The Legacy

Running head:

THE LEGACY OF ACTIVITY BASED COSTING

The Legacy of Activity Based Costing:

Addressing the Need for a Hybrid Methodology
for Costs Allocation
Tim Lowder
March 2006

Electronic copy of this paper is available at: http://ssrn.com/abstract=920957

The Legacy
Abstract
This paper introduces the historical development of concepts and
techniques in managerial accounting that have shifted management
paradigms toward alternative methods of costs allocation.

In

addition, the paper evaluates past, current, and future trends

in managerial accounting techniques and their influence on
companies throughout the United States.

The objective of this

analysis is to provide activity based cost accounting users with

a better, more focused perspective on how to transition their
current accounting systems into the future based upon these
paradigm shifts.

Activity Based Costing (ABC) has demonstrated

positive results for the companies that made it through the

implementation process.

As will be demonstrated, newly

developed paradigms in cost accounting methodologies are adding

to the complexity as to which system provides the best
information for decision-making purposes.

Within the context of

these new cost accounting paradigm shifts, a critical issue is

arising for current users of ABC.

The issue addressed in this

paper is the need for a hybrid methodology of costs allocation

that provides better information for all strategic planning time
horizons.

Electronic copy of this paper is available at: http://ssrn.com/abstract=920957

Lowder Page 3

The Legacy of Activity Based Costing:

Addressing the Need for a Hybrid Methodology
for Costs Allocation
Activity Based Costing (ABC) has become an increasingly
important tool for a large majority of organizations throughout
the United States during the past two decades.

This paper

introduces the historical development of concepts and techniques

in managerial accounting that have shifted management paradigms
toward alternative methods of costs allocation.

In addition,

the paper evaluates past, current, and future trends in

managerial accounting techniques and their influence on
companies throughout the United States.

The objective of this

analysis is to provide activity based cost accounting users with

a better and more focused perspective on how to transition their
current accounting systems into the future based upon these
paradigm shifts.
The primary alternative cost accounting method introduced into
US markets, called flexible margin costing (GPK), and has the

Electronic copy of this paper is available at: http://ssrn.com/abstract=920957

Lowder Page 4
potential to diminish ABCs impetus to managerial accountants.
Companies in Europe have used flexible margin costing methods
for decades and they are now beginning to become prevalent in
the United States.

Currently ABC and other watered down

versions are the primary systems used in the US.

The broader

issue concerning ABCs status quo in US companies entails the

costs of the long-term learning curve for the companies that
choose to undergo the implementation process.

ABC has

demonstrated positive results for the companies that made it

through the implementation process new paradigms in cost
accounting are surfacing.

As will be demonstrated, newly

developed paradigms in cost accounting methodologies are adding

to the complexity as to which system provides the best
information for decision-making purposes.

Within the context of

these new cost accounting paradigm shifts, a critical issue is

arising for current users of ABC.

The issue addressed in this

paper is the need for a hybrid methodology of costs allocation

that provides better information for all strategic planning time
horizons.
The Industrial Revolution
The major event that has affected every aspect of our
business environment and daily lives from the expansion of the
global economy to the price we pay for a loaf of bread is the
industrial revolution.

The development of accounting systems in

Lowder Page 5
the United States has been a slow process beginning in the mid
1800s throughout the early 1900s by companies that included
Northern Central Railroad in 1863 and United States Steel
Corporation in 1902 (Stice, 2003).

However, it was not until

after the Stock Market Crash of 1929 that a formalized system

began to take shape.

After the crash, Congress formed the

Securities and Exchange Commission (1934) and the Committee on

Accounting Procedures (1939).

It was at this time that a new

set of accounting standards called the Generally Accepted

Accounting Principles (GAAP) was established.

Still today in

the United States, GAAP guides accountants in every aspect of

financial accounting.
Along with the radical technological changes that occurred
in the United States industrial sector came the advent of
scientific management.

Scientific management instilled upon

managers the necessity to monitor and control costs at all

levels throughout the organization.

This need to monitor and

control all costs led to the development of a field of study

differentiated from financial accounting called managerial
accounting.

Developments within the field of managerial

accounting have resulted in three primary cost accounting

systems used throughout the world today that include absorption
costing, ABC, and GPK.

We will examine the historical

development of these managerial accounting methodologies and

Lowder Page 6
reach conclusions concerning their current impacts on US
companies.

