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ACTIVITY BASED COSTING

A SURVEY FOR THE GREEK COMPANIES

UNIVERSITY OF MACEDONIA
ECONOMIC AND SOCIAL SCIENCES
Demetrios Ginoglou
Assistant Professor
Department of Accounting and Finance
E-mail: ginogl@uom.gr

Tel. ++30310-891-688
Fax ++30310-891-688

















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CONTENTS
ABSTRACT.
INTRODUCTION...
LITERATURE REVIEW...
DESCRIPTION OF THE METHOD AND ITS DIFFERENCES FROM TRADITIONAL COST
SYSTEMS.....
DESIGNING AN ABC MODEL
1
ST
STAGE: DETERMINATION OF COSTS.
2
ND
STAGE: IDENTIFYING ACTIVITY CENTERS.
3
RD
STAGE: TRACING COSTS TO ACTIVITY CENTERS.
4
TH
STAGE: DETERMINATION OF PRODUCTS
5
TH
STAGE: ASSIGNING COSTS TO PRODUCTS .....
CRITERIA FOR ABC IMPLEMENTATION IN MANUFACTURING
INDUSTRIES...
BENEFITS OF ABC
DISADVANTAGES OF ABC.
ABC SOFTWARES...
RESULTS OF THE STUDY.
BIBLIOGRAPHY..


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ABSTRACT

The new manufacturing environment of 21
st
century create more efforts to
increase efficiency and improve information, new technologies etc. thus it gives
essential elements of survival to business. Examples of new technologies and
techniques are numerous and publicized such as computer aided manufacturing,
robotics, EDI, EFT, BBS etc. One of the main goal in manufacturing environment is
to measure accurately not only the unit cost but also the cost of each activity. Many
companies have problems with overhead costs because they want to allocate it more
accurately in order to have more precise measurement of each product unit cost.
In this research study an attempt is made to investigate in a random sample
of Greek companies if they use the Activity Based Costing technique(ABC) or not.
Other reasons that has led to this study were the article of G. Venieris (Prof. in
Accounting ) in the magazine Logistis, Also the study of a researchers team during
the program ADAPT Pigasos, with the study E-Commerce & Enterprises Activity-
Based-Costing and the practical implementation of this method in a pilot-
company(A) in Thessaloniki Greece which has gained a major cost advantage by
using new technologies and ABC.


INTRODUCTION
At the beginning of the 21th century we realize the new large revolution in
new technologies, in computer sciences, in telecommunication etc. New local area
networks arises and the VAN networks, internet etc. growth more quickly.
Technologies like Electronic Data Interchange (EDI), Electronic Funds Transfer
(EFT), Bulletin Board Services (BBS), internet, E-Mail and other Electronic
Commerce applications are commonly used by the companies in order to gain the
target markets and in order to be better in every stage of its value chain.
From the accounting point of view one major goal for many companies in
order to gain a strategic advantage in measuring the unit product cost is to adopt a
new technique called Activity Based Costing. A more accurate measurement of unit
costs may assist managers in many ways.
First of all the ABC system subdivide overhead cost into a number of activity
cost pools. Each cost pool represents an activity such as: machinery repairs, car
repairs etc. The overhead cost in every pool then applied to production separately
using the better cost driver.
Such cost drivers may develop new procedures that may reduce the overhead
costs.
The company that use the ABC system first of all determine many different
activities. Then prepare the cost of each activity, collect data for the activities and
finally estimates the cost of production. While the traditional cost system focus on the
division of:
Direct materials
Direct labor
Overhead cost etc.
In order to get total product cost we have to add the direct and indirect cost
of the product. A direct cost is directly related, or traceable to a cost objective. A cost
objective is any grouping to which costs are assigned, such as an individual unit of
inventory, a department, a product line etc. On the other hand, indirect costs relate to
more than one cost objective. If the cost objective is a particular product in a


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multiproduct factory, all manufacturing costs other than direct materials and direct
labour are considered indirect manufacturing costs (manufacturing overhead).





