INTEGRATED ABC WITH ECONOMIC VALUE ADDED
BY
KHALED SAID MOHAMED HUSSAINEY
A Dissertation submitted for the degree of Master of Social Science
Department of Accounting and Finance
Faculty of Commerce and Social Science
The University of Birmingham
September 2000
Abstruct--------------------------------------------------------------------------------------2
DECLARATION-------------------------------------------------------------------------------3
Acknowlegements---------------------------------------------------------------------4
CHAPTER 1-------------------------------------------------------------------------------------------- 6
INTRODUCTION--------------------------------------------------------------------- 6
1.1 Background---------------------------------------------------------------------- 6
1.2. The purposes of dissertation------------------------------------------------- 11
1.3. Organisation of dissertation------------------------------------------------ 11
CHAPTER 2------------------------------------------------------------------------------------------ 12
ACTIVITY BASED COSTING------------------------------------------------------------------ 12
2.1. Traditional cost systems----------------------------------------------------- 12
2.2. The need to ABC system:------------------------------------------------------ 14
2.3. The nature of ABC------------------------------------------------------------- 16
2.4. The advantages of ABC system---------------------------------------------- 19
2.5. The limitations of ABC system----------------------------------------------- 21
CHAPTER 3------------------------------------------------------------------------------------------ 23
ECONOMIC VALUE ADDED------------------------------------------------------------------ 23
3.1. The meaning of EVA----------------------------------------------------------- 23
3.2. Applying EVA as a performance measurement----------------------------- 25
3.3. The advantages of economic value added---------------------------------- 29
3.4. The disadvantages of economic value added------------------------------- 31
CHAPTER 4------------------------------------------------------------------------------------------ 34
INTEGRATED ABC WITH EVA--------------------------------------------------------------- 34
4.1. The need for the integrated system------------------------------------------ 34
4.2. Applying the integrated system---------------------------------------------- 36
4.3. Case study---------------------------------------------------------------------- 39
4.4. Benefits from the integrated system---------------------------------------- 42
4.5. The disadvantages of the integrated system------------------------------- 42
CONCLUSION--------------------------------------------------------------------------------------- 44
BIBLIOGRAPHY---------------------------------------------------------47ABSTRACT
Product costing information is useful for decision-making process. Companies can use either variable cost system or full cost system to determine the cost of each product. Companies need to use full cost system to consider both variable and fixed manufacturing costs.
In the 1980s, some companies change their cost system from the traditional cost systems, which use volume related measures to activity based costing (ABC). This change helps companies to gain more accurate product cost information. Although ABC corrects the arbitrary allocations of factory overhead to products, it fails to account for capital cost. For this reason, product cost information under ABC system still tends to underestimate the total product costs.
In order to improve product-costing information obtained by ABC system, it is argued that ABC system should be combined with economic value added (EVA), so that the cost of capital can be considered. Integrated ABC with EVA will improve cost system that helps managers to focus on all the necessary elements of creating value, including the management of both costs and capital.
Declaration
I declare that no portion of the work referred to in the dissertation has been submitted in support of an application for another degree or qualification of this or any other university or other institute of learning.
Acknowledgements
I would like to thank my god for giving me all the strength I needed to finish my dissertation.
I am indebted to my personal tutor and the supervisor of my dissertation Mrs. Amanda Nayak. Her invaluable guidance, comments, encouragement, and assistance were the most contributing factors for the completion of this dissertation.
I am pleased to thank my friends, Mr. Hesham El-Beshbeshy and Mr. Hafedh Ba-Omar, for their helpful assistance.
I would like to thank all staff in the Department of Accounting and Finance for their helpful assistance and kindness during my study.
Finally, I am gratefully acknowledging the financial support from the Egyptian Ministry of Education.
Deduction to:
My beloved wife, Nahla
my lovely son, Yasser,
my brothers, sisters,
and my Parents.
