the impact and importance of activity based costing on financial performance of manufacturing firm

At that time Traditional Costing system trace overhead costs to the product based on the assumption that product cause costs.. Therefore Traditional Cost Accounting TCA has not reflected

THE IMPACT AND IMPORTANCE OF ACTIVITY BASED COSTING

ON FINANCIAL PERFORMANCE OF MANUFACTURING FIRM

BY NGUYEN THANH HOA

DECLARATION OF ORIGINALITY AND WORD COUNT

I hereby declare that the graduation project is based on my original work except for quotation and citations which have been duly acknowledged I also declare that it has not been previously or concurrently submitted for any other course/degree at Help University College or other institutions The word count is 10,663 words

NGUYEN THANH HOA

Date:

ACKNOWLEDGEMENT

This research contains a lot of details and varieties, thus it would be difficult to carry out it on one‟s own Receiving encouragement and help from many people I feel indebted to their aids, and wish to express my

gratitude to them

First of all, I would like to thank our respected supervisor – Dr Le Van Lien for his immense support throughout my research I would like to express my indebtedness to Dr Lien for his continuous guidance and

support during my project Without his support, my project would not be completed

I also reserved on priority of my special acknowledgement to Mr Tran Huu Huan - Financial Director of Dutch Lady Vietnam Company, who gave

me useful ideas for my questionnaires

Thanks also go to many financial managers of Dutch Lady Vietnam,

Mr Nguyen Trung Kien, Mr Doan Le Minh, who had continuously guided

me with all the valuable information for my research

And finally, I am extremely grateful to all the staff of Dutch Lady Company who cooperated with me during the survey

THE IMPACT AND IMPORTANCE OF ACTIVITY BASED COSTING

ON FINANCIAL PERFORMANCE OF MANUFACTURING FIRM

financial performance of manufacturing firm by measuring impact and

importance of ABC - a way to measure changes in their productivity of

manufacturing firms The objectives of the project were to demonstrate

chances in financial performance when manufacturing firms apply ABC approach Benefits of applying ABC and factors affecting the successful performance of ABC approach will provide managers with useful

information in making better decisions on evaluating the application of ABC

To achieve these above objectives, questionnaires were made and given to the financial staff of Dutch Lady Vietnam (DLV) Company They were required to complete the questionnaires based on their understanding and perceptions of ABC related to financial performance

As can be seen, ABC has had a positive influence on improvement of financial performance at DLV Thus by applying ABC, managers of

manufacturing firms would be given more accurate information and able to take the right actions that would improve the profitability and the financial performance of a company

2.2 Conceptualization of financial performance

2.3 General look at ABC

2.3.1 What is Activity Based Costing?

2.3.2 Fundamental of ABC

2.3.3 Why is ABC needed?

2.4 Implementation of ABC

2.4.1 Cost classification in ABC

2.4.2 ABC in application management cost

2.4.3 Procedure of ABC cost allocation

2.4.4 Comparison with Traditional cost accounting

2.7 Initiative business strategies

3.8 Data analysis method

Chapter 4 RESULTS OF THE RESEARCH AND ANALYSIS

4.1 Overview

4.2 Discussion of statistic analysis

4.2.1 Respondents

4.2.2 Data analysis method

4.2.3 Reliability and validity

4.3.2.3.3 Business unit complexity

4.3.2.3.4 Intra company transaction

The perception of respondents about Activity Based Costing system

10

22

24

39

Figure 4.2 Component bar charts showing the response of yes

Figure 4.3 The opinion of respondents about factors that affect of Activity

Based Costing system on Financial Performance

42

Figure 4.4 Component bar charts showing the response of yes

Figure 4.5 The reaction of respondent about benefits of firm when

applying Activity Based Costing method

47 Figure 4.6 Component bar charts showing the response of yes

LIST OF ABBREVIATIONS

IT

JIT

TCA

Information Technology Just - in - time

Traditional Cost Accounting

company‟s cost and provide management with accurate information on financial operation and performance At that time Traditional Costing system trace overhead costs to the product based on the assumption that product cause costs It takes a total cost and assigns it to each part of the process It is the fact, it relies on an essentially illogical allocation of indirect costs, and thus systems do not give managers accurate product cost information, which leads to inaccurate calculation of product profitability Therefore Traditional Cost Accounting (TCA) has not reflected the realities of financial

performance of manufacturing firm and can mislead and increase production costs and have major negative effects on a company‟s profits