LITERATURE REVIEW

There are different approaches in the task of assigning overhead costs to the
product cost. In the early part of 20
th
century, when cost systems first began to be
developed, direct labour constituted a major part of total product cost. Therefore,
direct labour was typically chosen as the base for assigning overhead cost to products.
Data relating to direct labour were readily available and convenient to use, and there
was a high correlation in most companies between direct labour and the incurrence of
overhead cost.
However, events of the past two decades have made drastic changes in the
manufacturing environment. Automation has greatly decreased the amount of direct
labour required, product diversity has increased in those companies that manufacture
a wider range of products, and these products differ substantially in volume, lot size
and complexity of design; and total overhead costs has increased in some companies
to the point that a correlation no longer exists between it and direct labour. Wherever
these changes have prevailed, companies that have continued to use plant wide
overhead rates and direct labour as a basis for overhead assignment have experienced
major distortions in unit costs. In order to overcome these distortions, some
companies used a two-stage allocation process. In the first stage, overhead costs are
assigned to cost pools, such as individual departments or operations. In the second
stage, costs are applied from the cost pools (departments) to individual jobs. These
second-stage applications are made on various bases according to the nature of the
work performed in the department.
Unfortunately, even departmental overhead rates will not correctly assign
overhead costs in situations where a company has a range of products that differ in
volume, lot size or complexity of production. The reason is that the departmental
approach relies on volume as the key factor in allocating overhead cost to products.
Studies have shown that where diversity exists between products, volume alone is not
adequate for overhead costing. These studies show that overhead costing based on
volume will systematically over cost high-volume products and under cost low-
volume products. In order to overcome these problems some companies use Activity
Based Costing. ABC involves a two-stage allocation process, as described earlier,
with the first stage again assigning overhead costs to cost pools. However, more pools
are used under this approach, and they are defined differently. Rather than being
defined as departments, the pools represent activities, such as set-ups required,
purchase orders issued, and number of inspections completed. In the second stage,
costs are assigned to jobs according to the number of these activities required in their
completion. According to Noreen and Garrison ABC is considered to belong to a
third stage of cost systems.
ABC systems require a new kind of thinking. Traditional cost systems are the
answer to the question, How can a organization allocate costs for financial reporting


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and for departmental cost control? ABC systems address an entirely different set of
questions:
1. What activities are being performed by the organizational resources?
2. How much does it cost to perform organizational activities and business
processes?
3. Why does the organization need to perform activities and business
processes?
4. How much of each activity is required for the organizations products,
services and customers?
In 1984 two respected accounting professors, Dr. Robert Kaplan of Harvard
Business School began to expound the shortcomings of traditional cost accounting
systems. Concurrently, Dr. Robin Cooper of the Harvard Business School developed
the new cost system ABC. From these beginnings, ABC gained attention and spread.
Today ABC systems are widely used in USA, Great Britain and Germany. In Greece
activity-based costing systems are still rarely used by companies.

METHOD DESCRIPTION AND ITS DIFFERENCES FROM TRADITIONAL
COST SYSTEMS

An activity-based system can paint a picture of product costs radically
different from data generated by traditional systems. These differences arise because
of the systems more sophisticated approach to attributing factory overhead, corporate
overhead and other organizational resources, first to activities and then to the products
that create demand for these indirect resourses.
Companies need cost system to perform three primary functions:
Valuation of inventory and measurement of the cost of goods sold for
financial reporting
Estimation of the costs of activities, products, services and customers
Providing economic feedback to managers and operators about process
efficiency
The first need is driven by the needs of constituencies external to the
organization: investors, creditors, regulators, and tax authorities. The second and third
functions arise from the need of internal managers to understand and improve the
economics of their operations. Managers need accurate and timely cost information to
make both strategic decisions and operational improvements. Traditional standard
cost systems are still fine for financial reporting. Some companies, even today, have
systems that use simplistic direct labor overhead costing systems, perhaps with only a
single rate, despite operating with diverse processes, which might include both
manual assembly and highly automated machining.
But such aggregate methods for allocating factory overhead costs to products
provide managers with poor information. And the costs of many organizational
resources, especially those of marketing, sales and distribution, are not assigned to
cost objects at all since such costs are not in financial statements. Although these


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recourses clearly help an organization meet the demands of individual customers,
channels and markets, the financial system does not assign their costs to users. Such a
calculation is neither necessary nor allowable for financial reporting purposes.
As competition increased and as the basis of competition shifted away from
the efficient use of direct labor and machines, managers needed more accurate
information about the costs of processes, products and customers than they could
obtain from the system used for external financial reporting. Activity-based cost
(ABC) systems emerged to meet the needs for accurate information about the cost of
recourse demands by individual products, services, customers and channels. ABC
systems enabled indirect and support expenses to be driven, first to activities and
processes and then to products, services and customers. The system gave managers a
clearer picture of their business. The clearer picture from ABC cost system led
naturally to ABM (activity-based management) which is the set of actions that can be
taken, with activity-based cost information.