In particular, we will evaluate the present state of

ABC and its future implications.

Absorption Costing.

The most commonly used cost allocation

method in the United States, both historically and presently, is

the absorption costing method which is also known as the
traditional method or the full cost method.

The reason that

absorption costing is called the full cost method is because it

assigns all manufacturing cost to product cost (Garrison, 2006).
Absorption Costing's primary use is reporting information to
external stakeholders, primarily shareholders.

Absorption

costing proved to be a valuable tool for managers during the

Industrial Revolution.

However, cost structures within

organizations began to change dramatically during the 1970s and

80s.

Overhead cost and indirect manufacturing cost were

increasing at a greater rate than direct labor costs because of

the increasing cost of capital and technology within the
manufacturing environment (Cokins, 2002).

Until then, managers

and decision makers believed that a direct correlation exists

between direct labor hours and manufacturing overhead costs.
However, the nature of costs were changing and direct labor
costs and manufacturing overhead costs were becoming more and
more negatively correlated over time (Garrison, 2006).
Consequently, during the early 1980s two articles written and

Lowder Page 7
published in the Harvard Business Review by Jeffrey G. Miller,
Thomas E. Vollman, Robin Cooper, and Robert S. Kaplan that
addressed this issue and presented a new methodology for costs
allocation (Friedl, 2005; Geri, 2005).

These well-respected

accounting professionals addressed the need for a radical change

from the traditional costing methods in order to assign
manufacturing overhead costs to product costs.

These two

articles represented the humble beginnings of ABC methodology.

Activity Based Costing.

ABC provided management with a

valuable new tool to assist in determining and allocating

product costs more realistically.

It provided the means by

which to isolate and account for costs in relation to the

activities associated with those costs.

It is very critical we

understand that ABC is not a quality improvement program like

six-sigma, process reengineering, or statistical process
control.

This distinction is important so that we do not

classify ABC as a fad or fashion (Cokins, 2002).

Understand

that ABC is a methodology that encompasses the existing ledger

accounts and in addition provides a means for feedback and
decision-making support.

However, ABC does not replace the

company's existing accounting system because of GAAP

Requirements.
Under ABC, product costs are not strictly isolated to
manufacturing costs and are expanded to include non-

Lowder Page 8
manufacturing costs such as selling, marketing, distribution,
and administrative that can be directly traced to the product
through activities (Garrison, 2006).

ABC charges products for

the cost of capacity they actually use and not for idle capacity
like the absorption method.

In addition, ABC does not allow

costs shifting of batch-level or unit-level costs from products

produced in smaller volumes to products produced in larger
volumes.

These distinctions represented a tremendous

improvement over the lump-sum allocation method used under the

absorption costing methodology where there exists a strict
application of manufacturing costs to product costs.

However,

the true worth of ABC from a managerial perspective is its

ability to assign activity costs to cost objects.

This enabling

characteristic allows management accountants to reassign

activity costs across business processes and identify
relationships more accurately in decision-making processes.
Identifying and allocating costs based upon an activity rate
assist in making many types of decisions spanning across
functional areas that involve not only products, but also
distribution and customer related decisions (Cokins, 2002;
Compton, 1996; Friedl, 2005; Gabram, 1997; Hoshower, 1996).
Another important contribution of ABC is the use of
specific naming of activity cost pools and activity rates.
Under ABC, these activities and rates more precisely link to the

Lowder Page 9
actual work or job currently performed.

ABC terminology is very

work-centric verses absorption costing which is very

transaction-centric (Cokins, 2002).

As an example, an

assignment occurs between an activity cost pool called customer

orders to the activity measure called the number of customer
orders.

As can be determined, this terminology is function and

action driven which provides for a more accurate accounting of

each cost and its relationship to specific activities throughout
the organization.

Because of this work-centric naming

convention, ABC provides better tools for decision-making.

The

main positive characteristic of ABC is its effective influences

on decision-making, which has resulted in a decision making
process called activity-based management (ABM).
Flexible Margin Costing.

Prior to the development of ABC

in the United States, companies in Europe, particularly Germanspeaking countries including Germany, Austria, and Switzerland,
had already developed a specialized accounting methodology
called Grenzplankostenrechnung (GPK)(Friedl, 2005).

This name

loosely translated from German means flexible margin costing.

GPK also focuses on marginal costing like ABC and is more
concerned with short-term decision-making.

