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Teaching note: Traditional and activity based

costing systems

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Janek Ratnatunga
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Accounting Education 6 (4), 337-345 (1997)

Teaching note: Traditional and activity based

costing systems
Monash University, Victoria, Australia

Received: May 1996

Revised: December 1996, April 1997
Accepted: May 1997

• Abstract

A significant portion of the current managerial accounting literature contrasts the benefits and
importance of activity based costing (ABC) systems with the more traditional cost accounting
systems. This paper questions this tendency of making such a stark contrast, by placing ABC
systems within a wider cost accounting framework. Initially, the framework is developed by
providing an overview of the product costing, control and decision making process. Also outlined
are the various costing systems in terms of their objectives, advantages and deficiencies. A schema
for integrating the costing process with decision making and performance evaluation criteria is then
conceptualized. The role of ABC is recognized and integrated within this framework. The link
between 'traditional' and ABC systems is also studied via an analysis of the conventional wisdom
in some of the leading texts in managerial accounting. The analysis demonstrates that there is still
much ambiguity in both the contrasting and the linking of ABC with the more traditional costing

Keywords: costing systems, activity based costing, cost frameworks


Early management accounting literature focused on the design and implementation of

costing systems which ensured an allocation of costs to products for the purposes of
inventory valuation and income determination (Homgren, 1989). Current research, with its
emphasis on 'foundations', 1 recognises the role of management accounting systems within
complex and dynamic organizational settings in aiding managerial decisions relating to
performance evaluation and control2 (Hopwood, 1976; Hopwood and Bromwich, 1986;
Emmanuel et al., 1991; Wilson and Chua, 1993). This shift in emphasis has brought about
a change in the design and role of costing systems in organizations. The aim of this paper

*Address for correspondence: Professor Janek Ratnatunga, Syme Department of Accounting, Monash
University, PO Box 197, Caulfield East, VIC. 3145, Australia.
This term is borrowed from Horngren (1989) to reflect the current state of management accounting
The meaning and application of the decision making process will be reviewed in a later section of this

0963-9284 © 1997 Routledge

338 Sharma and Ratnatunga Cos

is threefold. First, it aims to provide a framework to educators and practitioners of such.

costing systems in terms of their objectives, advantages and deficiencies. Second, it aims
to show how these systems are linked in modem organizational settings. The final aim of
this paper is to recognize the role of activity based costing (ABC) and to integrate it within
this framework.

Overview of costing systems

This section will attempt to conceptualize a framework for studying costing systems and
will show how costing systems are operationalised from their cost objects.

Cost objects

At an operational level, the focus of costing systems are defined according to cost objects.
A cost object is an activity for which a separate measurement of costs is desired. These
measurements can be classified into three main categories : costs for stock valuation, 3 costs
for the purposes of control, and costs for decision making purposes.4 Costs for control
purposes are those costs which are reasonably subject to regulation by the manager who is
responsible for the particular costs (see Figure 1).
Generally, costing systems have a two-step allocation process between the aggregation
(accumulation) of costs into natural accounts e.g., direct material, direct labour, and
manufacturing overhead, and the accumulation of costs by cost object, e.g. products,
customers, channels, etc. Therefore, costing systems first disaggregate the costs in natural
accounts to functional cost centres, such as manufacturing, administration and selling, and
then reaggregates these functional costs to the cost objects.

Costing method

Product costing methods are typically job costing and process costing. Job and process
costing methods accumulate and trace costs to products using either an absorption costing
format or a variable costing format. Job order costing is appropriate when large, unique, or
special-order items are produced (Winicur, 1993), and is normally used when products or
services receive varying attention and effort. All the costs incurred are recorded on a job
order costing sheet. Process costing is more suitable for continuous operations, such as
batch or flow production. These methods are representations of the costs incurred on a
particular job or process and are suitable for stock valuations on external reports.5 Job-
order and process costing can be implemented ex-post via backflush costing, a costing