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CHAPTER 1
INTRODUCTION
The increasing competition in the global markets has highlighted the significance of using new management accounting techniques, such as activity based costing (ABC) and Economic value added (EVA), to react quickly with today’s highly competitive environment.
This chapter introduces the background of the dissertation, which includes the importance of product cost information, and the methods used by companies to calculate product cost. Also, it introduces the purposes of this work, and the organisation of the whole dissertation.
1.1 Background
Product costing information is an important factor in decision-making process. It is useful for setting prices,” particularly for customised products with low sales volumes and without readily available market prices “(Cooper & Kaplan, 1998, p.20).
Moreover, product-costing information can be used in planning and control process. It provides useful information that enables managers to set their long and short-term plan or budget. It informs management about the success or failure of their operations by comparing the actual cost at the end of the financial accounting period against the planned cost expressed in the detailed budget for manager to follow.
Furthermore, product cost information helps managers to assess the profitability, effectiveness, and efficiency of their companies. It serves a number of purposes including determining optimal product mixes, determining preferred channels of distribution, managing customers relations, placing values on stock, making investment in value added activities, accept or reject prices set by the market, identify product characteristics, and identify resources used by different products.
There is a disagreement exists in accounting literature about whether product costs should be measured by variable or by full cost system. In variable cost system, fixed costs are not allocated to products, and product costing reflects only the marginal cost of manufacturing. There are many benefits derived from variable cost system which are: Firstly, it provides more useful information for some aspects of the decision making process. This is because the separation between fixed and variable costs helps to provide relevant information about costs for where changes in volume or capacity use are being considered. Variable costs and changes in fixed costs are important for short-term decisions such as whether to purchase a component internally or externally, whether to accept or reject a special order, and whether to continue to produce a product or discontinue to produce it.
Secondly, Drury (1994, p.202) argued that variable costing removes the effect of stock changes from profit. This is because profit is a function of sales volume with variable costing, whereas it is a function of both sales and production with full absorption costing. Also, he stated that under absorption costing, “ it is possible for profit to decline when sales volumes increase. Where stock levels are likely to fluctuate significantly, profits may be distorted”. This is because changes in stock levels will affect the amount of fixed overhead charged in the income statement.
Finally, variable-costing system avoids the arbitrary and unrealistic allocation of fixed overhead to products. Also, it is argued that allocation of these costs is expensive and may be time consuming; therefore, these costs and time consuming can be avoided by using variable cost system.
Despite all of these advantages of variable costs, many companies use full absorption cost systems. Under these systems, overheads of a period are absorped to units produced during that period and, if those units are not sold, part of the fixed overhead will carry into the next period inside the cost of finished goods stock. There are many arguments support full absorption cost systems as follows:
Full absorption costing is considered more appropriate than variable costing for certain purposes. This is because it is impossible to produce products, if fixed manufacturing costs are not incurred. Therefore, it is necessary to include the full cost of production and other services used to make a product in the cost of that product carried forward and set against revenue from its sale. Also, it helps to avoid reporting untrue losses by deferring and including fixed overhead cost in the closing stock valuation, and it will be recorded as an expense only in the period in which the goods are sold. When companies were largely labour intensive, the cost of direct labour and materials were a large percentage of factory costs and factory costs were a large percentage of all costs. Therefore, they use the traditional costing systems that use volume related measures, such as direct labour hours or machine hours, to allocate overhead costs to products in proportion to the number of units produced of the individual products.
More recently, new manufacturing technologies, such as automated or/and computer-assisted production line are used in manufacturing. In order to justify the use of these technologies, companies require high volume which leads to considerable cost of selling, customer support, and advertising operations in other countries and so on. Also, other kinds of indirect costs are increased to support these technologies such as the salaries of computer programmers. Therefore, direct labour cost is decreased dramatically. It represents a small percentage of total overhead costs. As a result, if companies continue to use the traditional systems, it may produce distorted cost information, because under these systems, many administrating and selling costs were not allocated to products. As a result, managers may make incorrect decisions.
