Activity based costing in a small firm environment

Traditional approach to costing is an exercise divided in two parts. First part (direct costs) involves collecting for every job cost that can be clearly linked and measured in relation to each job. Second part or indirect costs(overheads) are allocated or apportioned to product cost centers and then charged to individual jobs according to the same formula as in first part. In practice this apportionment is mainly based on direct labour hours worked in that particular job. This approach to costing is from the time of industrial revolution, when although machinery was introduced which enabled large scale manufacturing, labour was at the heart of the production; cost of labour was the main cost driver. The role of machinery was to serve labour and therefore it’s use, and capacity, was labour dictated. Direct labour intensive manufacturing processes, low level of indirect costs in the total cost of production and relatively uncompetitive market made it practical and acceptable enough that overheads were dealt in an arbitrary manner; charging overhead costs on each job according to direct labour hours spent in the production of the same. Efforts to control overheads were not seen as a priority since potential rewards were small even at best scenarios. Service industry was practically inexistent or eventually self-employed professionals who were uninterested in finding out the cost of fixed assets use on top of their usual activities during a typical day’s work.

World of industrial production has undergone massive change since then. Industrial production of physical goods is characterised by large capital requirements, a high level of indirect costs, and a highly competitive market on a global scale. Incorporation of information technology (IT), in service sector specifically, has enabled growth of huge companies that although with no manufacturing plants are producers of services with huge impact in our day-to-day lives. Services sector is not a sector only for developed economies anymore. Countries like Philippines with call centers, India with IT support firms, and similar cases in South America have established a solid presence in the industry and are competing globally. These changes in the competitive environment that firms are operating in makes them much more cautious in their management of costs. Wrong estimation of costs can have serious consequences in all cases but it especially effects smaller firms. These types of firms, more precisely individuals, have become an important part of services sector as direct consequence of IT incorporation into the business model. Let us think about an internet provider firm, various application developers, virtual reality (VR) programming, recording studios, which often operate with very few full-time staff with others being recruited as and when needed and on contract basis. Even retail banking has seen a massive switch from direct labour activities and into very costly overheads of hardware and software. These are types of businesses which on the production process do not resemble in anything on those from the time of industrial revolution when the most important part was to produce as much as possible at a cost which will be known at the end of production period. With technology reaching new levels of developments in artificial intelligence (AI) and robotics cost measurement principles from the time of industrial revolution seem completely out of place.

Cost estimation and activity based costing

In the process of calculation cost of a product the sticking point is estimation of manufacturing overheads (MOH), or indirect costs. The first part of costs, direct costs, is very straightforward as both material and labour involved in the process of production are known. When production is dominated by direct labour paid, it might be reasonable to have an arbitrary overhead charged by labour hour. When, however, direct labour plays a relatively small part in production, to have an overhead charged for each direct labour hour is likely to lead to very arbitrary product costing. Even a small change in the amount of direct labour worked on a job could massively affect the total cost deduced – not because the direct worker is very highly paid, but because of the effect of the direct labour hours on the overhead cost loading.

For any firm correct estimation of costs is vital in order to avoid situations when although more products are being sold profits are not growing with the same rate. This can potentially be a make or break situation for a smaller firm even in cases when the firm has identified a niche, it has successfully passed the first stage of setting a foothold in the market and now in order to continue its growth and moving into the profit stage it needs to expand on the depth and breadth of its product portfolio. This situation is very common in the case of technology firm, application development, but it can be easily applied to any smaller start-up such as a bakery. Cost estimation is important in cases when a firm produces many products or varieties of the same product which will be marketed at different prices. As already mentioned, in the case of application development it is very common to come across an app which is free of charge for basic version, but more features user wants to access it will be priced differently. This is also the case with a wide range of internet services, one of which I always use while I am in China. However, it doesn’t end here! It is also applied in the case of a fast food outlet or in the case of a spa center.

Application and usefulness of ABC method of costing has been proven and accepted. One of the important tasks is to make it more accessible and as straightforward to use as possible for smaller firms, which as mentioned earlier could be most severely affected in the case of incorrect estimation of costs. During my experience dealing with smaller firms, it’s owners, very often I was told that the best way practice of dealing with an unknown is to ignore it. It may sound strange, but many firms do get away by doing exactly that; ignore estimation and concentrate on what they know best, their product. It could be said that that is just lucky, but there is nothing wrong to be lucky. However, for those of us less lucky, we must make sure that the estimation part proves correct or falls within an accepted margin of error. Most of the smaller firms don’t have the luxury of leaving for the end of the process and hopping for the best.

