ACTIVITY BASE COSTING TECHNIQUE AND ITS IMPACT ON MANUFACTURING COMPANY PERFORMANCE

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

The availability and relevance of accounting information underlies many business decisions. In recent years, traditional volume-based cost models have been the subject of much criticism, especially in relation to the accuracy of product costing. The popularity of activity-based costing (ABC) in the mid-1980s and the subsequent evolution (Bromwich and Bhimani 1989) vs. revolution (Johnson and Kaplan 1987) debate has enriched both the management accounting literature and practice.

Research to date, however, has concentrated on assessing the integrity of the ABC process (for example, Foster and Gupta 1990; Noreen 1991; Roth and Borthick 1991; Banker and Johnston 1993; McGowan 1998; Maher and Marais 1998); examining its application and implementation in a single case study situation (for example, Cooper and Kaplan 1999); assessing the degree of interest and adoption (for example, Nicholls 1992; Armitage and Nicholson 1993; Innes and Mitchell 1995, 1997; Malmi 1999); and factors impacting the success of implement ation (for example, Anderson 1995; Shields 1995; Foster and Swenson 1997; Anderson and Young 1999).

Despite the limited number of confirmed non-adopters in our sample, we were able to match 37 of the 47 activity base costing firms within a reasonable level of accuracy. The structure of the paper is as follows. Section two presents a brief review of the ABC literature and a summary of the attributes and characteristics of ABC, as interpreted in this study. It also sets out the hypothesis and the theoretical model underpinning this study. Section three documents the research method and data source used. Section four presents the research findings. Section five summarizes the results of the robustness tests. The paper concludes in section six with a summary and interpretation of the findings, as well as a discussion of the limitations of the study.

Organizations have witnessed tremendous change in the operating environment over the last 50 to 60 years (Kaplan, 1991). Manufacturing lines handled small product mixes, competition came primarily from domestic rivalries, and technology was prohibitively expensive in the past. Today, manufacturing lines have the capacity to produce thousands of different products, international competition impacts most businesses, and technology has replaced labor in the market. The operating environment has become dynamic and complex due to rapid changes in technology that have accelerated globalization and worldwide competition (Govindarajan & Gupta, 2001). The current economic and financial meltdown in the United States has created a fragile business world.

Firms must adopt strategic initiatives to align company resources, gain a competitive advantage, and improve organizational performance. Traditional accounting methods fall short in providing management with the strategic information needed in today’s operating environment (Brimson & Antos, 1994; Euske & Vercio, 2007; Kaplan, 2006; Kocakulah, 2007; Lea, 2007; Raab & Mayer, 2007). Innovative managerial accounting techniques can assist in the development and implementation of the strategic management process (Anthony & Govindarajan, 1998; Brewer, 2008; Chenhall, 2003; Frezatti, 2007; Herath, 2007; “Linking Strategy to Operations,” 2008; Shank & Govindarajan, 1993; Sharman, 2008). Managerial accounting systems such as activity-based costing (ABC) can play an important role in bridging the information gap and supporting management decision making (Brimson, 1991; “Linking Strategy to Operations,” 2008; Maiga & Jacobs, 2006). ABC can offer fast, reliable, and strategic information for decision making so that management can react quickly to the market, competition, and customer demands.

1.2 STATEMENT OF THE PROBLEM

Assessing the effect of ABC success implementation on the firms’ performance is considered as an important research topic. Previous empirical studies provide the evidence that the implementation of ABC could improve firms both financial performance and nonfinancial.. There has been a great deal of research into product costing practices, but much of this has paid little attention to differences in product costing practices between various sizes of firm. This paper addresses this deficiency by comparing the product costing practices of large enterprises.

Management of these organizations needs fast, reliable, and accurate information to make sound business decisions. Many innovative managerial accounting tools are available that can aid in the strategic management process. It is vitally important that organizations select the appropriate system for their strategic objectives. ABC has the potential to provide management with the resources to streamline business activities, identify fundamental problems, eliminate waste, design cost out of activities, improve efficiencies long term, and link corporate. strategy to operational decision making (Brimson, 1991; “Linking Strategy to Operations,” 2008; Maiga & Jacobs, 2006).

However, empirical research (Bhimani, 1996; Gordon & Silvester, 1999; Innes & Mitchell, 1995; Innes et al., 2000; Lukka & Granlund, 1996) has shown mixed results from ABC adoption and its ability to improve organizational performance.

1.3 OBJECTIVE OF THE STUDY

The purpose of this study was to determine the impact of ABC on organizational performance using a contingency perspective. The managerial accounting contingency theory specifies that no one accounting control system applies equally to all organizations (Bruns & Waterhouse, 1975; Burgess et al., 2007; Emmanuel et al., 1990; Jermias & Gani, 2004; Neely & Bourne, 2000; Reid & Smith, 2000). Every organization faces a different operating environment that must be evaluated carefully through the strategic planning process.