Introduced by Robin Cooper and Robert S Kaplan (1991) Activity Based Costing (ABC) was described as a potential approach to solve

traditional costing problems It soon claimed its major advantages and

overcame limitations of TCA despite of a rising number of questions

concerned with adoption and implementation ABC However Ittner ET all (2002) stated that ABC would only have indirect effect on financial efficiency Since then various studies have been conducted on the real benefits and the actual influences of ABC on performance of accounting system and

production of a company in order to see whether or not applying ABC was the right solution This project will illustrate the impact and importance of ABC on financial performance of manufacturing firms In addition, it will focus on the empirical testing of the impact of ABC in Dutch Lady Vietnam (DLV) and the effect of ABC to financial performance

DLV Company is a subsidiary of Friesland Foods – a firm operating based on profits All business activities in DLV are aimed to increase

additional values to investors Its business activities are supposed to gain a profit that can cover its capital cost This project is based on certain

perceptions and experiences on implementing this method in this firm in order to verify these following hypotheses

1.2 The elements of the research

1.2.1 Research question

Can the application of ABC on manufacturing firm lead to impact on financial performance?

applying ABC could be different from those who use TCA Certain factors affecting ABC were also analyzed Therefore, hypotheses were conducted to study ABC‟s impact and in order to understand ABC and its role in financial performance

Hypotheses on ABC will be also analyzed by studying manufacturing firms which have been applying ABC for several years Quantitative research was used to obtain information which focuses on numerical data, financial reports; survey was given to auditors and financial executives of a company

to gather information on ABC and its relation to financial performance This was carried out by discussing the research questions, questionnaire design, the data collection, population and sampling, variables, data analysis and reliability

After the statistical analysis was conducted, based on the data

gathered, results will reveal the positive effect of ABC and will demonstrate the strong connection between ABC and efficient financial performance

1.3 Significance of research

This project will verify the benefits of ABC which provides accurate information and precise costs and updates daily for financial managers in decision-making, production controls and business operations Moreover, this project also contributes to other previous researches by studying the impact of using ABC not in general manner but in depth of how ABC

influences a firm‟s accounting process Being aware of applying ABC

successfully, managers can improve their business operations, thereby

improving the quality and management activities, increasing

competitiveness and economic power in open market economy; and as a result this may also have a great effect on the success of a company In

addition, this project will demonstrate the current limitations of ABC which may enable future researches to make improvements to this model

1.4 Structure of research

The project is organized as follow:

Chapter 1 introduces the problem of research It identifies the research question, the purpose, the objective and the significance of the project; a structure of the project is also included in this chapter

Chapter 2 gives a review of the relevant literature Specifically it gives information about the principles of ABC and the financial performance Chapter 2 also includes the application of ABC in DLV; and covers the three hypotheses which indicate the impact and importance of ABC on financial performance

Chapter 3 presents the research methods, techniques as well as data collections This chapter creates the perception of the staff regarding to the use of ABC in DLV

Chapter 4 presents the three results of the hypotheses which were discussed in chapter 2 All of the cases are based on the company‟s staffs The first hypothesis shows the impact of ABC on financial performance; the second hypothesis demonstrates some factors affect of using ABC on

financial performance of the company Finally, the third hypothesis

illustrates that using ABC leads to the improvement of financial

performance

Chapter 5 includes the conclusions derived from this research and the contribution of this research to existing body of knowledge It also discusses about limitations of current ABC model and future research opportunities

2.2 Conceptualization of financial performance

Financial performance is the measuring of the results of a firm‟s

policies and operations in monetary terms In the manufacturing firms,

financial performance refers to the rate of return for a financial portfolio The portfolio includes the financial instrument which is used with different level

of risk of different rate of return (Cagwin and Bounman, 2002)

In current business environment, financial performance has related to the profit of firm Sales profit and cost was used to evaluate the value of business activities These values will be measured with current budgets or sales forecast to create business strategy in which to answer the “big

question “: how to maximize sales profit, reduce cost and better financial management

