back ground of Activity-based-costing (ABC), its criticisms, problems, weaknesses, benefits and strengths. I decided to share this on this accounting blog for those that might be doing research in this area. Feel free to reference this post if you need to and also share with people whom you know may need it.

Brief historical background of ABC costing method

The idea of (Activity Based Costing) ABC as a system of costing was first proposed by Professors Johnson and Kaplan (1987) and made popular by Cooper and Kaplan (1988). Their attention was focused on manufacturing and services industry.

Some authors however according to Major (2007) argued that ABC as a costing method has been around much earlier. For example, see (Innes and Mitchell, 1998; Drucker, 1963; Staubus, 1988). The above claims

Jones and Dugdale (2002) pointed out that the development of ABC has been described as associated with two important networks: the ‘Harvard network’ and ‘Computer-Aided Manufacturing, International (CAM-I) network’ that was later entitled ‘Consortium for Advanced Manufacturing, International’

Both networks described the conventional accounting system as obsolete and inadequate, claiming that the existing system of costing promotes inefficiencies while at the same time hindering the competitive advantage of American firms Major (2007). Gupta and Galloway (2003) also concluded that traditional accounting methods, which relies on single driver to allocate overhead is inaccurate and misleading.

Their reason for this conclusion according to them is the fact that this method allocates too much cost to one product and too little to the other. Similarly, Baines (1992) blamed the traditional accounting on poor management information system that characterises many organizations today.

In order to address this problem, ABC was developed to provide a means of accurate representation of value added activities Gupta and Galloway (2003).

Criticisms, Problems and weaknesses of ABC (bulleted points)

1. Inability to utilise information
2. Complex and uses a lot of resources in gathering information (not much of a problem in this current era of big data)
3. Difficulty in implementing change in organizations
4. Difficulty in assigning costs that has no solid cost drivers

Criticisms, Problems and weaknesses of ABC (detailed academic analysis)

Problems, criticisms and weaknesses are hallmark of every system that is formulated by human beings and ABC is no exception. From the point of view of Malmi (1997), it appeared that one of the major criticisms faced by ABC is the one of information utilization. This problem of not utilising the output of the ABC process is the main bone of contention as huge amount of resources is expended in processing those cost information. Accommodating this problem will still amount to accommodating the wastes inherent in the traditional system of costing.

Another major problem of ABC is the fact that it requires a complex and resource consuming formalities in gathering and processing information. This is in fact the main reason why companies that embrace ABC with high hopes all of a sudden abandon it for the old traditional cost accounting process.

This development gave concern to many including Kaplan and Anderson (2005) who subsequently advocate for what he called ‘time-driven ABC’. Kaplan and Anderson (2005) are of strong opinion demonstrated in their book titled ‘Rethinking Activity-Based Costing’ than abandonment is not the solution to solving the identified problems of ABC.

Aside the physical problems of ABC, managers also face tough and stiff challenge in attempting to change the organizational structure of a company so as to provide an enabling environment where ABC can thrive.

The fact that enabling environment where ABC can function without friction needs to be created before importing the system into an already existing system makes it imperative that systematic approach is employed. Any systems integrator will tell you that the problem with integrating two systems is the area of conflict resolution.

This is to say that implementation problems and drawbacks of any process are not solely embedded in the process but also in the attitude and behaviours of the custodians of the process. The law of inertia established that human beings are reluctant to adapt to changes even when not adapting could be very disastrous.

Those that have allowed the traditional system of allocating overhead costs tend to have some reservation about the information produced by ABC.

According to Cohen et al (2005) research indicates that stretch in time schedule of ABC process, exceeding budget and inadequacy of computer software (this will no longer be a problem in today’s world) are the main culprit to be blamed for the criticism levelled against ABC system.

Another area where ABC is found wanting is in the area of assigning costs that has no solid driver. A good example is the salary of the chief executive officer (CEO). The salaries of CEOs though part of the monies spent on the work force of a company cannot be directly traced to any segment of a company or product. This is just one of the many cases where it is difficult to trace expense to any activity in an organization.

One can still argue in favour of ABC as no other better alternative way of tackling the problem of costs that cannot be traced to any particular product exist. In other words, it is better to have a clue to a problem than not to have at all.

Just because ABC fail to assign some costs to products or services does not make it a complete failure. This is in line with the objectives of the founding fathers of ABC “…the objective of ABC is to approximately right…” Kaplan and Anderson (2005)

Strengths and benefits of ABC (Bulleted points)

1. Better and more accurate cost information
2. Provision of insight into the fastest growing and least element of cost overhead
3. Improving profitability through product analysis
4. Encouragement of Kaizen accounting and TQM techniques
5. Provides avenue for training

Strengths and benefits of ABC (detailed academic analysis)

The strongest claim that the proponents of ABC project is that ABC provides better and more accurate cost information that is necessary for modern days businesses to effectively and profitably compete.

This claim of ABC costing method providing accurate information have been questioned by some scholars who argued that ABC is a process that sucks resources and would only be justified if the benefits that would be obtained from such investment in processing costing information is justified.

Other good sides of ABC includes: (a) provision of insight into the fastest- growing and least element of cost overhead, (b) improving profitability by monitoring total life-cycle cost and performance, (c) encouraging continuous improvement and total quality control as it allows planning and control to be directed to desired direction at process level,  and (d) encouraging the elimination of wastes.

Homberg (2001) while developing a mathematical model that establishes an optimal cost driver selection in the ABC process pointed out the dilemma that comes with the implementation of ABC.

Aiming for high accuracy in costing will require that more cost drivers be identified which contravenes one of the features of useful information – manageability.

According to Homberg (2001), the major issue in implementing ABC costing system in the selection of cost drivers as accuracy is traded off for complexity. The implication of this is that information generated through the use of ABC is not in fact as accurate as many thinks it is- Kaplan and Anderson (2005) also confirmed this.

Another benefit of ABC as indentified by Anderson et al (2002) is the fact that it provides technical knowledge to managers of a company as training is often required as part of the implementation process of ABC.

This technical knowledge will be extended to other parts of the company to bear positive fruits on the bottom-line. Although this claim of Anderson et al (2002) might not work in companies engaged in other forms of business outside engineering.

Conclusion and Summery

This post is an excerpt from a thesis which I contributed a lot to back in school. The sections that talks about the background of ABC costing method, its criticisms, weaknesses, problem, strengths and benefits have been shared on this accounting blog. Feel free to email me if you wish to get the unabridged copy of this article.