Activity based costing in services industry: a conceptual framework for entrepreneurs.

Author:Onat, Osman Kursat
 
FREE EXCERPT

INTRODUCTION

In highly competitive environments, businesses struggle under cost pressure and profit margin squeezes. As a result of intense competition, businesses must effectively manage costs and competitively price their products and services. Therefore, cost measurement and cost management methods are becoming more important aspects of pricing and overall marketing decisions.

Doing business can be defined as the art of getting most profit with scarce resources available. Companies may move in two possible directions: profit or cost. In international business, all prices are determined globally, and local or global competitors cannot set prices freely. Therefore, profit is limited because of pricing constraints. As a result, many businesses often prefer to focus on managing their costs more efficiently.

Cost management is the process of managing all resources efficiently. It is a more complex and complete activity than costing products and services alone. Cost management not only involves determining costs, but also requires making decisions about the whole process, cost allocation, pricing, and resource management. An important issue in cost management is selecting the right costing tool for the industry, company, and product or service. Cost management methods can be classified as either traditional, focusing on volume and labor, or contemporary, focusing on efficient and suitable cost drivers.

Traditional costing methods often fail to adequately deal with overhead costs. Most of these methods directly allocate overhead costs, often based on volume or direct labor, and do not relate them with activities. This approach leads to incorrect allocations and disrupted costs (Baines, 1992). Traditional cost methods also fail by emphasizing high volume activities; consequently, highly important but less volume-generating activities incur fewer costs.

In contrast, contemporary costing methods focus more on value and value-adding activities than on batch sizes and product units. Contemporary methods appear to be in line with value that goes beyond price, whereas service options and delivery times become more important in service industries. In such situations, activity based approaches seem to be more useful than unit based methods. Just-in-time (JIT), activity based costing (ABC), theory of constraints, and target costing are contemporary costing methods that have gained recognition during the last several decades. These contemporary costing methods differ from traditional ones by emphasizing function and value, reducing miscalculations by better classifying activities, and reducing bottlenecks in production stages. ABC deserves special attention as it is based on classification and allocation of costs via cost drivers.

In this paper, two emerging concepts of business--services marketing and activity based costing--and how they can be integrated are discussed to help entrepreneurial businesses in service industries. This paper's main goal is to develop a conceptual framework that is highly applicable to those businesses' entrepreneurial marketing activities. The main elements of ABC and services marketing are also described, and the conceptual framework is explained.

ACTIVITY BASED COSTING

DEFINITION OF ACTIVITY BASED COSTING

Johnson and Kaplan (1987) first attracted attention to the need for contemporary, activity focused cost management techniques with their paper entitled "Relevance Lost." They stated that traditional costing methods cause miscalculations in product pricing by giving more importance to production volume than to activities. To fill such gaps and prevent incorrect costing and pricing, Johnson and Kaplan developed and introduced an activity based costing method.

Costing is one of the most important concepts in business activities. True and efficient costing provides an essential base for true pricing and improved profit margins. Incorrect costing practices may cause businesses to invest in the wrong product portfolio and the overall business strategy to fail.

The activity based costing method differs from traditional costing methods, which measure costs through cost drivers and costing not only products, but also activities (Baines, 1992). Activity based costing (ABC) focuses on the idea that activities create costs, while products use activities to gain value added. ABC first identifies the major activities creating overhead costs, then groups activities having the same cost drivers into cost pools, and finally assigns total overhead costs to each product or service by calculating each cost pool's absorption rate (Ahmed et al., 2011, p. 994).

CORE CONCEPTS OF ACTIVITY BASED COSTING

Compton (1996) described ABC's eight key elements, which are listed in Table 1. Some of the key elements, such as resources, are fundamental. Others are specific to activity based costing, such as the first four that are ingredients of the last four concepts. In determining a service's indirect costs, each activity is examined in terms of the resources that activity involves so that indirect costs are based on the quantities and types of activities required to perform a service or produce a good. Furthermore, ABC involves allocating costs via cost drivers. Although cost drivers are similar to traditional costing, being designated to specific activities make them specific to ABC.

Key elements of ABC can be counted as elements about resources, about costs, and about activities that produce goods and services. Resources represent assets used to perform production activities. Determining and classifying activities are the most discriminating sides of ABC. Activity is the start and end point of the costing process. Product/service costs should be noted according to the number of activities performed and resources used for them. Cost pool is also a new ABC concept that summarizes all the activities-related costs. Cost drivers are metrics used in allocating costs to cost objects. Cost object is also a general concept including both products and/or services.

COSTING PROCESS IN ABC

The activity based costing process (Figure 1) involves three phases. The first phase involves determining activities, including classifying and entitling those involved in producing a good or service (Oker, 2003).

The second phase of activity based costing is determining cost drivers, which are metrics used for allocating costs to goods or services. Cost drivers are based on the activities and product/services relationship and should be designed to most suitably allocate cost according to the structure of activities. Cost drivers must be determined by both how activities use/consume resources and whether performing a specific activity is essential (Oker, 2003).

The third phase in the activity based costing process is cost allocation, which is based on the rate of products/services to consume activities. The level of resources is determined via cost drivers (Oker, 2003).

In traditional costing methods (especially in full costing), one of the most important factors is allocating overhead costs. Misallocations may cause relatively incorrect costing and pricing. The fundamental assumption of ABC is that cost objects (goods or services) are results of activities that consume resources therefore; activities direct the cost management process. On the other hand, batch production is a volume-based production methodology in which unit sizes and volumes are more important. Batch-focused costing methods fail in allocating overhead costs because producing more units considered loading more overhead.

In the ABC process, units going through more activities get more overhead costs. Consequently, miscalculations are avoided. Another important factor of ABC is allocating costs via activity drivers that provide the most suitable cost allocation to product/service characteristics because drivers dissimilar to production characteristics may cause miscalculations. For example, direct labor hours are used to allocate most of overhead costs in the traditional costing method, but it may cause incorrect costing because of using the same metric for every type of calculation. Those issues are solved in ABC by determining activity drivers similar to characteristics of activities.

PROS AND CONS OF ABC

Every costing method may naturally have some advantages and disadvantages. Therefore, none of the costing methods can be considered excellent for all types of business needs. Those methods having more advantages than disadvantages and being more convenient for most industries are widely accepted and often used among businesses. Activity based costing (ABC) may be an advantageous cost management method, especially for entrepreneurs in services industries. According to the literature, businesses give up traditional costing methods for the following reasons: not providing non-financial information, generating inaccurate cost...

To continue reading

FREE SIGN UP