2.3 General look at ABC

2.3.1 What is Activity Based Costing?

Traditionally, the cost of manufacturing a product have categorized as direct material, direct labor and overhead Traditional cost systems trace overhead costs to the product based on the assumption that products cause costs (Turney, 1990)

On the other hand, ABC focuses on activities in manufacturing the product ABC is defined by Computer Aided Manufacturing - International (CAM-I) as “Activity Based Costing integrates financial and non – financial related to activities performed in a firm to produce goods and services” In this instance, costs assigned to products are based on resource consumption

of activities to produce goods

As defined in MBA venture line Business Dictionary: “Activity Based Costing is a costing system that identifies the various activities performed in

a firm and use multiple cost drivers (non volume as well as volume based cost drivers) to assign overhead costs (or indirect costs) to product ABC recognizes the casual relationships of cost drivers with activities”

According to Deepak Mohan & Hemantkumar Patil (2003), “Activity Based Costing is a costing model which to measure activity costs, results, resources and cost objects ABC assigns resources to activities, activities to cost objects according to actual consumption by each and recognizes the

causal relationship of cost drivers with activities, ABC focuses more on costs and the cause based on process and activities rather than on departments and traditional functions”

From the view of Stewart, G.B (1991), “Activity Based Costing

provides complete data on business activities in “financial metric form” It can be applied to business according to variable factors – thus it is more innovative compared with TCA, ABC has three main objectives: A tool to guide strategic decision making; insights in process of business to allowed resources to be efficiently allocated and minimize costs; an allocation

technique in determining internal cost prices and selling prices”

Therefore, ABC can be defined as a model of aggregated financial and non financial data related to operation activities in a firm to produce goods,

by assigning resource consumption in a firm to products and services

provided to customers

2.3.2 Fundamental of ABC

ABC is based on ideas: product design, productivity and distribution require diverse activities to be performed; the performance of the activities demands for the purchase and use resources, these generate costs (Cooper Robin, 1988)

ABC includes that: resources lead to costs, activities consume

resources and products consume activities (Novin, Adel M, 1992) Thus, a firm‟s activities are identified, then costs are assigned to those activities or

activities cost pools based on resources required After that costs are

allocated and traced from activity cost pools to products based on

proportional use of each activity In this theory, ABC is aimed at refining limitation of TCA or Inventory costing method

Activities are works, actions, or specific tasks performed in a firm (Novin, Adel M, 1992) For example, the transportation of raw materials from Warehouse to factory is the activity Activities selected in establishing ABC system are main operating activities and often performed by a variety of supporting activities For example, many different activities performed in purchasing such as order preparation, negotiating with suppliers, these activities will be organized within ABC system

Cost drivers are the qualitative measures of consumed resources to produce an activity, used to allocate cost of a consumed resource connected

to one or more activities (Novin, Adel M, 1992)

Activity drivers are the quantitative measures of the number of

activity units performed with a cost pool object, used to allocate activity costs

to output (Novin, Adel M, 1992) For example, the number of operating machine hours to produce Dutch Lady sweetened milk at DLV

Cost drivers and activity drivers are the same in nature Each factor is the basic cause of costs In general, anything that producer‟s activities causes‟ activity costs These factors are related to changes in costs, measuring and determining cost volume

The connection between activities and cost objects are implemented by cost driver activity, this is core of improvements in ABC model

Figure 2.1 Activity based costing model

2.3.3 Why is ABC needed?

ABC is a costing system which is applied in many manufacturing firms Many researchers noticed ABC method and considered ABC as an innovation in cost management accounting Many ideas stated that ABC method is necessary to trace overhead costs to cost objects and thus properly account for batch and product- level costs (Cooper 1990) Moreover, Robin Cooper, Robert Kaplan and H.Thomas Johnson reported that ABC method is

a costing method employed to assign direct costs to the general audience costs (Cooper, 1998a; 1998b; 1990; Cooper and Kaplan, 1998; Johnson 1990) Thus, ABC method is designed to devise the limitations of TCA ABC also enables managers to make right decisions, corresponding with product structure and competitive strategy of a company Although ABC system is

applied widely in manufacturing firms, according to Rotch (1990); according

to Tanju and Helmi (1991), Activity Based Costing can be used in all forms of business firm Many writers recommend using ABC method to support improvement in Work - in - process (Turney 199Ib) and develop designs of product cost efficiently (Cooper and Turney, 1990)