Global competitive market that firms of all sizes are operating in makes every estimation and projection of utmost importance as getting any of them wrong will cause them to fail even in those cases when they generated an excellent product idea and identified a niche in the market. Examples of such situations are everywhere with firms of all sizes. It is enough to think of companies like Nokia and Blackberry just a few years ago and search for their products today.

ABC method targets this variety of products within given portfolio and assigns a value of overheads (MOH) according to each product’s consumption of a given fixed cost. For example, it would be incorrect if cost of equipment and support staff be assigned equally to the free version of a mobile application with that of premium version, which customers are expected to pay some additional amount, but which also includes extra features and 24/7/365 online and/or telephone technical support. ABC method recognises these differences and divides fixed costs in cost pools and attaches a driver to each of them. Let us think of a spa center offering basic facial treatment and premium yoga classes. It would cause a substantial mismatch in costs if overheads for rent and maintenance are to be applied according to labour hours spend for each activity as it would cause an overcharge of costs on facial treatment and undercharge for premium yoga classes. This would inevitably result in making less profits as percentage of sales even though more premium products were to be sold. Similarly, in the case of fast food outlet offering meals with the option of take-away or sitting-in.

Technology has caused globalisation effect to be felt in all areas of our day-to-day life. Smaller firms although may want to place their products only locally they will inevitably face global competition. Attempts to ignore it are destined to fail. It seems to me that the only way is to embrace the reality, including in cases when a small firm wanting to market their products locally, they would still have to act in order to protect themselves and their product globally. We are witnessing a crossing point for humanity with the artificial intelligence slowly but surely expanding their presence in our lives, in addition to ever larger capacity of machines to store and process information. Let us just compare the value of Facebook, Google, Twitter, LinkedIn and similar firms with any of the large physical equipment holding organisations from the last century? There may be less people needed to make, maintain and operate these machines but the amount of capital spent in the making and upgrading are incomparable to any manufacturing plants from 18th and 19th century, probably put together.

ABC! Easier said than done

Although there is an undisputed agreement that activity based costing ensures a better apportionment of manufacturing overheads and many businesses have adopted it as a method there also well-argued criticisms. Activity based costing can be time consuming and costly. The very fact that there should be someone skilled enough in management accounting and well informed about how business operates, incurs costs, makes it costly to set-up and running it as a separate function. In the case of large businesses with complex operations these costs can be substantial. Furthermore, information produced can be difficult to understand resulting in high risk for missing on the benefits of the method altogether. Additionally, not all businesses are expected to benefit from activity based costing adoption. In those cases where products that the business markets have similar output and cost structure, detailed measurements that ABC provides on consumption of MOH is unlikely that will have any real impact. The complex process of collecting and measurement of information carries the risk of undermining the potential benefit.

However, in my opinion all these facts about the difficulties that ABC contains in its application can be overcome and turned to support its application in smaller firms, specifically in the service sector. These firms at their early stages of their operations and with limited products that they market will make adoption of ABC easier and simpler comparing to large organisations with complex business operations. It is true that it will require someone with a fair understanding of management accounting. The fact is that firms are already paying for similar services and in my opinion eventual increase in professional fees is well worth it. An earlier and more active involvement of management accounting/accountant practices in smaller firms is proven beneficial. Furthermore, it continues alongside concept of strategic management accounting which requires firm owners communicate and share their ideas and plans with other stakeholders, something that numerous researchers found that they rarely do. Adoption of ABC earlier in their life will make these firms go through steeper learning curve.

Expansion of service sector in variety of products, coupled with continuous technological development seems that it will enable entrepreneurs from various parts of the world provide services to firms globally. Whole new world of opportunities is already open in the far east with expectations that this growth will continue for at least another twenty years. Considering the size of the market it seems that the saying ‘sky is the limit’ that I was told when I first visited China is proving correct. As long as there are opportunities there will also be people that will take them. The earlier they start adopting methods and techniques that will enable better estimation and more efficient use of resources the better. That way they will grow faster and in turn create opportunities for others after them.