DESIGNING AN ABC MODEL
In order to implement an Activity-Based Costing system we have to follow the
stages of the following exhibit:
Determination of
costs
...
Identifying Activity
Centers 60% 30% 10%
Tracing Costs to
Activity Centers
... ...
Determination of
Products
50% 20% 30%
Assigning Costs to
Products

!"#$%& 1 Cost 1 Cost 2
Cost n
Total Cost of
Activity
Center 1
Total Cost of
Activity
Center 2
Total Cost of
Activity Center m
Total Cost of
Activity Center '
Product 1
Product 2 Product 3
Product 4 Product p


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1
st
stage: Determination of Costs
The term Cost is defined as the sacrifice made to obtain the objectives of the
company. We can classify cost into the following categories:
1. Materials Costs
2. Labor Costs
3. Taxes
4. Interests
5. Depreciations
6. Several Costs

2
nd
stage: Identifying Activity Centers
A well-designed activity-based costing system starts with process value
analysis (PVA). PVA consists of systematically analyzing the activities required to
make a product or perform a service. It identifies all activities involved in
manufacturing a product or serving a customer and labels these activities as being
either value-added or non-value-added in nature. Only the actual processing of goods
is a value-added activity, all other steps in the manufacturing process, including
moving goods from station to station, inspection and waiting for processing are non-
value-added activities in that they consume resources without adding value to the
product. The company should find ways to reduce or eliminate the non-value-added
activities.
After a PVA has been completed, the activities involved with the production
of each product will be clearly documented on a process flowchart. Since there may
be dozens of activities identified, a decision must be made at this point as to how
many of these activities to treat as separate activity center. An activity center can be
defined as a part of the production process for which management wants a separate
reporting of the cost of the activity involved. For most companies, it would not be
economically feasible to treat every single activity as a separate activity center.
Rather, companies frequently combine several related activities into one activity
center to reduce the amount of detail and data-keeping cost involved. For example,
several actions may be involved in the handling and movement of raw materials, but
these are typically combined into a single activity center titled material handling.
Perhaps the greatest accuracy in costing is achieved by recognizing four
general levels of activities, with various of these levels then subdivided into specific
activity centers. These four general levels can be described as follows:
Unit-level activities are those that arise as a result of the total volume of
production going through a facility. The consumption of power, for
example, is a function of the number of hours of machine time required
to complete all units of product and would therefore be considered a unit-
level activity. Some companies combine activities at the unit-level into a
single activity center, while others recognize at least two unit-level
activity centers-one related to machine activity and the other to labor
activity.
Batch-level activities would include tasks such as placement of purchase
orders, setups of equipment, shipment to customers and receipts of


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material. Costs at the batch level are generated according to the number
of batches processed rather than according to the number of units
produced, the number of units sold or other measures of volume. In
addition, cost at the batch level are generally independent of the size of
the batch.
Product-level activities are those that relate to specific products
manufactured by a company. These activities are performed as needed to
support production of each different type of product, thus, product-level
activities will relate to some products but not to others. For example,
doing quality inspections is a product-level activity, since some products
require inspections while others do not. Typically, a separate activity
center is needed for each product-level activity that can be identified.
Facility-level activities are typically combined into a single activity
center, since they relate to overall production and not to any specific
product manufactured. Facility-level costs include such items as factory
management, insurance, property taxes and worker recreational facilities.
Theoretically, facility-level costs should not be added to products since
doing so involves the use of volume-based measures such as direct labor-
hours or machine-hours. However, virtually all companies do add
facility-level costs to products.

3
rd
stage: Tracing Costs to Activity Centers
We said earlier that ABC uses a two-stage costing process. In the first stage,
costs are assigned to the activity centers where they are accumulated while waiting to
be applied to products. Costs can either be assigned directly to activity centers in this
first stage or they can be assigned by using first-stage cost drivers.
Where possible, companies prefer to assign costs directly to activity centers
in order to avoid distortions. For example, if a company has an activity center titled
material handling, then it would identify all costs directly associated with material
handling and assign the costs to that center. Such costs may include salaries,
depreciation, etc. Other costs associated with material handling might arise from some
resource that is shared by two or more activity centers, these costs would need to be
assigned to the centers according to some first-stage cost driver that controls
utilization of the costs involved. Plant space, for example, might be shared by several
activity centers, including material handling. The costs associated with plant space
would be assigned to the centers according to the amount of space occupied by each.

4
th
stage: Determination of Products
In this stage we determine the products, services or customers in which we
will later assign the cost of the activity centers.