Management

accounting has been important in German-speaking countries for

many years prior to its interest in the US and as a result, GPK
has been time-tested in Europe (Friedl, 2005).

At this point,

Lowder Page 10
we must make an important distinction between accounting
methodologies in the US and overseas.

As mentioned earlier,

data provided by accounting systems in German-speaking countries

focus on the financial information required by creditors.
Conversely, data provided by accounting systems in the United
States primarily focuses on information that is required by
shareholders.

This distinction is very important because it has

a direct impact on the type of financial information provided to

management for decision-making purposes.
Throughout the 1950s and 1960s, Plaut and Kilger developed
and refined GPK with a focus was on developing a cost accounting
methodology that produces information specifically for decisionmaking purposes.

In addition, Plaut and Kilger developed their

new accounting methodology using two distinct cost centers

called primary and final cost centers.

Primary cost centers are

used for the allocation of costs that are not directly related
to the manufacturing process.

On the other hand, final cost

centers are for the allocation of costs directly related to the

manufacturing process.

In the end however, an allocation occurs

only for the primary cost centers variable costs into the final
cost centers.

This allocation occurs because the variable costs

and the manufactured products are closely connected.

This

consistent and methodical allocation of costs provides a more

accurate calculation of product cost (Friedl, 2005).

After the

Lowder Page 11
allocation of variable costs from the primary to the final cost
centers, only fixed costs remain in the primary costs centers.
In the final stage of the allocation process, a combination of
manufacturing costs occurs which includes variable costs from
the final cost centers, direct materials costs, and direct labor
costs.

Management allocated these combined manufacturing costs

to the cost objects in the flexible margin costing system.

This

variable costing methodology is the key to why GPK is an

effective system for short-term to medium-term decision making.
The flexibility of GPK is that when the need arises for longterm decision-making, management has the capability to add fixed
costs back to total costs in a parallel calculation.

Hence,

calculation of fixed costs takes place separately from that of

variable cost.

Typically, an allocation of fixed costs occurs

based on a percentage of variable costs.

A final important aspect of GPK is the calculation that
results from subtracting the variable product cost from the
product revenues and results in the contribution margin.

Using

a contribution margin approach provides an excellent tool for

short-term decision making by using cost-volume-profit (CVP)
relationships.

CVP relationships provide many analytical tools

that can be used by management including breakeven analysis,

target profit calculations, sales mix calculations, costs
structure evaluation, profit stability analysis, and operating

Lowder Page 12
leverage analysis.

In addition, by recalculating fixed costs

and adding them into the final costs centers, management may
also use GPK for long-term decision-making.

In summary, GPK is

a very effective and very flexible cost accounting system that

offers many positive benefits for companies that need accurate
and timely information for decision-making purposes.
GPK Verses ABC.

GPK uses a flexible margin costing

approach that allocates only variable cost to products during

the primary allocation process.

This means that GPK is an

excellent tool for short-term decision-making.

The short-term

decision-making capability under GPK uses the contribution

margin approach, provided by GPKs calculations.

In addition,

management often expands and uses GPK for long-term decision

making through the reallocation of fixed costs.

This

reallocation of fixed costs is relatively simple under GPK

because of its use of primary and secondary costs centers.
Conversely, ABC allocates costs based upon activities and
processes and its focus is upon analyzing long-run product
decisions.

The underlying formal structures of ABCs costs

drivers and GPKs costs pools are similar in nature.

However,

the differences in GPK and ABC is not about the structure of the
systems but is related to the costs drivers and how fixed costs
are allocated.

Because ABC uses non-output related costs

drivers and applies fixed costs to product cost during the

Lowder Page 13
allocation process, it is difficult to convert ABC information
into a format for making short-term decisions because an
allocation of fixed costs has already occurred.
Both accounting systems focus on costs and profitability
control with variance analysis.

However, an important

difference arises because of ABC's systematic focus on processes

which results in better tracking of activities throughout the
production process.

The distinction between the two approaches

is that ABC focuses on a horizontal, process orientation as

compared to GPK, which focuses on a vertical, functional
orientation.

This primary difference in systematic orientation

of costs allocation provides ABC with an advantage over GPK

because it supports continuous accountability across
interdependent functions and activities in the production
process (Friedl, 2005).

ABCs horizontal, process orientation

allocates fixed manufacturing overhead costs early and makes it

more appropriate for long-term decision-making.