Because of the deficiency of the traditional cost systems, some companies change their cost system from full absorption cost to activity based costing (ABC). ABC is valuable system. It is used to allocate and assign the overhead costs, including administrating and selling costs, to products in a fair way, and with an appropriate proportion. It is based on activities rather than products and it makes a link between the cost of activities and the products or services produced by suitable cost drivers. Therefore, ABC system provides companies with more accurate product costs, which enable them to determine the actual price for their products or to produce realistic product costs to prices produced by the market. There are many benefits of using ABC system, for example, if the company has an actual product cost, it can determine the actual price for that product, and it will be more competitive in the market than other companies, which use the traditional cost systems.
Despite the advantages of ABC system over the traditional cost systems, there are also many disadvantages of using ABC system. An important one is that ABC fails to account for cost of capital (Roztocki & Needy, 1999). ABC traces only the operating costs and expenses, stated in the income statement, to products or services. It ignores the financial data given in the profit and loss account and balance sheet. Therefore, ABC system produced cost information that still not expresses the actual cost of products.
To solve the previous problem, Hubbel (1996), Anctil et. al. (1998), Cooper & Slagmulder (1999), Kaplan & Atkinson (1998), and Roztocki and Needy (1999) stated that ABC should be integrated with economic value added (EVA) in order to consider the cost of capital beside the operating costs.
EVA is a financial performance measure that estimates the economic profit of companies. It corrects the potential distortion caused by generally accepted accounting principles (GAAP) by identifying over 160 accounting adjustments to (GAAP) in order to produce an effective indicator of the performance of the company. It charges profit for the cost of both debt and equity capital employed in the company.
Combining ABC with EVA helps companies to identify the actual cost of products. It also guides companies to determine the economic return of products, customers, and distribution channels. Moreover, it will help managers to manage costs and capital, improve process, and create shareholders value.
1.2. The purposes of dissertation:
The purposes of this dissertation are; first of all, to highlight the limitations of the traditional cost systems, to discuss the nature of ABC system, and to determine the advantages and disadvantages of ABC system.
Secondly, it will study the meaning of EVA as a performance measure technique, followed by the adjustments to GAAP- based accounting advocated by Stern Stewart to calculate EVA, and the argument against and for EVA.
Lastly, it will discuss the proposed ABC and EVA system, the procedure for implementing it, its importance, benefits, and limitations.
1.3. Organisation of dissertation:
In order to provide comprehensive information, the outline of the dissertation is as follows. The first chapter is an introduction that discusses the meaning of ABC, EVA, the reasons for integrated ABC with EVA, and the purposes of the study. Chapter two will discuss the nature of ABC system. In the third chapter, using EVA as a performance measurement technique will be examined. In chapter four, an integrated ABC and EVA system will be explained with a case study. The final chapter will represent a summary of the main finding and concluding remarks.
CHAPTER 2
ACTIVITY BASED COSTING
Product costing is the source of one of the longest running controversies in management accounting. The major controversy is that whether product costing should be calculated by variable cost system or by full cost system.
This chapter will discuss the arguments for and against each system. Also, activity based costing, as a full absorption cost system, will be clearly explained in more details.
2.1. Traditional cost systems:
Traditional cost systems use a few general bases to allocate the overhead costs to products. They fail to categorise overhead costs into detailed cost pools. They use only one or few cost drivers, such as machine hours, units produced or materials processed, to allocate overhead cost to products. Moreover, they often use financial cost allocation bases such as direct labour costs or direct material costs. On the other hand, Cooper and Kaplan (1998) argue that product line and marketing channels have proliferated. Therefore, direct labour or direct material cost will be represented a small percentage of company costs and it is impossible to depend on these bases to allocate overhead costs. In other words, if companies depend on direct labours base (for example) to allocate their overhead costs, the resulting cost information may be distorted.
