Introduction:

Most businesses employ costing systems for a variety of tasks, such as project
scheduling, project selection, product costing, and pricing. In order to evaluate
the cost implications of their short- and long-term planning and control
activities, managers make an effort to understand how costs behave and how
cost objects utilize resources through cost functions. A cost function is a
mathematical illustration of the relationship between changes in the intensity of
an activity or process and the rate at which a cost rises.

In contrast to traditional costing systems, which see cost as a linear function of

volume, more complex costing techniques, such as activity-based costing
(ABC), view cost as a function of variations in activity level.

Previously conducted study on the sophistication of product costing systems

defined sophistication in terms of the methods used to include indirect overhead
cost in product costs.

The three key definitions were: (1) assigning indirect overhead costs to product
costs, (2) include all costs in product costs, and (3) making product costs
understandable to non-accountants. All of the product costing systems were
straightforward when these three categories of sophistication were measured by
the number of cost pools and cost drivers.

According to Drury and Tayles (2006), it is better to use the term complexity to
refer to the way of associating indirect overhead expenses with product costs.
According to Al-Omiri and Drury (2007), the accuracy of direct costs is
unaffected by the sophistication of the cost system. They believe that
sophistication depends entirely on the consideration of indirect costs, which
impacts the accuracy of product costs. Sophistication is defined in several ways.
 This might imply that past study was too limited and insufficient, and that
further research is needed to investigate different sorts of sophistication in order
to enhance the concept's formulation.

This research examines knowledge gaps in management accounting using

cross-sectional field investigations. By doing so, it may be possible to confirm
that include indirect overhead expenses in product costs is the best method to
define sophistication.

The marginal cost is the most important cost element to consider when making
decisions in a multi-product organization. Given this, a more complex product
costing system is likely to generate more accurate marginal costs for decision
making.

This is significant because incorrect marginal costs in the context of decision

making can lead to improper judgments, such as the production of costly items
and the nonproduction of profitable products (Kaplan 1988; Drury and Tayles
1995, 2000; Kaplan and Cooper 1998). Any gain in sophistication, whatever
measured, should be expected to lead to an increase in satisfaction with
accuracy.

The goals of this study are to first investigate what is meant by the
sophistication of the product costing system. If several definitions of
sophistication exist, the article determines if the level of sophistication changes
between them.

1- Background

2.1) Defining and Measuring Sophistication:

In the context of product costing, Drury and Tayles (2005) defined low levels of
sophistication as those product costing systems with a single plantwide, first-stage
cost pool and a single volume-based, second-stage cost driver. Although Drury and
Tayles (2005) did not discuss the makeup of these cost pools in any detail, they
are, presumably, the equivalent of both responsibility-based cost centers in a
traditional costing system and activity cost pools in an ABC system.

In both of these cases, a higher number of cost pools is expected to reduce the
likelihood of costs being averaged across cost pools and to represent better the
consumption of cost pool resources by products.

This would be indicative of a higher level of sophistication. Similarly, an increase

in the number of cost drivers is expected to be indicative of an increase in
accuracy, because a higher number of cost drivers is likely to represent a better
measure of the quantities of resources consumed by individual products through
identifying the appropriate cost driver of each individual cost pool.

Drury and Tayles (2005) also argued that sophistication will be affected by the
extent to which different cost drivers are used, such as volume-level, batch-level,
and product sustaining cost drivers, with sophistication increasing with the use of
non-volume-level cost drivers.

In addition, they stated that sophistication is also dependent on whether

transaction, duration, or intensity cost drivers are used. Drury and Tayles (2005)
stated that transaction drivers are the least sophisticated cost driver because they
represent the number of times an activity is performed.

Duration drivers represent a higher level of sophistication because they represent

the amount of time taken to perform an activity. Intensity drivers represent the
highest level of sophistication because these are based on directly charging for the
resources used when an activity is performed. Given the above, Drury and Tayles
(2005) identified a product costing system with a high level of sophistication as
consisting of many cost pools and many cost drivers. In other words, a highly
sophisticated system would be an ABC system.

2.2) Cost system complexity:

A major issue in the design of cost systems is whether the system only assigns
direct costs or whether it also assigns indirect costs to the cost objects (e.g.,
products, services and processes) of an organization and, if so, how. Variable cost
systems only assign direct costs, whereas absorption cost systems also assign
indirect costs.

In order to assign indirect costs, various cost allocation methods have been
developed, of which activity-based costing (ABC) is the most recent. In general,
these methods consist of two stages. In the first stage the homogeneous costs of
resources are gathered in cost pools. Dependent on the type of allocation method,
these cost pools are functionally (e.g., based on departments) or process (e.g.,
based on activities) oriented.

In the second stage the costs from the cost pools are assigned to the cost objects
using cost allocation bases. Dependent on the type of allocation method, volume-
based or hierarchical (e.g., batch-level) cost allocation bases are used.

2.3) Cost system complexity and purposes of use:

Cost systems can be used for many different purposes. Major purposes include
stock valuation, product pricing, customer profitability analysis, new product
design, performance measurement and budgeting (e.g., Kaplan & Cooper, 1998).
Kaplan and Cooper (1998) argue that firms essentially need multiple cost systems,
to perform three primary functions: (1) valuation of inventory and measurement of
the cost of goods sold for financial reporting, (2) estimation of the costs of
activities, products, services, and customers, and (3) providing economic feedback
to managers and operators about process efficiency.

2- Literature Review
3.1) Empirical research on cost systems sophistication level in developed
countries

In developed countries, there have been limited studies that categorize product cost
systems based on characteristics rather than the traditional alternatives of
traditional and activity-based costing (ABC) systems (Abernethy et al., 2001).

The design of cost systems is influenced not only by product diversity but also by
the use of technology to manage diversity. Factors such as product diversity,
degree of customization, size, and corporate sector influence the complexity of cost
system design in UK companies, with financial and service sectors having higher
levels of complexity compared to the manufacturing sector (Drury and Tayles,
2005).

Sophisticated cost systems in UK companies are associated with the importance of

cost information, size, competition intensity, and the financial sector. ABC
adoption is also linked to the use of other management accounting techniques, lean
production, just-in-time, and the service sector (Al-Omiri and Drury, 2007).
Cost system complexity affects the intensity of cost system use and satisfaction,
depending on the purpose of usage, such as product planning or cost management
(Schoute, 2009).

Various studies have explored the impact of cost systems on performance. Some
studies found that the use of ABC is associated with higher return on investment
(ROI), particularly in business units following a differentiation strategy (Frey and
Gordon, 1999; Cagwin and Bouwman, 2002). However, other studies found no
significant relationship between ABC practices and firm performance, as measured
by ROI (Sanford, 2009).

The extensive use of ABC has been shown to affect plant performance by reducing
production costs, improving quality levels, and decreasing cycle time (Ittner et al.,
2002; Zaman, 2009). Only a few studies have considered cost systems as
mediators between contextual factors and performance (Cagwin and Bouwman,
2002; Sanford, 2009).

Abernethy et al. (2001) view cost system design choices as varying along three
dimensions: number of cost pools (single versus multiple cost pools), nature of cost
pools (responsibility-based versus activity-based cost pools) and nature of cost
allocation bases (volume-based versus hierarchical cost allocation bases).

Al-Omiri and Drury (2007) also identified the issue of the effect of the allocation
of overhead costs to individual cost pools on sophistication. In this case, higher
levels of sophistication are associated with directly assigning overhead costs to
each cost pool or using cause-and-effect drivers to identify overhead costs with
cost pools.