GPKs vertical,

functional orientation allocates fixed manufacturing cost during

later stages and makes its methodology superior for short-term
decision-making.
Shifting Managerial Paradigms
Thus far, we have evaluated the three primary accounting
methodologies including absorption costing, activity based
costing, and flexible margin costing currently used throughout

Lowder Page 14
the United States.

In addition, we have discussed the

background and development of these systems in relation to the

field of managerial accounting.

The research has also

demonstrated several paradigm shifts in the way management uses

accounting information in the decision-making process due to the
industrial revolution and the development of scientific
management techniques.

These paradigm shifts have resulted in

new accounting system methodologies that provide various types

of information to different organizational stakeholders who have
different needs and demands.

The greatest paradigm shift in

accounting systems has resulted in the development of ABC and

GPK.

Currently, companies in the United States are at a

crossroad concerning which methodologies to adopt as they

proceed into future.

Because of this continuing paradigm shift,

we will address specific issues facing management today in order

to determine the future of ABC.

Lowder Page 15
Strategic Implications.

There are several important

strategic implications to be addressed concerning existing cost

accounting methodologies.

Each of these considerations will

play a role concerning the outcome of ABC's future in US

companies.

Throughout the history of accounting methodologies,

paradigms shifts have rebounded back-and-forth between marginal

decision-making and full absorbance costing.

Traditional or

absorbance costing will remain important to US companies because

of its requirement by the Generally Accepted Accounting
Principles (GAAP) by the Financial Accounting Standards Board.
On the other hand, GPK and ABC still face the test of time and
survival.

We will now evaluate various strategic implications

in the role they play on the future of managerial accounting.

Lowder Page 16
Planning Horizons.

ABC focuses on medium to long-term

decision making in comparison to GPK's focus on short-term to

medium-term decision making.

It is evident that both accounting

methodologies provide relevant information for managers who are

making product decisions.

The problematic issue arises when

trying to attain data used to make both short-term and long-term

decisions.

The bottom line is that GPK is a better accounting

system than ABC for making short-term decisions while ABC is a

better accounting system than GPK for making long-term
decisions.

The obvious answer to this dilemma is to combine the

two methodologies.

However, the dilemma faced by decision

makers is that this solution can be very costly.

Global Competition.

An extremely important issues facing

companies in the United States is global competition.

US

companies must compete with organizations throughout the world

that have lower labor cost and manufacturing overhead cost.
Hence, the margins are much tighter and consequently the bottom
line profit is much slimmer than it has ever been.

Companies

can no longer afford to make mistakes in decision that impact

product mix, price quotes, capital investment, technology,
outsourcing, and make or buy decisions because of bad numbers
from their accounting system (Cokins, 2002).

As a result,

decision makers must fine-tune their accounting processes and

make every effort to understand the cause-and-effect

Lowder Page 17
relationships within their companies (Cokins, 2002).

As was

discussed earlier, ABC and GPK allocate fixed cost differently.

Because of this difference in the allocation of fixed costs, ABC
is more suitable for medium to long-range planning and GPK is
more suitable for short to medium-range planning.

In order for

US companies to compete with organizations in countries with

lower labor costs and manufacturing overhead costs it is
essential that cost accounting systems have greater flexibility
in allocating and dealing with both variable and fixed costs.
In addition, it is essential that US companies are able to
attain accurate data from their cost accounting systems for both
short-range and long-range time horizons.
Throughput Evaluation.

Another issue managers must address

concerning their accounting systems is how the methodology

measures production throughput.

Both ABC & GPK provide

management with very detailed revenue and costs data that for
performance measurement and evaluation.

However, neither system

is effective at locating bottlenecks or constraints during the

production process that can slow down throughput (Geri, 2005).
Hence, both systems have an inherent limitation that can result
in systemic problems in making decision related to throughput.
ABC in particular does not consider internal capacity
constraints because of its treatment of activities and resource
consumption as linear, absolute, and certain (Geri, 2005).

This

Lowder Page 18
fact reinforces the earlier premise that ABC is not a good tool
for short-term decision-making.
Future Changes.

Thus far, we discussed the advantages and

disadvantages of both ABC and GPK in relationship to one

another.

In addition, we have also addressed the many paradigm

shifts that have occurred in the field of management from a

historical perspective.

It is important at this time to

consider the future of ABC and the role GPK will play in the
future.