There are many arguments against traditional cost systems in that they provide managers with an incorrect product cost and might lead them to make wrong decisions about pricing, or any relevant decisions. Another argument is that, “ any product that is overcosted by the traditional cost systems may be priced too high, resulting in loss of market share"(Horngren, 1999,p.367). Furthermore, it is argued that arbitrary allocating overhead costs distorts the product cost so that some products appear unprofitable although in fact discontinuing them will lead to loss of a highly valued channel or customers (Walker
There are a number of indicators that indicated the problems with the company’s cost system (Adler, 1999). The first indication is that difficult -to- produce products show high profit margins even though they do not command a premium price. These kinds of products consume a greater proportion of total manufacturing overhead than less difficult -to-produce products. However, traditional cost systems do not reveal this products behaviour. The second one is that when product profits margins cannot be easily explained. The third one is when managers are unable to predict the results of competitive prices. The fourth one is that when the company’s high volume products are being priced by competitors at what company believes to be unrealistically low levels. The fifth one is when a decision is made to outsource parts, which were previously made in- house, and the customers’ price are lower than expected. The sixth one is when customers ignore price increase, even when there is no corresponding increase in cost. Finally, cost system might be provided incorrect cost information when products or services appear to be unrelated to the company’ core competencies.
From the previous indications, it may mean that where they occur, traditional cost systems do not allocate overhead costs to products in the actual proportion in which they are consumed. Therefore, they produce wrong information, which leads managers to make wrong decisions.
Many researchers argued that companies must change their cost system from the traditional cost system to activity based costing (ABC). This is because ABC system can provide companies with more accurate product cost.
2.2. The need to ABC system:
In addition to overcome the limitations of the traditional cost systems, companies can use ABC system, which provide them an accurate product costing. There are some factors that indicate the need to ABC system. These factors are:
(1) The overhead costs are becoming a large percentage of total product cost. Adler (1999,p.43) argued, “When the amount of overhead to allocated represents only a very small percentage of a product or service’s total cost, then the chance for cost distortions is similarly small. However, as the overhead percentage to total cost increases, so too does the chance for cost distortions”.
(2) Companies produce multiple products or services. Furthermore, their production uses many common resources, and the products consume the resources in different proportions. In these cases, companies are more likely to face cost distortions.
(3) There are high levels of competition in the market. Because of the incorrect information resulting from the traditional cost systems, companies need a new cost system, which enable them to determine the actual product cost and the actual price to continue in the competitive environment.
In his study, Krumwiede (1998) gave certain factors that appeared to separate those who adopted ABC from who did not. These factors may also enhance the need for ABC system. These factors are:
(1) Potential for cost distortions:
The study shows that many ABC adopters (71%) had above -average cost distortion potential versus only (39%) of non-adopters. It is meant that the higher the potential for cost distortions, the more motivated an organisation may be to adopt ABC. Also, It is stated that the percentage of overhead costs to total production costs is differed between ABC adopters (32.8%) and non-adopters (28.7%).
(2) Decision usefulness of cost information:
It is observed that the percentage of decision usefulness is higher for ABC adopting companies (65%) than non- adopting companies (54%). It is meant that companies that basically depend on the cost information in taking their decision, they tend to use ABC to obtain more accurate cost information.
(3) Lack of system initiatives:
It is argued that system initiatives can impede implementing ABC for two reasons. First, implementing ABC can take considerable time and effort. If the focus is on other important system enhancements, fewer resources are available for the ABC project. Second, because of detailed information required by ABC system, many companies may wait until supporting systems are improved or replaced.
The study shows that only 7% of ABC adopters report major system or software initiative occurring whereas the percentage of non-adopters is 15%.
(4) Size of the organisation:
It is observed that ABC adopters tended to be larger on average than non- adopters.
The study stated that adopting firms had average sales in the $101-$500 million range versus $51-$100 million for non- adopters. This is because large companies have more resources available than the small ones. Also, they may produce more products with high proportion of overhead and be more distant from the operations of the business.