2.4 Implementation of ABC

2.4.1 Cost classification in ABC

- Activity levels

To determine costs of resources to activity, according to Blocher

(1991), a business must classify levels of costs, resources and activities ABC system often uses a four-level system:

+ Output unit level costs

Output unit level costs are costs of activities performed on each

individual unit of products and services which are assigned directly to

products (Blocher, 1991) For example, production costs to turn raw materials into units of product These activities must be performed on each unit such

as direct labor costs that are related to activities of running automated

machinery

+ Batch Level costs

Batch level costs of activities are related to a group of products and services, which help to produce a batch of product rather than each

individual unit of products (Blocher, 1991) A good example is production planning for a batch of product or service, when a business purchases a variety of raw materials, purchasing costs account for a considerable

proportion in overhead Purchasing cost involves costs of order planning, raw material receiving, and payment to suppliers

+ Product Sustaining Costs

Product sustaining costs are costs of activities undertaken to support individual products or services regardless of the number of units or batches

in which units are produced and consumed, such as product design,

marketing, advertising, research, etc (Blocher, 1991)

+ Facility Sustaining Costs

Facility sustaining costs are costs of activities performed at each

facility that can be seen as periodical costs (Blocher, 1991) They are traced to all activities performed at every stage to support the organization as a whole, such as management costs, facility sustaining cost, taxes and asset assurance Most activities of facility sustaining costs are assigned to all products and cannot be traced to each individual product because they support the

business as a whole

2.4.2 ABC in application management cost

ABC is one of the best ways to improve costing ABC system improves costs by focusing on individual activities as the basis of cost objects An activity is an event, task or a job with a goal defined For example products design, operating machinery, product distribution ABC calculates individual activities and allocates these costs to the object Since direct costs can be charged to each product, ABC can focus on indirect costs, improve cost

allocation to departments, processes and products

2.4.3 Procedure of ABC cost allocation

According to Cooper (1998c), procedure of ABC cost allocation has two steps:

Step1: All cost originated during a given period are gathered and assigned to each activity based on appropriate cost consumption

Step2: Base on performance of each activity in production and sales to assign activity costs to product‟s price

2.4.4 A comparison between ABC and TCA

 Similarities

Compton, Ted R (1996) stated that costs in TCA are allocated to

products mainly based on direct or indirect cost classification Raw material costs are considered as those that are assigned directly to products Direct labor costs are seen as costs directly connected to product and are based on

number of working hour Overhead costs are the biggest concern and are assigned to products based on number of working hours and hours of

running machines

Activity Based Costing also gathers cost factors into cost pool and uses suitable cost driver to assign costs to product

 Differences

 Cost centre / Activity centre

In Traditional Cost Accounting, costs are gathered into cost centres because this centres are established based on function or purposes, it is

convenient in collecting costs originated in the centers

In ABC, activities of a company are objects to analyze; costs are

computed based on these activities Then an organization can decide

appropriate activities for their business operation Coskins, G, (1997) said that there are activities in a business which are not connected to product such as: training, sales representatives, cost of these indirect activities are assigned

to main activities which are closely related to products

 Cost driver

In TCA, costs are allocated based on the number of working hours on hours of running machines However, in many cases this allocation base is not persuasive, not related to the use of resources, which makes costs wrong, unreliable

In ABC, Coskins, G, 1997 also reported that many cost allocation bases are identified not only to help a business explain better about variable cost but also improve cost management Examples of allocation bases are: the number of orders, the number of time operating machines, time of running machines, area uses, etc

 Focus on cost

The difference between the ABC system and the TCA system is that ABC focuses on all costs not only on costs to produce a good or services (Naughton-Travers Joseph P., 2001) In some organization, costs that are not related to products can sometimes increase much more than production costs; therefore a costing system which focuses mainly on production costs cannot compute accurately the actual costs of the organization Costs as management costs, advertising costs, financial costs, etc should be assigned properly to products