According to the contingency theory, management must conform or fit the strategy and the structure, including the accounting control system, to the existing environment to improve performance (Donaldson, 2001; Gordon & Miller, 1976; Haldma & Lääts, 2002; Jermias & Gani, 2004; Otley, 1980; Pleshko, 2007; Simon, 2007; Waterhouse & Tiessen, 1978). The Institute of Management Accountants (2000) recommended that cost control systems incorporate and support the overall strategic goals of a company. One important organizational goal is to improve performance. Therefore, this study investigated ABC to determine how it can impact organizational performance.

1.4 RESEARCH QUESTION

1. Is it true that previous empirical studies provide the evidence that the implementation of ABC could improve firms both financial performance and non financial?
2. Can activity base costing contributes in improving the financial performance of service firms?
3. Are there problems identified with cost control using activity base cost principles?

1.5 RESEARCH HYPOTHESIS

H0: It is not true that previous empirical studies provide the evidence that the implementation of ABC could improve firms both financial performance and non financial.

H1: It is true that previous empirical studies provide the evidence that the implementation of ABC could improve firms both financial performance and non financial.

H0: Activity base costing cannot contributes in improving the financial performance of service firms.

H1: Activity base costing can contributes  a lot in improving the financial performance of service firms.

H0: There are no problems identified with cost control using activity base cost principles.

H1: There are problems identified with cost control using activity base cost principles.

1.6 SIGNIFICANCE OF THE STUDY

The importance of this study was to add to existing research of ABC in the following two aspects:

1. First, this study contributed to the limited contingency research that is available in managerial accounting to evaluate whether ABC improves organizational performance. The investigation built on the findings of Gordon and Silvester (1999), Kennedy and Affleck-Graves (2001), and Cagwin and Bouwman (2002). The study used the basic contingency model found in the research of Anderson and Lanen (1999) as the underlying foundation for the examination. ABC research has been credited with providing management with accurate and reliable information for strategic decision making. However, ABC research has provided little support for performance improvements. The researcher expected to find that successful ABC organizations need to find an optimal fit between their environment, strategies, structures, and accounting processes (Murray & Kotabe, 2005; Yin & Zajac, 2004).
2. The analysis used publicly reported financial information to evaluate longitudinal changes in organizational performance due to the implementation of ABC. This study evaluated the changes in performance between Fiscal Year 2006 and Fiscal Year 2003. Organizational performance was evaluated utilizing seven traditional financial measures: (a) market price, (b) earnings per share (EPS), (c) return on investment (ROI), (d) operating performance, (e) asset turnover, (f) debt-to-equity management, and (g) return on stockholders’ equity (ROE). These financial measures best represent how interested third parties such as investors and creditors evaluate overall organizational performance.

 1.7 SCOPE AND LIMITATIONS OF THE STUDY

The primary scope of the study was limited to 139 publicly traded organizations who have adopted ABC. The test population was selected using two methods. First, an Internet query of ABC consultants was conducted on the Google and Yahoo search engines. The client lists from the consultants’ Web pages were used to build the population of this study. Second, case studies from texts and journal articles were used to add to the population. The 139 ABC organizations were matched with 139 non-ABC organizations within the same industry and market capitalization. These population selection methods were used because it is not a common practice for organizations to announce or publicly disclose changes in managerial accounting systems. Performance measures were collected from annual reports, organizational Web sites that publish financial reports, and Reuters Provestor plus Company Reports. Supplemental company, industry, and environmental information were collected from company Web sites, annual reports, 10K reports, consultant Web pages, Standard and Poor’s Stock Reports, Argus Analyst Reports, and Reuters Provestor plus Company Reports for the contingency variables. These were the most efficient sources of company information. Several limitations were apparent due to the method in determining the population and collecting supplemental information. The population was selected using third-party information, which did not provide the scope of ABC use throughout each organization.

1.8 ORGANIZATION OF THE STUDY

The first chapter of this dissertation introduces the background, purpose, importance, theoretical framework, the research question, and the hypotheses. Chapter II examines empirical research on the contingency theory of organizations, managerial accounting, ABC, and organizational performance. The literature review in the second chapter serves as the theoretical foundation for this study.

1.9 DEFINITION OF TERMS

Organizational performance can be defined in many different ways. This research views organizational performance as a function of seven traditional financial measures, which are defined in this section according to Barron’s Dictionary of Accounting Terms (Siegel & Shim, 2000).

Asset turnover: Measure of effective use of assets to generate revenue. Effectiveness can be measured as Net Sales divided by Average Total Assets.

Debt-to-equity management: Measure of debt and equity utilization. Debt and equity utilization can be calculated as Average Total Liabilities divided by Average Stockholders’ Equity.

Earnings per share (EPS): Profit accrued per share held. EPS can be measured as Net Income less Preferred Dividends divided by Average Common Stock Outstanding.

Market price: Price per share on the open market.

Operating performance ratio: Measure of profitability. The operating performance ratio can be measured as Net Income divided by Net Sales.

Return on investment (ROI): Measure of management effectiveness. Management effectiveness can be measured as Net Income divided by Average Total Assets. Return on stockholders’ equity (ROE): Measure of overall performance or the return to shareholder investment. ROE is calculated as Net Income divided by Equity