Therefore, large companies tend to use ABC more than the small ones. On the other hand, some researchers such as (Hicks, 1992&1999), (Benjamin et al, 1994), and (Needy and Bidanda, 1995) argued that it is possible to implement ABC for small business as well as large business.
2.3. The nature of ABC
Activity based costing (ABC) is new system developed by Kaplan and Cooper to assign overhead costs to products and services in an accurate way. It is more realistic, compared with the traditional cost systems, because it assumes that activities cause costs and the cost objects (products or services) create the demand for activities. On the other hand, the traditional cost systems assume that products cause cost, not activities (Turney, 1996).
There are two main stages to implement ABC system. Identifying the activities of the company and assigning the indirect resource expenses to these activities is the first stage. In the second stage, ABC system traces activity costs to products by identifies a suitable cost driver for each activity and using the following equation:
(The quantity of each cost driver * Standard cost driver rate).
To implement the first stage successfully, companies should identify their activities effectively. There are two types of activities. The first one is the direct activities, which are directly concerned with the production generation or service provision process. The second one is the indirect activities that support direct activities and may be products, or customer. It is argued, “the activities chosen should be at a reasonable level of aggregation based on costs versus benefits criteria” (Drury, 1997, p.111).
In the second stage, the designers of ABC system can choose from different kinds of activity cost drivers to use them to allocate the cost of activity to products. There are three types of cost drivers. The first one is the transaction drivers such as; the number of set-ups, the number of receipts, and the number of product support. The second type is the duration drivers, which reflect the amount of time required to perform any activity. They should be used when significant variation exists in the amount of activity required for different products. The obvious example of duration drivers is set-up hours, which used to allocate the cost of set-ups to individual products. The last one is the intensity drivers that directly charge for the resources used each time, an activity is performed. Some complex products, for example, have special requirements such as “special set up and quality control people, as special gauging and test equipment each time the machine is set up to produce the product “(Kaplan, Atkinson, 1998,p.109). Therefore, intensity drivers are suitable for these kinds of products. There are some factors must be taking into consideration when the Company selects a suitable cost driver. Firstly, it should provide a good explanation of costs in each activity cost pool. Secondly, it should be easily measurable with a reasonable cost. Finally, the data should be relatively easy to obtain and be identifiable with products or services (Drury, 1997).
Horngren (1996, p.150) has recognised that “the driver of many costs in organisations is units of output”. However, some kinds of costs are not driven by output units. Therefore, it is stated that costs could be categorised into hierarchy of different costs. There are four levels of manufacturing costs/activities as the following:
(1) Unit-level activities/costs; they are represents the work performed for every unit of product or service produce. Cost drivers for unit-level activities include labour-hours, machine hours, and material quantity processed.
(2) Batch-level activities/costs; these costs are independent of the number of units in the batch. They include activities such as setting up a machine for new production rum, purchasing materials, and processing a customer order and so on.
(3) Product sustaining or customer sustaining activities/costs; these are performed as needed to support the production of each different type of product. Also, customer-sustaining activities which represent work that supports the company to sell to an individual customer, but that is independent of the volume and the products and services sold and delivered to the customer. There are many activities reflect these costs such as; maintaining and updating product specifications, special testing and tooling for individual products and services, and customer market research and support.
(4) Facility sustaining activities; these are supported a facility’s general manufacturing process.
Many companies have implemented ABC system successfully. They obtain multiple benefits from this system. On the other hand, other companies fail to implement this system. In the next section, the advantages and the limitations of this system will be illustrated.
2.4. The advantages of ABC system
The implementation of ABC system is said to be capable of generating multiple benefits for any company. The most important one is that it produces more accurate product cost. This means that product cost will be an actual cost, because ABC allocates overhead costs in actual way for each product. This information helps managers to better plan and control costs and helps them to make good decision about pricing. If managers have actual costs for products, they can give an actual price for these products. That is meant that company’s profit will be an actual profit. Moreover, actual costs help accountants to prepare the financial statements correctly, because product costs affect some numbers in the financial statement such as the cost of goods sold in the income statement, the stock value in the balance sheet. Therefore, Innes and Mitchell (1990) argued that ABC would enhance the creditability of cost information, its comprehension by management, and its perceived usefulness.
