Journal Critique MBA 202

The Research Inquiry

Title : The ABCs of Cost Allocation in the Wood Products Industry: Applications

in the Furniture Industry

Author: : Henry Quesada-Pineda

Source: : Produced by Communications and Marketing, College of Agriculture

and Life Sciences, Virginia Polytechnic Institute and State University, 2010

retrieved from https://www.pubs.ext.vt.edu/420/420-147/420-147.html

Published : September 17, 2010

Ref No. : 420-147

No. of Pages : 11

Theoretical and Conceptual Framework

This publication was developed based on concerns from furniture producers that

more training in cost accounting methods should be available for practitioners. The paper

discusses the basics of cost accounting and explains the strengths and weaknesses of two

cost accounting techniques — the direct method and the activity-based costing (ABC)

method — using simple examples and applications in the furniture industry. Manufacturing

costs including design and engineering activities have critical impacts on overall

manufacturing costs.

Many of the problems encountered in manufacturing can be traced back to the

design process. In wood products companies such as furniture firms, there are many

manufacturing problems that arise because of a bad design. The lack of attention to the

design process has harmed the competitiveness and profitability of the wood products

industry, which might have significant savings down the production stream if design factors

The ABCs of Cost Allocation in the Wood Products Industry: Applications in the Furniture Industry
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such as engineering, tooling design, finishing, and tolerances were considered when

designing a new product. Figure 1 shows the behavior of total cost as a function of time

(from design to manufacturing).

Figure 1. Product life cycle and relationship with cost (Dorf and Kusiak 1994).

As much as 80 percent of total costs is committed during the first 20 percent of lead

time. However, less than 2 percent of total sales is spent or allocated to design and

engineering activities in many industries, including wood products industries. Specific

assertions about cost commitment in design are offered by Dorf and Kusiak (1994).

❖ Factors such as quality and lead time are mostly design problems, not manufacturing

problems.

❖ Market loss by U.S. companies is primarily due to design deficiencies.

❖ Many technical problems associated with manufacturing are traceable to design

problems.

❖ The best opportunities to compete in the global marketplace are found in

engineering design.

ABC is a management accounting process that allocates resource costs to products

or customers based on activities, which are the factors causing work and incurring cost,

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used by products or customers. The heart of ABC is the activity concept. ABC assumes that

activities originate cost and that outputs build the demand for activities. Cooper et al.

(1992) conclude that the ABC system comprises four basic steps:

1. Identify activities;

2. Assign resource costs to activities by three methods: direct charging, estimation or

arbitrary allocations;

3. Identify outputs; and

4. Link activity costs to outputs.

In the ABC system, manufacturing procedures can be segregated into four categories

(Cooper and Kaplan 1991):

1. Unit-level activities

Costs are assigned to activities that act on each individual unit of product or

service, such as direct labor or materials.

2. Batch-level activities

Costs are allocated to activities which are performed to support a specific product

or service, such as process engineering, product specifications or engineering

change notices.

4. Facility-sustaining activities

Costs, which are viewed as period costs, are assigned to activities underpinning the

organization as a whole. Most of these activities are administrative, such as plant

management, security, taxes, building and grounds or heating and lighting. Seeing

that the facility-sustaining activities are not based on product-related

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characteristics (such as product quality, product complexity, product flexibility or

production volume), argue that these activities should not be viewed on a product

basis.

Management of Accounting Problem or Concept

A bad estimate of product and process costs could lead to increases in overhead

and lot sizes, quality problems, unnecessary higher inventory levels, and other types of

waste that affect the performance of the firm. Also, extended lead times could potentially

result in delays, thus increasing customer dissatisfaction.

Traditional cost systems such as the direct method are very popular because of

their simplicity and low cost to maintain. However, they carry the potential for many

problems. For instance, the use of a single cost driver to allocate overhead might hide

critical cost issues that could harm the company’s performance. The use of direct labor as

the cost driver to allocate overhead has been the norm in manufacturing firms such as

furniture industries. In the past, this was acceptable because direct labor was the major

cost component in furniture firms, among other wood products industries.

Traditional accounting systems rely mostly on cost drivers originated from direct

costs (materials and labor) to allocate overhead, and a two-stage process is used. First,

overhead is reported to cost centers. Second, the overhead is distributed from the cost

centers to the actual products, depending on the amount of cost driver consumed by

each product in a specific cost center. This way of calculating cost does not provide an

effective operating management performance system that can help managers obtain

relevant product and process information that can lead to improvements, as we noticed

in the previous section.

