Group Assignment: BKBM 5013

Management Accounting for Managers

CASE STUDY 4
IS ABC SUITABLE FOR YOUR COMPANY?

Prepared by:
Chong Hui Wen
Nyanapriyaa a/p Mageswaran
Leow Sha Ly

819907
818934
819982

Prepared for:
Dr. Faudziah Hanim Fadzil

In Partial Requirement of:

Management Accounting for Managers
[BKBM 5013]

No.
4.1.1

Topics
Discussion

Page
2-7
0

4.1.2

Results

4.1.2

References

Case Study 4

Is ABC Suitable for Your Company

4.1 Using Estrin, Kantor and Albers contingency grid, if an organizations score puts
it in Quadrant III, is ABC implementation recommended? Explain. Is their method
fool proof?
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4.1.1 Discussion
Nowadays, we know that activity based costing system assigns overhead costs to products or
services products that use a two-stage process, which focuses on activities. ABC is a
relatively new and a very important topic in managerial accounting. ABC allows us to find a
way that we could determine the profitability of every product, profitability of every
customer we serve, and the profitability of our process. Contents in brief, first are comparing
potential advantages of ABC versus traditional costing methods. The second is on how does
management use ABC information in decisions, which consists of weighting and combining
the weights of the ten factors and to evaluate implementation of ABC. ABC analysis is based
along two separate dimensions, and there are ten mediating factors that can guide
management in determining the answers. The first five factors are based on the probability,
the second dimension of the model seeks to establish decisions. Finally an impartial analysis
of ABC operations can determine it is appropriate or not by using contingency analysis
model. Interpreting the results:
Quadrant 1(both X and Y is positive) : it is recommended to use ABC.
Quadrant 2 (X-positive, Y-negative)

: ABC is not recommended.

Quadrant 3 (both X and Y is negative) : ABC is not recommended.

Quadrant 4 (X-negative, Y-positive)

: It is possible to implement ABC in long-term.

The ten factors discussed above are based on the condition that ABC method is better than the
traditional method. So, the management should consider the reality on deciding to use the
ABC.

Many companies are switching to activity-based costing (ABC). ABC is just a new way of
allocating overhead costs. ABC is not the process of making of products that directly affects
costs but is the activities that directly affect costs. As activities are created or changed, costs
are created or changed. So, Activity-based costing systems focus on activities rather than
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products, which help to prevent the distorted product costs that can arise from the use of
traditional cost systems based on volume. As we are aware, ABC is a relatively new and very
important topic in managerial accounting. It allows us to find a way to determine the
profitability of every product, profitability of every customer we serve, and the profitability
of our process. ABC information have results is more accurate and more useful for decisionmaking. Managers can see the strategic importance of having highly accurate product cost
information.

Potential Advantages of ABC versus traditional costing methods.

Traditional costing methods often lack the degree of precision:
It is not pure and doesnt objectivity allocate overhead to the cost objects.
Overhead is allocated to the products based on volume-based measure. (E.g.: labour
hours, machine hrs.)
There is the relation between overhead and the volume-based measure.

Advantages of ABC method:

More accurate cost management methodology

Focuses on indirect costs (overhead)
Trace rather than allocate each expense category to particular cost object
Makes indirect expenses direct
Traditional costing methods do not reveal what is the true cost of their product and

service
To determine the true cost for a cost object (product, job, service, or customer), the true
cost of product is very prominent because it can identify money-makers and money
losers and to finding an economic break-even point.
In order to discover opportunities for cost improvement, business top management need to
prepare actualize business plan and improve strategic decision-making. How does
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management use ABC information in decisions? This methodology is based on a company's

analysis of itself. It consists of weighing and combining the weights of the ten factors and to
evaluate the implementation of ABC. The potential benefits of ABC can be analysed in
advance along two separate dimensions. And there are ten mediating factors (Pricing
Diversity, Support Diversity, Common Processes, Cost Allocation, Growth of Indirect
Costs, Pricing Freedom, Fixed Expense Ratio, Strategic Considerations, Cost Reduction
Effort, and Analysis Frequency) which can guide management in determining the answers.
The first five factors (PD, SD, CP, CA, and FG) are based on the probability.
The second dimension of the model seeks to establish decisions. Y axis is the potential for
ABC due to cost distortion---PD.SD.CP.CA.FG. X axis proclivity uses cost information in
decision---PF.FE.SC.CR.AF.