ABC helps managers to make strategic decisions. For example, if the company wants to know whether to produce a specific product or not, it can calculate the actual cost by using ABC and then it can calculate its actual profit. By actual profit, managers can know whether this product is profitable or not, then they can decide to produce or not to produce this product.
The knowledge of cost behaviour from cost driver analysis enables companies to prepare activity based budgeting (ABB) approach. It gives a clear picture of how cost is generated and how it may be more effectively controlled. This information is useful for budgetary planning and control.
ABC helps engineers to redesign products. Kaplan (1998,p.161) argued, “ Many products are expensive because of poor product designs. Without an ABC system to guide their product design and product development decisions, engineers ignore many of the costs of component and product variety and process complexity". The ABC analysis will identify whether activities added value to products, services, customers, and markets. It guides managers to make investment in those value-added activities that support products, customers that will increase shareholder value (Ward & Patel, 1990). Also, it identifies non-value added activities helps them to look for ways in which they can be eliminated. Also, the availability of cost driver rates might have an impact on the design of new products and resulted in modification to the design of existing products.
Cashell and Presutti (1992) argued that implementing ABC system would provide internal auditing with an improved basis for monitoring and investigating the efficiency of manufacturing operations. Therefore, ABC system can significantly enhance the effectiveness and efficiency of internal auditing.
It is argued “ABC has stressed managers to manage costs by overseeing activities instead of products. The accounting for costs by activities highlights the interdependencies among activities in many departments and functional areas. For example, the total costs of a company may be affected by how design, engineering, manufacturing, and marketing activities interrelate” (Horngren, 1995, p.283).
Finally, Innes and Mitchel (1990) stated another benefit that the cost driver rates could be monitored over time to highlight where cost changes were occurring in order to assist to improve cost in those products which were less cost effective.
2.5. The limitations of ABC system:
It would be fair to say that ABC system or any other costing approach cannot generate true costs but only costs that are more accurate within an alternative managerial logic. There are many arguments against implementing an ABC system. The most obvious problem with ABC system is that it is more complex and very expensive to implement. That is because identifying the activities of the company especially the large one and determining the suitable cost driver for each activity will take a lot of effort and a lot of money. Also, it takes a lot of time to change from the traditional approach to ABC system.
Bhimani (1994,p.86) argued that “although ABC software packages are sold over a range of prices tied to degrees a complexity and functions, a wide array of other costs are implicated, including training of staff, design and data gathering and ensuring acceptability of a system change.”
Another limitation is that there are some activities not directly associated with products or customers. "Activities that sustain plant, for example, are very difficult to assign to product. Such activities include cleaning, securing, and landscaping the plant"(Turney, 1996, p.59). It is impossible to assign these costs to products. For example, it is impossible to calculate, for example, the cleaning cost for each product. These costs can be assigned by arbitrary traditional cost systems.
One further problem with ABC system is that it stills an arbitrary cost allocation system. This problem is particularly happened when joint costs or sunk costs are involved. Cost- causing activities in these cases cannot always identify. Also, ABC system uses arbitrary time period in calculating costs. This is because measuring the profitability of a product over its life cycle may be preferable, but companies cannot wait until the end of product life cycle to evaluate its cost behaviour and profitability. Moreover, it is argued that “ABC is primarily an internal cost system and other activity-based techniques have a similar internal orientation”(Friedman & Lyne, 1995,p.18). ABC system provides information, which encourages the decision-makers to focus on internal activities of the firm rather than direct their attention externally to the competitive market environment.
Finally, ABC system focuses only on the operating and expenses costs stated in the income statement. It fails to account for the cost of capital. It ignores the financial data given in the balance sheet. It considers only one part of capital cost, which is depreciation. On the other hand, other parts of capital costs are not considered. Therefore, ABC system might give wrong information about the actual cost for each product and might lead managers to make inappropriate decisions.