5
th
stage: Assigning Costs to Products
The fifth stage of activity-based costing system involves tracing costs from
the activity centers to products. This is accomplished through the use of second-stage
cost drivers. Two factors must be considered when selecting a cost driver for use:


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First, the ease of obtaining data relating to the cost driver and second, the degree to
which the cost driver measures actual consumption by products of the activity
involved.
The ease of obtaining data strikes at the very heart of activity-based costing,
since detailed information relating to a particular cost driver may be difficult to find.
Assume again that a company wants to establish an activity center titled material
handling. After careful analysis, management has determined that number of times
handled would be the appropriate cost driver to use in assigning material-handling
cost to products. In choosing a cost driver for an activity center, managers must be
sure that it accurately measures the actual consumption of the activity by the
companys various products. If a high degree of correlation does not exist between the
cost driver and the actual consumption, then inaccurate costing will result.
High-tech companies have a distinct edge in the matter of gathering data
relating to cost drivers, since the computers controlling their system routinely gather a
wide range of information relating to each step in the manufacturing process. This fact
probably explains in part why highly automated companies have been the leaders in
adopting the activity-based approach.
In the following exhibit we have the cost drivers that are used in ABC
costing systems and also the cost drivers that are used in traditional costing sytems:
ACTIVITIES TRADITIONAL
COSTING
ABC COSTING
Materials orders Labour-Hours Number of orders
Transportation of materials Labour-Hours Number of batches
Production Planning Labour-Hours Number of batches
Machine Adjustment Labour-Hours Product Change
Production Control Labour-Hours Number of checked pieces


CRITERIA FOR ABC IMPLEMENTATION IN MANUFACTURING
INDUSTRIES
Companies that have some of the following characteristics are likely to
benefit from activity-based costing:
1. Products differ in volume, size and complexity of manufacturing process.
2. Products differ in their need for various activities such as setups,
inspections etc that are involved in the manufacturing process.
3. High overhead costs.
4. Top management people largely ignore the cost data provided by the
existing system when setting prices or other significant product decisions.
5. The variety of products being manufactured has increased since the
existing cost system was established.



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BENEFITS OF ABC
Activity-based costing improves the costing system of organizations in the
following ways, thereby leading to more accurate product costs:
Activity-based costing increases the number of cost pools used to
accumulate overhead costs. Rather than accumulating all overhead costs
in a single, company wide pool, or accumulating them in departmental
pools, costs are accumulated by activity. As a result, many pools are
created according to the number of cost-driving activities that can be
identified.
ABC changes the base used to assign overhead costs to products. Rather
than assigning costs on a basis of direct labor or some other inaccurate
measure of volume, costs are assigned on a basis of the portion of cost-
driving activities that can be traced to the products.
ABC changes also a managers perception of many overhead costs in that
costs that were formerly thought to be indirect (such as power,
inspections and machine setup) are identified with specific activities and
therefore are recognized as being traceable to individual products.
As a result of having more accurate product costs, managers are in
position to make better decisions relating to product retention, marketing
strategy, product profitability and so forth. For example, with ABC
margins vary significantly from product to product and increased profits
become the focal point of decision making-not revenue. So with ABC,
management has better information to measure marketing and sales
performance. Also ABC information helps set discount and service
policies. The company now knows how much a consolidated order, to
one shipping destination, saves.
Moreover ABC leads to better-cost control because it eliminates
distortions that are caused by the labor-based costing systems and also
helps investment decisions. Labor-based cost systems under cost capital
intense processes, while over costing labor intense processes. ABC
provides more accurate process cost information, which lays the
foundation for better capital justification. Using activity-based costing,
companies not only know what each process real overhead amounts to,
but what it consists of. The system tells management how much tooling,
maintenance and utilities each process consumes. These costs can be
used in capital justifications or as targets in cost reduction programs.


DISADVANTAGES OF ABC
ABC improves the costing systems of organizations but also has some
limitations such as:
Critics of activity-based costing argue that even though some overhead
costs can be traced directly to products through the use of activity