The term ' stock valuation' is used synonymously with ' inventory valuation' in this paper. It refers to the
valuation of inventory for external reporting purposes.
This classification framework for cost objectives may seem generic because of the scope for overlap between
the various categories. However, it is useful for formulating the kind of argument presented above. A similar
framework with a more detailed analysis of costs is provided by the Chartered Institute of Management
Accountant' s Official Terminology (CIMA, 1996).
In management accounting, costs for decision making would require future costs and opportunity costs. This
information can be provided by a job order costing system when undertaking a 'cost estimation' exercise using
expected future costs.
Costing systems 339




Direct (Cost attachment),
Life cycle-based,


j Relevant Costing,
Marginal Costing,
Capital Budgeting,
Slrategic Value
Hybrid ·


Fig 1. Conceptual framework for costing systems

340 Sharma and Ratnatunga

method most suitable within the just-in-time philosophy of waste reduction (Shillinglaw
and McGahran, 1993).

Cost type
The 'costs' accumulated and traced under job and process costing may be measured as
historical costs actually incurred (called actual costing) or may be predetermined costs
(called standard costing) or be a combination of the two: i.e. direct material and direct
labour being 'actual' and the manufacturing overhead being 'predetermined'. Horngren
et a/., (1994) call this hybrid variant normal costing. Standard costing is used when
activities consist of a series of repetitive operations. This is not really a costing system, but
instead a means of assigning predetermined costs to products within a job or process
costing system. Standard costs are target costs set under efficient operating conditions.

Treatment of overheads

For the purposes of the first measurement category, i.e. stock evaluation, the two most
commonly used 'costing systems' employing the above two-step definition are: absorption
costing and variable costing. In addition to the direct material and direct labour costs, full
absorption costing allocates all of the manufacturing overhead (both fixed and variable) to
the cost objects. This costing approach is used for the valuation of inventories in external
financial reports, as it is consistent with the Generally Accepted Accounting Principle
(GAAP) of conservatism and does not understate the value of such inventories. The
alternative format is variable costing, which treats the fixed manufacturing overheads as
period costs and, therefore, only allocates variable manufacturing overheads to products.
This system is not used for inventory valuation, and is generally only used for short-run
internal decision making. 6

Cost allocation base

The multiple of allocation possibilities which are available with traditional costing
systems, resulted in Vatter's (1945, p. 176) identifying the need for costing systems to
develop more objective and systematic bases for the allocation of overhead. Traditional
costing systems responded by using volume related cause-effect relationships (drivers) for
the allocation of overhead in the second phase of the two-step process described earlier.
This approach was criticized by Cooper and Kaplan (1991) who showed how the
allocation of service department overhead on the basis of volume could lead to distortions
in product costs in a diverse product setting. They argued that this kind of allocation can
result in incorrect decision making by managers. Furthermore, traditional costing systems
have been identified as failing to provide relevant information on quality management,

There is considerable debate in the literature regarding the suitability of variable costing over full absorption
costing for decision making and inventory valuation. Fremgren (1964) provides a summary of the arguments. In
an absorption costing system profit figures are affected by both production and sales volumes, while in a
variable costing system these figures are affeced only by volume changes. This distorts the profit figures when
there are high fluctuations in sales and production volumes. Consetjuently, variable costing is a more relevant
measure of profit for short-run decision making purposes as it is unaffected by changes in production
Costing systems 341

inventory management, manufacturing management, and timeliness (Johnson and Kaplan,

19R7; Hendricks, 19RR; Steedle, 1988; Green et al., 1991). Another shortcoming reported
in terms of traditional costing models is the emphasis placed on GAAP, particularly that
of conservatism7 (Brimson, 1991, p. 176). These criticisms have been reported to have
resulted in a growing number of firms pursuing activity based costing (ABC) as an
alternative in a competitive marketing environment (Jeans and Morrow, 1989). 8

Cost control approach

The second measurement category for the classification of costs is for the purposes of cost
control. Cost control can be achieved by comparing expectations with actual outcomes,
and taking corrective action in areas where outcomes fall far below expectations. This
process is called 'budgetary control' in which we deal with expected future costs, or
standards for cost estimation. The subsequent corrective action process involves a
comparison of such estimates with the actual costs incurred for the purposes of pinpointing
responsibility. Traditional variants of budgetary control have been cost control approaches
such as zero based budgeting (ZBB) and planning programming budgeting systems
Within the 'control framework' standard costing has two major limitations. First, control
in this system depends heavily upon the standards which are used for comparison with
actual figures. If standards of appraisal are weak, then the results from a comparison are
unsatisfactory. Therefore, standards should be revised to reflect changes in the environ-
ment if such changes are unanticipated (Demski, 1977). Second, the standard costing
system fails to link the operational control techniques clearly with a product's strategy.
This limitation is overcome with target costing (Morgan, 1993).