CHAPTER 3
ECONOMIC VALUE ADDED
Performance measurement system is a subsystem of management control systems. Managers want to ensure that resources are obtained and used efficiently and effectively within the organisation’s objectives. It argued that performance measurements reflect the organisational culture and philosophy and describe how well work is done in terms of cost, time, and quality. A large number of criticisms are issued for the traditional performance measurement techniques such as; return on investment (ROI), return on assets (ROA), and residual income (RI).
Tatikonda et al (1988,p.49) stated that “ traditional performance measurement techniques are criticised for being obsolete, irrelevant to managerial decision making, unrelated to strategic objectives, too late, too aggregated, and detrimental to organisational improvement”. Therefore, companies must search for new performance measurement techniques to be able to continue and succeed in the competitive environment.
3.1. The meaning of EVA:
Economic value added (EVA) is the registered trademark of Stern Stewart & Company for their version of residual income (RI). It is a measure of financial performance that helps companies to calculate their economic profit. It combines the usual concept of residual income with principles of modern corporate finance. It charges profit with the cost of all the capital employed by the company. It is argued that if a company’s return on capital is greater than its cost of capital, it is creating true value for the shareholder (Dierks & Patel, 1997). Therefore, companies must try to improve their performance in order to increase their EVA and, as a result, increase their shareholders’ value.
EVA is simply after-tax net operating profit minus an appropriate charge for the opportunity cost of all capital (both debt and equity) invested in the company. Therefore, it is considered that EVA is an estimation of true economic profit.
EVA consists of two components. The first one is net operating profit after tax but after tax. and the second one is the capital charged. It is not constrained by the generally accepted accounting principles (GAAP) that govern corporate financial reporting. It corrects the potential distortions caused by GAAP by adjustments advocated by Stern Stewart. The net income figures reported in company income statement consider only the most visible type of capital cost which is interest on debts, while it ignores the cost of equity finance. Financial accountants do not measure the cost of finance provided by the company’s shareholders because these costs, like all opportunity costs, cannot be observed directly. Although estimating the cost of equity depends on subjective methods, (Epstein & Young, 1999,p.46) argued that measures of performance that ignore such costs can not reveal how successful a company has been creating value for its owners.
EVA can be calculated by the following formula;
EVA = Net Operating Profit After Tax (NOPAT)- (Capital* The Cost Of Capital)
From the previous formula, the capital charge equals a company’s invested capital or capital employed times the weighted- average cost of capital. It is the required cash flow to compensate debt and equity investors for bearing risk of the business given the amount of capital.
Before implementing EVA, companies must understand and implement the concepts of equity equivalent reserves or EEs. Equity equivalent are adjustments that move the standard accounting book value into “economic book value, which is a truer measure of the cash that investors have put at risk in the firm and upon which they expect to accrue some returns”(Stewart, 1991,p.91).
3.2. Applying EVA as a performance measurement:
Stern Stewart has identified over one hundreds and sixty accounting adjustments to generally accepted accounting principles (GAAP) in order to produce a more economically meaningful version of residual income which serves as an effective indicator of the performance of the company. However, not all of these adjustments are required for each company. Dierks (1997,p.53) stated that “only about 20 to 25 have to be addressed in details, and only a portion of these actually may be made in practice. Stewart (1994) stated that only from 5 to 10 key adjustments are actually made in practice.
Stewart (1994, p.74) recommended that “adjustments to EVA should be made in those cases that pass four tests or questions as follow: Is it likely to have a material impact on EVA? Can the managers influence the outcome? Can the operating people readily grasp it? Is the required information relatively easy to track or derive”. In other words, adjustments to GAAP should be made only if the amounts are significant, there is an opportunity to influence the outcome by managers, the non-finance professional can easily understand them, and the required information is readily available.