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centers, the portion that relates to operational-level activities must still be
allocated to products by means of some arbitrary base such as machine-
hours or labor-hours. Therefore it is argued that any attempt to gain more
accurate product cost through activity-based costing is meaningless.
Perhaps the most significant problem of activity-based costing is the
high measurement costs that are required for its operation. As the number
of activities involved in the production process increases, the cost of
gathering data for ABC system becomes higher. In short, the
implementation of activity-based costing can present a formidable
challenge, and management may decide that the measurement costs
involved are too great to justify the expected benefits.
There are two common problems in using activity-based costing in
service industries. One problem is that a larger proportion of costs in
service industries tend to be facility-level costs that cannot be traced to
any particular billable service provided by the firm. The second problem
is that it is more difficult to gather activity data in service companies,
since so many of the activities tend to involve human tasks that cannot be
automatically recorded.
ABC SOFTWARES
In the following exhibit we have a list of the major softwares that are used
in ABC implementation and each supplier:
PRODUCT SUPPLIER
ABCost-Manager Coopers & Lybrand, Chicago, IL
Activa Price Waterhouse, St. Louis, MO
Activity Alalyzer Lead software, Inc, Bloomingdale, IL
Alpha Cost VanDe Mark Products, Medford, OR
ARIS-ABC IDSheer, Germany
CASSO Automation Consulting, Brighton, MI
CMS-RC ICMS Software, Inc, Arlington, TX
ComMIT-ABC ComMIT Systems, Willowdale, Ontario
3 System Polaris Systems, Houston, TX
Easy ABC ABC Technologies, Inc, Portland, OR
NetProphet Sapling Corp., Etobieoke, Ontario
Prism Mancam Corporation, Newton, MA
Profile ABC Applied Computer Sciences, Inc,
Norwalk, CT
Profit Manager KPMG, Hartford CO
Quite-A-Profit Manufacturing Manage systems,
Madison, OH
R/ACM Deloitte & Touche







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DATA COLLECTION AND RESULTS OF THE STUDY
The sample of this study consists of more than 500 random large companies
from all over the Greek State. The data collection were made through a questionnaire
(by the students) of the department of Accounting and Finance, University of
Macedonia
ABC is a recent system that can used for more accurate measurement of unit
cost. It can also encourage the management of the company in process activity based
approach versus functional operational based approach. It also meets the need for
accurate information about the cost of resource demands by individual products,
services, customers and channels. This system gave managers a clearer picture of the
economics of their operations.
An activity-based system can paint a picture of product costs radically
different from data generated by traditional systems. These differences arise because
of the systems more sophisticated approach to attributing factory overhead, and other
organizational resources, first to activities and then to the products that create demand
for these indirect resources.
Results from this research in the Greek companies shows that, even though the
number of companies that has adopted the ABC system remains relatively low (8
companies according to 1999 data), the conditions in Greece nowadays make the use
of ABC system necessary.
The results also show that:
The majority of the companies (84,86%) believe that their cost system can
totally meet the needs of the company.
A small percentage of companies (appr.10%) have adopted ISO and B.P.R
techniques.
In most of the companies (67,18%) there is a major demand for reduction
of cost, while in the 65,30% of the companies indirect costs is increased
by the same analogy with in the total costs. Finally, the 16,44% of the
companies are aware of the cost of their basic activities and the cost of
each of their units.
Only 18,01% of the companies knows ABC system, of whom 53,85%
have thorough knowledge about the system, while 49,61% of the
companies would like to be informed.
ABC system has been adopted only by 4,66% of the Greek companies,
half of which use the system precisely. 29,07% of the rest of the
companies are going to adopt ABC system in the future.
The implementation of ABC system in the companies influences mainly
the decisions which are related to the cost and price of the product, while
the decisions which are related to profitability and productivity are less
influenced.
A minor percentage of companies (only 2,99%) assign the process of ABC
system implementation to an external organization. As well, only 1,85% of
the companies uses special software for the implementation of ABC


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system. Finally, 14,77% of the companies collects ABC system with their
information systems.





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BIBLIOGRAPHY

Venieris Georgios Sandra !"en : #ctivity Based Costing (ABC). :Logistis #pril-
$%y 1999 p. 480-5.
A survey of 70 manufacturing companies in the USA, in a range of industries, for the
identification of the allocation of the overhead costs, Emore & Ness, Chartered
Institute of Management Accountants, 1991.
Cooper R., Kaplan R.S., Measure Costs Right: Make the Right Decisions, Harvard
Business Review, September-October 1988.
Garrison R.H.,Noreen E.W., Managerial Accounting, McGraw-Hill, 8
th
edition,
1997.
The ABC experience in the UKs top 1000 companies, Chartered Institute of
Management Accountants, p. 4-7, 1994.
Kaplan R.S., One Cost System isnt enough, Harvard Business Review, January-
February 1988.
How much does quality cost?, Papoutsis G.., Hellenews, Newspaper !erdos, $ay
1995.
Activity Based Costing in Service Industries, Rotch W., Journal of Cost
Management, 1990.
R.S. Kaplan-R. Cooper, Cost & Effect, Harvard Business School Press, 1998