The one certain factor in business is change.

In order

to effectively deal with this change, management decision makers

must have an accurate, relevant, flexible, and comprehensive
cost accounting system to aid them in their decision-making
processes.

Lowder Page 19
Conclusion and Recommendations
A Legacy to Build Upon.

The original issue addressed in

this paper was addressing the need for a hybrid methodology for
costs allocation".
to address.

In a perfect world, this issue would be easy

However, change is inevitable and paradigm shifts

continually occur within the field of management accounting.

Management must understand that ABC is a useful tool that has
added tremendous value to the many organizations that
successfully implemented its processes into their operations.
Therefore, Management cannot overlook or forget ABCs positive
legacy in the United States.
First, management accountants must focus on taking
advantage of the positive aspects of both ABC and GPK.

It is

essential that practitioners integrate the best components of

both methodologies into one accounting system to take advantage
of each systems strength and overcome each systems weakness.
This integrated methodology will provide accurate decisionmaking information that is appropriate for short, medium, and
long-term strategic planning.

The primary management concern in

developing a hybrid model is the extensive costs of development

and implementation.

However, there are many existing economic

resource planning (ERP) systems on the market today that will

make this task easier and less costly(Friedl, 2005).

The

resource requirements and commitments needed to implement this

Lowder Page 20
integrated accounting system are becoming more manageable as
technological capabilities increase and technology costs
decrease.
Second, decision makers must acknowledge and understand
that current ABC and GPK models are not total quality management
(TQM) programs.

As a result, neither accounting system focuses

on the maximization of throughput and/or throughput quality

control within the organizations production processes.
Consequently, the new integrated accounting methodology must
integrate the framework of an existing TQM program in order to
better address throughput and quality issues and ensure that the
system provides both appropriate financial information and
statistical process control information to aid in short, medium,
and long-term decision making.

As was stated earlier, many

existing ERP systems on the market today already contain

integrated TQM Modules.
Third, the hybrid accounting system must incorporate the
basic modeling of the ABC system where both variable and fixed
costs are allocated pre-designated costs pools.

However, the

current ABC methodology lacks sufficient ability to deal with

fixed costs because of early allocated early in the allocation
process.

This fact makes reallocation very difficult, if not

impossible, under most ABC systems.

However, management can

eliminate the fixed cost allocation issue by adapting a first

Lowder Page 21
stage and second stage allocation process used in the GPK
methodology.

In the hybrid model, variable costs are allocated

in the first stage allocation to the various costs pools and

fixed cost are then allocated in the final or second stage of
the costs allocation process.

This dual-stage allocation

process provides ABC users with the advantage afforded by a GPK

accounting system and provides information that can be adapted
and used for short, medium, and long-term strategic planning
purposes.
In conclusion, we can build upon the legacy of ABC
established in the United States.

The key to this legacy is

developing a hybrid, integrated accounting system using both

ABCs and GPKs time-tested methodologies.

The concept of an

integrated accounting methodology using both ABC and GPK

concepts will provide accounting information for decision makers
that covers the complete strategic planning time horizon.
Lastly, this hybrid, integrated system will provide the impetus
needed by US Companies to compete globally in an effective and
efficient manner.

Lowder Page 22
References
Cokins, G. (2002). Activity Based Costing: Optional or Required?
AACE International Transactions, 03.01.
Compton, T. R. (1996). Implementing activity-based costing. CPA
Journal, 66(3), 20.
Friedl, G., Kpper, and H-U., Pedell, B. (2005). Relevance
Added: Combining ABC with German Cost Accounting. Strategic
Finance, 86(12), 56-61.
Gabram, S. G. A., and Mendola, R. A. (1997). Why activity-based
costing works. Physician Executive, 23(6), 31.
Garrison, R. H., Noreen, E. W., and Brewer, P. C. (2006).
Managerial Accounting, Eleventh Edition (Eleventh ed.). New
York: McGraw-Hill Irwin.
Geri, N., and Ronen, B. (2005). Relevance lost: the rise and
fall of activity-based costing. Human Systems Management,
24(2), 133-144.
Hoshower, L. B., and Compton, T. R. (1996). As simple as ABC.
Ohio CPA Journal, 55(4), 50.
Stice, E. K., Stice, J. D., and Skousen, K. F. (2003).
Intermediate Accounting, 15e (15 ed.). Mason, OH: Thomson
South-Western.