Decision making and performance evaluation

The third measurement category for the classification of costs is for the purpose of decision
making. In order to make such decisions various performance evaluation criteria such as
contribution margin, profit, return on investment, residual income (EVA), NPV, etc., will
be used. Both absorption and variable costing can be used for decision making with the
incorporation of future expected costs (i.e., cost estimations and budgets). This need for
decision-oriented information has also resulted in the development of two other costing
systems: relevant costing and marginal costing. 9 A relevant costing system places an
emphasis on correct decision making, with regard to the choice among alternatives. This
involves a two-step process in which only future costs and revenues which differ between

The conservative principle requires costs to be based on verifiable data. Verifiable data is normally historical,
whereas managers require future costs for decision making. This principle also distorts life cycle costs as it
encourages the expensing of many costs when these costs should be capitalized.
Staubus (1988, p. 139) argues that the emphasis on products as objects of costing in the early cost accounting
literature might have arisen out of a misrepresentation of Clark's (1923) statement on using 'different costs for
different purposes. ' Clark recognized ' that the terminology of costs was in a state of confusion.' The generic
nature of Clark's statement might have shifted the emphasis from the products themselves to the activities that
result in the costing.
Marginal.costing is sometimes called direct costing. This view is not taken in this paper (see definition later
in the paper).
342 Sharma and Ratnatunga

alternatives are considered relevant. 10 A marginal costing system is defined as a costmg

system which includes the cost and benefits (revenues) from the production of additional
units in the decision making framework (Drury, 1996). However, both these costing
systems are difficult to operationalize in reality. For example, cost-volume-profit (CVP)
analysis, a short-term decision making tool which dovetails with marginal costing, is
limited in use to single-product firms. Dillon and Nash (1978) have shown that both
relevant costing and marginal costing can yield incorrect decisions in a world of
uncertainty where individuals constantly move along their preference functions. In
addition, irrelevant items in a relevant costing approach may become relevant when these
items are large in financial terms, especially if the behavioural consequences are
considered. Medium and long-term decision making approaches include techniques of
capital budgeting incorporating the time-value of money and strategic value analysis
incorporating life-cycle costs and revenues for the valuation of business entities.
The above discussion indicates that the term 'costing system' has been used liberally in
related but different spheres of cost accounting. However, the varying foci of what have
been termed costing systems by leading managerial accounting researchers (see Cooper
and Kaplan, 1988; Cooper, 1989, 1990) and texts (Shillinglaw and McGahran, 1993;
Horngren et al., 1994) can be conceptualized in terms of Figure 1. Essentially, Figure 1
outlines a seven step framework for integrating the costing process with decision making
and performance evaluation criteria. These seven steps entail the following: the
identification of the costing method; selection of cost type; treatment of overheads;
allocation of costs; cost control; decision making and performance evaluation. Within this
framework one could show, for instance, that the cost of a job using the absorption costing
format, incorporating standard costs, could give rise to both decision-oriented information
and subsequent budgetary and cost control information. Many other permutations are
obviously possible, and this leaves what has been identified collectively as traditional
costing systems open to criticism as being too general.
Therefore, revisiting Figure 1, activity based costing could be simply seen to represent
a cost allocation method within the costing framework. The recognition within the ABC
allocation system that activities drive costs impacts upon cost control, decision making and
performance evaluation. This has resulted in the representation of ABC as an alternative to
other 'traditional' costing systems in the management accounting literature. The debate
rarely focuses on the links between the two, especially in the different spheres in which the
traditional systems operate. Instead, ABC tends to be promoted as an entirely new costing
system distinct from other costing systems. This paper makes such links, as illustrated in
Figure 1, so that both the practitioner and the educator will not consider traditional and
ABC as being at two opposite ends of the spectrum.
The next section puts the entire debate in perspective from an educational point of view
by conducting a content analysis of some of the leading texts in management accounting.
This content analysis is conducted in order to determine the extent to which the contrasts
and linkages that other costing systems share with ABC are highlighted. Such an analysis
is necessary as it enables an understanding of the educators' viewpoint in seeing traditional