Cost objects in TCA are tangible products, but in ABC they also

include intangible products or services of the business Other cost objects of business operation in a firm can include customers, channels of distribution, orders or anything which a business wants to change costs

 Cost accumulation / Cost management

Roztocki, Porter, Thomas and Needy (1998) expressed that TCA

system is mainly based on cost accumulation and cost measurement; thus the transactional costing system cannot provide such information as unnecessary

activities, inefficient advertisements, etc Therefore one of the main reasons for developing ABC is better cost management

In order to have a proper view of ABC, benefits and limitations of ABC must be considered

2.4.5 Benefits of using ABC:

 Cost

Cooper, Robin (1991) reported that ABC system reveals costs for any transactional information; it represents all types of costs to produce that transaction Thus, even detailed costs are shown clearly and accurately Cost management in ABC approach is gaining better support in comparison with TCA Cost driver are allocated based on suitable and detailed procedures, thus this ensures high trust worthiness in cost ABC focuses on diverse costs which can be obviously seen in over heads ABC system almost provides a more completed, manageable report on cost structure The successful

implementation of ABC system requires a deep understanding of cost

structure of an organization, establishing cost modeling and target costing to perform without an unexpected factor The most important advantage of ABC system is its attraction to advanced costing system, its unique and logical features of business process

 Management of activities in a firm

When a manufacturing firm applies ABC method, it has to establish system cost drivers and has to be reliable all activities happening in a firm in

a given period of production (Cooper Robin 1991) Then a firm needs to determine the cost level for each activity periodically and finally, level of distribution of each activity to each product are decided With the ability to determine such detailed information, managers can easily classify activities

in a firm into pools, pool of high valuable contribution, pool of low

contribution and also pool of no valuable contribution for business activity

By understanding the importance of each activity, managers can give out solutions to improve efficiency of business operation in order to reach higher profits, and then improve financial performance Profitability from

customers is considered as a suitable improvement of ABC approach by stating different prospects of profit as profits really come from customers, not from product Some management processed as quality management, time management, productivity process is implemented more easily by ABC system Management of business operation can turn from functional

management into process management; moreover this reflects better the real function of an organization

 Information providing

While TCA only provides information on cost levels, ABC method provides information on process and cause of coats (Cooper, Robin and

Robert S Kaplan, 1992) When managers are aware of process and cause of costs, they can find proper solutions and cut unnecessary costs; besides, it helps managers to establish criteria to evaluate their staff which contributes

to improvement of efficiency

2.4.6 Limitations of ABC :

ABC system is surely more complicated than Traditional method In order to provide detailed cost structure, it requires many calculations and analyses to be performed Plans must be carefully set in detail, management process must be more detailed which will increase input factors (increase cost)

Joseph P Naughton-Travers (2001) stated that when a company

decides to implement a more complicated accounting system, it must be taken into consideration if the organization is lack of workforce or

management experts, because it may lead to unreliable system due to

unreliable information

In summary, gathering costs is vital in proper understanding of the real use of resources in a business to make investment decisions and set a conceivable price While Traditional costing methods allocate costs based on simple criteria and cannot reflect the relationship, ABC method is based on system of complex criteria to be able to reflect the relationship between cost objects and indirect cost

2.5 Case study from the literature

2.5.1 Description of DLV

DLV operates on a model of a partnership between Friesland Foods- FFs and Binh Duong manufacturing Friesland Foods is one of the biggest milk groups in the world originated in Netherland and is operating in many different countries The main objective of DLV is to research and develop dairy development programs in producing nutritional milk products;

merchandising marketing and distributing well know dairy products of the company

Accounting in DLV is designed to suit the form and operating features

of the company This is a manufacturing and retail company with the

management system based on specialty of each division and management Accounting in DLV is designed on the model that combines managerial accounting and financial accounting, but there is distinction and specification

of responsibilities for work, providing information, as well as the connection between managerial accounting and financial accounting to avoid delays in processing and providing accounting information Financial accounting records in AIS according to cost objects, in order to conduct plans for

detailed analysis and on the other hand to construct financial statements DLV ensures to follow Vietnamese and international accounting standards

Management accounting is designed to provide quantitative

information about financial situation in each division Management

accounting enables managers to make decisions to choose the most efficient technique For example: what to produce, how to produce and how to sell these products

