Evaluation of the abc model

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EVALUATION OF the activity based costing model

STUDENT NAME: MAHZI Mohsine
STUDENT NUMBER: 101343
COURSE NAME: Management accounting and control
DEPARTMENT: MSc CF

SUPERVISOR: PILKINGTON Mark

DATE OF SUBMISSION: 16/12/2010
CONTENTS

INTRODUCTION 2
WHY DO WE NEED ABC: A RESPONSE TO THE CHANGING ENVIRONEMENT (cost distortion problem) 2
WHEN DO COMPANIES IMPLEMENT ABC 2WEAKNESSESES OF THE ABC COSTING 3
A complex model with a debatable relevance 3
Important measurement errors 4
A long set up 4
Updating difficulties 4
Misleading in the decision making process 5
Subjectivity 5
Ignorance of internal constraints 5
Wrong assumption of linearity between activities and resource consumption 5
SOLUTION PROPOSED BY KAPLAN AND ANDERSON (2005): TIMEDRIVEN ABC 5
CONCLUSION 6
References 7
INTRODUCTION

Activity based costing (ABC) is a model that identifies the activities of an organization and assigns the costs of each activity to products and services within this organization. ABC is particularly concerned about assigning overheads or indirect costs.
. It is claimed that “Activity Based Costing (ABC) is the perfect cure for theproblem of assigning overheads to products and services within organisations”. This paper will critically evaluate this statement by answering the following questions:

1- Why is ABC costing needed? What factors led to the development of this costing model?
2- When do companies decide to use ABC?
3- What are the weaknesses and the limitations of the model?
4- What are the solutions tocope with those lmitations?

WHY DO WE NEED ABC: A RESPONSE TO THE CHANGING ENVIRONEMENT (cost distortion problem)

The manufacturing environment on which the development of traditional costing methods was based changed. As a matter of fact, companies moved from an environment characterized by “high volume production, long production runs and life cycles, small number of product variation ina domestic market, high direct costs and low indirect costs and high costs of information processing” to a completely opposite environment (John et al., 1996, p6). The new environment is characterized by low production runs, volumes and product life cycle, high product variations within a global market, low information processing costs, low direct costs and large overhead costs relative to directcosts (John et al., 1996).
Due to this change of the operating environment, traditional costing methods became irrelevant. As a matter of fact, they were developed based on the fact that direct costs, especially labour, account for a high percentage of total costs. However, the increase of the flexibility of the companies and their efficiency thanks to technology developments within the newenvironment, has decreased, on one hand, the labour costs since companies rely more on machines than human capital in manufacturing. On the other hand, it has increased overhead costs. This has led to a problem of assigning overheads to products and services within organizations. In fact, according to Frances and Liggett et al. (1993, 1992), the allocation of overhead costs to products and serviceson the basis of direct labour hours used by those products or services leads to product cost distortion.
The solution of the product cost distortion problem discussed above is ABC developed by
some American researchers (Cooper, Kaplan, Porter, Miller) and French (Mevellec, labas, Lorino). ABC provides enough information in order to determine the overheads elements with accuracy. It is based onfacts and assigns overheads to products and services within organizations with an acceptable relevance to decision making. John et al. (1996) added that the relevance of ABC is even higher in manufacturing companies than service companies. Traditional costing methods are more arbitrary (Frances, 1993).

WHEN DO COMPANIES IMPLEMENT ABC

ABC is expensive, and as any other course of action,...
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