Sorter and Horngren (1962) have extended this approach to inventory valuation. Under relevant costing, only
those costs which represented 'service potential' in the form of an increase in future revenue or a decrease in
future cost were recognised in the cost of inventory. No distinction was made between the behaviour of costs
as fixed and variable.
Costing systems 343

Table 1. Evidence from managerial accounting texts

Chapters covering Chapters

Authors costing systems covering ABC Contrasts Linkages
Homgren et al. (1994) 10 2 - *
Drury (1996) 10 1 - *
Hilton (1994) 7 1 *
Atkinson et al., (1995) 4 1 *
Hansen and Mowen (1995) 6 1 *
Hurch (1994) 8 3 *
Shillinglaw and McGahran• (1993) 1 1 *
Barfield et al., (1994) 8 2 *
Maher and Deakin (1994) 18 4 *
Garrison and Noreen (1994) 11 3 - *
a Both costing systems and ABC were covered in a single chapter

costing as a precursor to ABC or, alternatively, as a means for achieving competitive


Evidence from a content analysis

The application of content analysis to leading textbooks in a discipline to evaluate trends
in emphasis is an established tool in bibliometrics. Homgren (1989) used this method to
highlight the change in emphasis of cost accounting textbooks from 1945-70.
An analysis of the current 'conventional wisdom ' as depicted in the most current text-
books in cost and managerial accounting indicates, in general, a distinct separation in the
treatment of 'traditional' costing systems and techniques and ABC systems. Table 1
summarizes the approaches taken by the various texts according to author, chapters
covering other costing systems and ABC, and chapters contrasting and linking ABC.
Chapters in texts which had (a) one or more chapters devoted to ABC and (b) one or more
sections within each chapter highlighting the overhead allocation process with ABC and
other costing systems were classified as linkages. On the other hand, chapters in texts
which (a) identified criticisms of traditional costing systems and, (b) specifically devoted
one or more section to highlighting the overhead allocation process in order to, (c)
highlight a new costing system for competitive advantage, were treated as contrasts.
Table 1 shows that there is dissension in the texts. Some have emphasized the contrasts
rather than make the links and vice versa. For instance, Homgren et al., (1994, p. 115)
emphasize the links when they note that: "ABC is not an alternative costing system to job
or process costing. Rather ABC is an approach to developing costing numbers used in job
and process costing systems. The distinctive feature of ABC is that it focuses on activities
rather than fundamental cost objects." On the other hand, Atkinson et al., (1995, p. 23)
emphasize the distinctions (or contrasts) between ABC and traditional costing systems
when they say" ... one of the central themes of this book, is the design and use of activity
based costing systems. Activity based costing is now being introduced in many
manufacturing and service organisations to overcome the inability of traditional costing
systems ·to accurately assign overhead costs." The evidence therefore does not give
344 Sharma and Ratnatunga (

unequivocal support to the notion that ABC constitutes the means for achievinog F
competitive excellence. Johnson (1992) goes further when he notes,
The widely touted cost driver systems defined under the heading of ABC is no c
more than an accounting solution to an accounting problem-distorted overhead
allocation. Improving how companies trace overhead costs may be important for c
some things, but in the guise of cost driver ABC it doesn't necessary stimulate
continuous improvement nor does it mark a pathway to competitive excellence.
(Johnson, 1992, p. 265) I-

Summary I-
This paper suggests a framework for categorizing costing systems by outlining the various I-
systems in terms of their objectives, advantages and deficiencies. A schema for integrating
the costing process within decision making and performance evaluation criteria is then I-
conceptualized. The role of ABC is recognised and integrated within this framework.
It is observed that a significant portion of the current managerial accounting literature I-
contrasts ABC systems over the more traditional cost accounting systems. This paper
questions this tendency of making such a stark contrast by placing ABC systems within a
wider cost accounting framework. J

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