In system of accounts, DLV use a chart accounts at Friesland Foods Accounts accord to the basic of homogenous overhead costs In cost

accounting, DLV use standard costs in setting overall prices as process

costing; and analyzes variability of planned costs This is the analysis of the based difference between real costs and planned cost to evaluate

responsibilities and ensure to provide accurate and proper information in a given period Moreover, DLV improves the model of department costs in the way that realizes benefits of ABC and lessen the use of TCA

For cost pools, the limit to coverage costs that suits the authority and responsibility of each pool in cost controls DLV sets up a structure of cost pools suitable for the business technology and operation structure to

recognize the results of management DLV employs a number of cost pools (50 cost pools) to establish flexible budgets, all work in a homogenous

process

2.5.2 Application of ABC in DLV

ABC method was applied on DLV in 2006 It is used as a separate system to support managerial decisions in order to gather more accurate information used to make managerial decisions every 6 months in DLV ABC

model is established according to cost allocation and based on process to provide information about resources, activities and cost objects

Process

Costs

Figure 2.2 Application of ABC in DLV

From the view of cost allocation, DLV applies a multiple stage

approach to get closer to actual costs in the company, in order to emphasize the relationship among activities, as well as between activities and cost

objects in a chain of stages

Among factors causing overhead costs in DLV, normal costs of a

product, variable production cost, cost adjustment, distributing,

merchandising costs and part of advertising and promotional costs can be directed to each product when posting to informative system of accounting Thus, ABC model focuses on indirect costs (includes: management costs, part

of advertising and promotion costs which cannot be assigned directly to each product) ABC improves methods of allocation of direct costs to departments, processes, products and other cost objectives

Resources

Cost Objects Cost factors Activities Achievement

Why to have costs?

Human resources

Cost factors

Make better decisions What causes costs?

ABC model in DLV focuses on individual activities as basic cost

objects These activities are ranked to cost levels: unit level cost, product level cost, corporate level cost

ABC also can be used to make business decisions based on

information on profit and profitability for each product, each sales area, and channel of distribution

2.5.3 Cost management in DLV

DLV realizes that seeking opportunities to improve profit is necessary but how to identify and realize these opportunities?

DLV implementations in the following methods of cost management:

 Identifying costs: to realize costs of products, its contribution to profit and its profitability

 Identifying assessable profit for products: assessable profit as well as assessable realized profit, channels of sales, brands, etc

is identified by applying specific allocation techniques in budget planning and operation plans

 Cost cutting: plans for activities of each division are aimed at lower costs and higher productivity, possible, realistic and benchmarking

 Cost management: to measure real costs, in corporation with assessable costs to provide the basic for analysis of variable cost and identify opportunities to improve profits

Figure 2.3 Diagram of cost management in DLV

Power cost: number of kwh/machinery ability

Electricity costs: number of kwh/ electricity areas

Cost of maintenance and repair: number of machine hours, total

Variances Level of Products

Contribution to Profit

Balance Sheet Net Profit

Other Information

Cash Flow & Cash Flow Statement

Working Capital Management

Cost

Allocation

Actual Cost

Net Revenue

Depreciation costs: value of machine

Insurances costs: (factories, equipment), value of equipment

2.6 Description of Activity Based Costing with the financial performance

Some recent researchers gained success in realizing the connection between the use of Activity Based Costing and Financial Performance in particular business environment Kenedy and Afleck – Grave (2001) was successful in connecting the application of Activity Based Costing and the improvement in financial efficiency for producers Ittner (2002) Cagwin and Bounman (2002) states that Activity Based Costing has indirect rather than direct influence on improvement of financial efficiency

2.7 Initiative business strategies

Activity Based Costing is one of many initiative businesses strategies including Total Quality Management (TQM), Just-in-time (JIT) Although researchers in recent year have tried to link the use of methods in stimulating business operation to improve financial performance, they have not yet come

up with a final conclusion and still have a lot of limitations Huston and Nanda (1995) showed that the use of JIT can improve Earnings per Share after controlling cost units, revenue and profit Easton and Jarrel (1995) states there are proofs that TQM is related to real financial performance However,