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The ABC Calculation vs. Traditional Method

As this publication shows, cost has three main elements: direct materials, direct

labor, and overhead. Table 1 shows a summary of the final unit costs for each type of

product (the company manufactures 3 models of chair which stands for products A, B,

and C). By looking at table 1, we can see that the final cost, for instance, of product A is

$167.35 — the sum of direct materials and direct labor costs and overhead. If we were to

calculate the cost of these three products using conventional costing techniques, the

results would be as shown in figure 2.

Table 1. Summary of Cost Calculations

The top section of figure 2 shows the results of cost calculations using three different

methods. The conventional (direct) method uses the number of labor hours to distribute

the overhead to every product. The multiple allocation method combines more than one

type of cost driver to do the same allocation. For instance, the overhead allocation found

by using the direct method could be very misleading because it does not show hidden

critical cost factors that might be affecting the total cost calculations. Take a look at

product C. The unit cost of product C using the direct method is $137.17; using the ABC

method, the unit cost is $362.67. The reason behind this difference is that the direct method

does not consider that product C requires 10 deliveries, compared to only three deliveries

for product A and five for product B.

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Figure 2. Figure 11. Comparison between the traditional costing and ABC methods.

Also, product C requires 10 production orders, compared to two for product A and

five for product B. This tells us that 82 percent of the cost of product C is overhead (small

volume, too many deliveries and production orders) and the direct method was not able

to account for this. This analysis shows that perhaps product C is not a good fit for this firm

because the overhead is too much compared to the other products, unless the company

is getting a good profit from it.

Managerial Accounting Analysis, Approach, and Model

The author had specified the furniture industry as the subject of this study,

particularly in the cost allocation of wood products based on the following rationale:

1) In the current economic downturn in the furniture industry companies, to face

competition, requires new costing methods to succeed, in a flexible manner,

fructifying market information, inside to find levers to identify places, resource intensive

activities and then cost reduction opportunities.

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2) It would be an important aid in making management decisions, particularly for

improving pricing practices by making costing more accurate.

The study used both quantitative and qualitative information. First, the product,

process, and current cost system were studied and analyzed. Second, an appropriate ABC

model was developed and implemented at the factory, measuring product cost,

identifying profit and understanding cost drivers.

ABC system requires first to identify activities within an organization in order to

identify the cost driver related to that activity. In a manufacturing firm, cost drivers can

occur at four different levels: unit, batch, product, and factory levels. Cost pools are

generated from which cost rates are determined and charged to products accordingly.

Third, a comparison between the traditional system and the ABC system was made. Finally,

benefits and obstacles in the application of ABC system were discussed. The findings

indicated that the costs under the traditional cost system were different from those

computed using the ABC system. It allows the creation of a costing system that provides

management with reliable cost information.

Managerial Accounting Implications of the Study

a. Corporate Managers / Executives – the will study help identify expensive and

unprofitable products. This information is important from management point of view as it

will help in the reduction and elimination of non-value-added activities of such

manufactured products by applying additional industrial engineering methods.

b. Academe – the study will provide a practical way of presenting the ABC model in the

class as applied in the real world. Through this, students will appreciate more the model

as the teacher presents it.

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c. Customers / Clients – this study also benefit customers because they can be advised

on how to reduce their own cost. The information can analyze and present the cost per

unit of similar customers.

d. Future researchers – the study will be a good start for future researches to study ABC

model and know other factors (not found in the study) that influenced the model.

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The Critique

Point of View

I’ll take this critique in my point view as a practicing design professional and a project

architect.

Thesis Statement

The objective of the study is to provide understanding on how activity-based

costing or even better activity-based management can be used to the advantage, but

also what the limitations are. While in view of the fact that there is very little evidence of

research conducted to determine the extent to which small manufacturing firms of specific

sector/industry adopt the ABC model in the Philippine setting , I want to critique and

investigate related studies from the neighboring countries in Asia, particularly Malaysia,

Thailand and India about their experience of the practical issues and reasons why firms do

not adopt ABC despite its success and reliability.

Critiquing

The approach in this literature review is to summarize and explain the existing

knowledge of the Activity-Based Costing system. This study may be categorized as

preparatory to a thesis because it identifies gaps in the literature. These gaps are might

open research opportunities and future studies in the Philippines setting.