To start, management must analyse and respond to two key questions:

For a given organization, is it likely that ABC will produce costs that are significantly
different from those that are generated with conventional accounting, and does it seem
likely that those costs will be "better"?
If information that is considered "better" is generated by the system, will the new
information change the dependent decisions made by the management?
After finish these questions managers of company can discuss the ten factors that
support or reject implementation. Finally, the combined weighted scores are plotted as
a point on one of the four quadrants of a graph using Contingency Grid Method.
The steps in the contingency approach in implementing ABC: ABC
approaches to cost allocation are: score range between -5 to +5
Contingency Grid: Quadrant 1(both X and Y is positive): It is recommended to
use ABC Quadrant 2 (X-positive, Y-negative): Management is free to utilize

product cost information but there is no direct benefit in implementing ABC

thus ABC is not recommended.

Quadrant 3 (both X and Y are negative): Management has limited ability to

utilize or react to modified costs, No direct benefit in implementing ABC, thus
ABC is not recommended.

Quadrant 4 (X-negative, Y-positive): Management has little ability to modify

cost. Implementing ABC has potential benefit, Management should reexamine its use of product cost information and its freedom to react to
changes. It is possible to implement ABC in long-term.
When we are using Estrin, Kantor and Albers' contingency grid, if an organization's score is
put it in Quadrant three: ABC implementation is not recommended.

Reasons of why Y value is negative

Lack of product variety

Indirect costs are less assigned
Different products have less common process;
Assigned overhead to period cost allocation
Rate of growth of period costs is lower

Reasons of why X value is negative

Less control of pricing freedom

Fixed expense ratio is lower
Lack of strategic considerations
Short of ability of cost reduction
Analysis infrequency

While the scoring system is subjective, it is grounded on factors cited in ABC as being
causal in determining the superiority of ABC over traditional costing. ABC method
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presents a structure for managers to use in their decisions to arrive at some consensus
with regard to the degree to which the factors are present in their company and ultimately
to convince themselves as desirable for implementation of ABC. Although ABC method
is not powerfully fool proof method, it should help managers by matching the
characteristics of their company, its products, and the costing system used with the factors
that make ABC most effective. In a summation, ABC is a more accurate cost management
system over traditional cost accounting. Traditional cost accounting is unable to calculate
the true cost of a product.

4.1.2 Result
+5

Quadrant I

Quadrant IV

-5

+5

Quadrant II

Quadrant III

-5
X Axis, Proclivity to use Cost
information in Business Decisions
PF Pricing Freedom
FE Fixed Expenses Ratio
SC Strategic Considerations
CR Cost Reduction Effort
AF Analysis Frequency

Y Axis, Basic potential for ABC

based on Cost Distortions
PD Price Diversity
SD Support Diversity
CP Common Processes
CA Cost Allocation
FG Growth of Indirect Costs

Results plotted in this quadrant clearly indicate that ABC is not recommended. It is unlikely
that material product cost distortions are present, and management has limited ability to
utilize or react to modified costs.

4.1.3 Reference

Atwater, Brian; Gagne, Margaret L; "The theory of constraints versus contribution

margin analysis for product mix decisions ", Journal of Cost Management; Boston;

Jan/Feb 1997
Umble, M Michael; Umble, Elizabeth J; "How to apply the Theory of Constraints'
five-step process of continuous improvement ", Journal of Cost Management; Boston;

Sep/Oct 1998
Ruhl, Jack M; "The theory of constraints within a cost management framework ",

Journal of Cost Management; Boston; Nov/Dec 1997

Robin Cooper; Regine Slagmulder; "Integrating activity-based costing and the theory

of constraints" Management Accounting; New York; Feb 1999

Steve Demmy; John Talbott; "Improve internal reporting with ABC and TOC "

Management Accounting; New York; Nov 1998

Charles J Coate; Karen J Frey; "Theory of constraints: It doesn't mean good-bye to

variances " Management Accounting; London; Nov 1998

Karen M Kroll; "The theory of constraints revisited" Industry Week; Cleveland; Apr
20, 1998