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Table 2. Reasons for non-implementation of ABC
MALAYSIA
Ahmad, Kamilah & Teng, Neoh & Mohamed
Zabri, Shafie. (2017)
• Costly to switch ABC
• Lack of expertise to implement ABC
• Too complex and time-consuming
• Satisfied with the current system.
• Difficulties in collecting data on the cost
drivers
• Lack of awareness of ABC
• Difficulties in selecting cost drivers
• Lack of internal resources
• Consultants too costly
• Small proportion of overheads
• Lack of top management support
• No significant problems
• Resistance from employees
• Lack of management policies
• Less complexity in products/services
The ABCs of Cost Allocation in the Wood Products Industry: Applications in the Furniture Industry
Journal Critique
THAILAND
Chongruksut (2002)
• Too complex and time-consuming
• Difficulties in selecting appropriate
software
• Difficulties in collecting data on the cost
drivers
• -Higher priorities of other changes or
projects
• Lack of internal resources
• Lack of expertise to implement ABC
• Satisfied with the current system
• Difficulties in selecting cost drivers
• Consultants too costly
• -No significant problems with current
system
• Lack of awareness of ABC
• Costly to switch to ABC
• Lack of management policies
• Ambiguity of ABC benefits in literature
• Lack of top management support
• Less complexity in products/services
• Have relatively small proportion of
overheads in total manufacturing/service
costs
• No intensity of competition
• Resistance from employees
MBA 202
INDIA
Joseph, Kumar & Kumar (2019)
• Lack of Knowledge by Staff in
understanding the ABC model
• Non-Compatibility with existing
accounting systems, ABC is just an
informational tool
• Viewed as ABC will do more harm than
good
• No idea of immediate expansion of
business
• Obtaining Data is Complex and
Cumbersome, No MIS in our firm
• More Efficient solutions are available
than ABC
• Not Needed now, already my firm is in
profit zone
• No Top Management Support
• Resources Constraint
• Complexity in the identification and
Selection of Activities
• High Implementation Costs, than the
benefits ABC provides
• Difficulty in identifying cost drivers
• Difficult to embed with information and
Communication Technology
• Not Suitable for the type of production
systems being used in our firm
• Hard to assign activity cost to products
or services
• Not a Priority for the firm at present
given the leadership style
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In a sorted manner from highest to the lowest rank, table 2 shows are the most dominant

reasons of non-adoption of ABC model within three different Asian settings, respectively

Malaysia, Thailand and India.

Even though conducted in three different settings, the three studies also imply that

business enterprises are complacent with their existing traditional approach which is

probably simpler and inexpensive. Besides that, lack of expertise and high cost to switch

to ABC are the major reasons for the non-adoption of ABC. The results also show that most

respondents are at the adaptation stage which means training is provided to employees

for improving their understanding on objectives and scope of ABC. Previous studies have

warned about the challenges on ABC implementation argued that ABC systems requires

a substantial investment of resource to design and execute. The managerial difficulties can

arise in dealing with discrepancy between formal departments and activities. If this study

will be conducted in the Philippines, the result will probably be the same as with the other

mentioned countries.

In my experience as a project architect/ construction manager, I would definitely

agree that given the lack of understanding about ABC is very common why it is difficult to

saturate the entire system without proper training and experiences. Just like one in the

research journal, cost has three main elements: direct materials, direct labor, and

overhead. Activity delays are a common issue in the construction industry and can

increase project schedules and costs. Activity delays can negatively affect several

dimensions of construction-project performance. Delays can lengthen schedules, increase

project costs, and jeopardize quality and safety. Delays are one of the most common

problems that affect the competitiveness of construction companies. That is why it is

important for the manager to be seasoned and competitive in identifying the activities

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and existing problems in projects and developing corrective actions is to determine their

causes.

I recommend that in any business sector or industry, a top-level management

support is very much needed to implement ABC. From hiring the right experts to training

and research. With technology on the horizon, ABC is a sustainable management

approach in this era of globalization where competition is highly unprecedented.

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References

Cooper, R. and Kaplan, R.S. (1991). Profit Priorities from Activity-Based Costing, Harvard

Business Review, May-June, pp.130-135.

Cooper, R., Kaplan, R.S., Maisel, Lawrence S., Morrissey, E. and Oehm, R.M.(1992).

Implementing Activity-Based Costing Management: Moving from Analysis to Action, IMA,

Montvale.

Ahmad, Kamilah & Teng, Neoh & Mohamed Zabri, Shafie. (2017). The Implementation of

Activity-Based Costing in Malaysian Small and Medium-Sized Enterprises. Advanced

Science Letters. 23. 3170-3173. 10.1166/asl.2017.7692.

Chongruksut, Wiriya (2002). The Adoption of Activity-Based Costing in Thailand. PhD thesis,

Victoria University.

Joseph, C.S. & Kumar, F.J.P. & Kumar, R.M. (2019). Implementing Activity-Based Costing

Among Automotive Engineering Industries in Small and Medium Enterprises Sector of Tamil

Nadu. International Journal of Mechanical Engineering and Technology. 550-563.

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