EVA adjustments aim to produce a performance measure that encourages managers to behave like owners (O’Hanlon& Peasnell, 1998). Also, Young (1999) stated that EVA tries to produce a performance measure that is closer to cash flows, and therefore not subject to the distortions of accrual accounting. It removes the arbitrary treatment between investment in tangible assets, which are capitalised, and intangible assets, which are written off as incurred. It prevents the amortisation, or writes off of goodwill. It eliminates the use of successful efforts accounting method in the petroleum companies. It brings off-balance sheet debt, such as leased assets, into the balance sheet. Finally, it corrects biases caused by accounting depreciation.
It is necessary to adjust the NOPAT and capital components of residual income for accounting distortions. Biddle et al (1999) argued that some adjustments reverse the effects of traditional accounting accruals, such as eliminating deferred tax accounting. Other adjustments switch accrual methods, for example; moving inventory calculation from LIFO to FIFO. And finally, there are others still introduce new accruals not used in the GAAP, such as; capitalisation and amortisation of marketing and research and development (R&D) expenditures.
There are many examples of EVA adjustments; O’Hanlon and Peasnell (1998) argue that there are three purposes of these adjustments, which are;
1) To undo accounting conservatism.
2) To discourage earnings management.
3) To immunise performance measurement against past accounting errors.
Actually, Stewart proposed some adjustments that can be removed the accounting conservatism. Here are some examples to support this purpose. The first one is the capitalisation of all intangible investments such as goodwill, R&D and marketing costs. The aim of this treatment is to treat the intangible assets in the same manner as tangible assets. This treatment might be moving the book value of the business closer to its economic value. Also, it is used to “avoid penalising managers at the time of investment decision, without going so far as to credit the value of future (undelivered) performance to the managers at that time (O’Hanlon and Peasnell, 1988, p.430). Goodwill, for example, can be treated in different ways between countries. Some countries, such as USA
The second adjustment, which removes accounting conservation, is related to the treatment of oil and gas exploration expenditures. Petroleum companies use successful efforts’ methods of accounting for oil and gas exploration, which means that only the costs of successful exploration are capitalised and placed on the balance sheet. On the other hand, Stewart (1991) argues that the costs of unsuccessful exploration (those with no economic quantities of oil and gas) represent of the true cost of discovering productive fields and that such costs should therefore be capitalised rather than expensed.
The third adjustment is deferred taxes that are treated as an asset and/or liability under GAAP. On the other hand, Stewart is opposed to this treatment for two reasons. “First, accounting for deferred tax liabilities can give rise to conservatism, since deferred tax balances may be expected to be paid so far in the future as to have a present value close to zero. Second, such accounting reduces managers’ incentives to engage in efficient tax planning” (O’Hanlon& Peasnell, 1998, p.431).
The fourth adjustment is that the capitalisation of interest in order to encourage managers to invest in assets which will not immediately generate profit. There are also some examples of adjustments advocated by Stewart to reduce or eliminate the opportunities open to management to smooth accounting profits. The treatment of provisions for warranties, bad debts, and inventory obsolescence are considered on an accrual accounting basis. It is meant that companies make provisions for costs that are expected in the future as a result of decisions that have already taken. To calculate EVA, Stewart suggested that only cash flows should enter into the calculation of NOPAT. Therefore, increases in provisions are added back to NOPAT, while decreases in provisions are subtracted. This EVA treatment tries to reverse accruals to reflect cash basis reporting.
Furthermore, Stewart suggested many adjustments to eliminate the possibility of accounting distortions. He stated that, for example, companies must convert inventory-costing calculation from last in, first out (LIFO) to first in, first out (FIFO). Although LIFO gives companies an important tax advantage over other costing methods, it is not preferable for EVA calculation. This is because it understates net assets and invested capital. Also, it will overstate the operating income when the company sells its old inventory. This is because the company matches old product costs against current revenue. As a result, it is important for companies to use FIFO instead of LIFO when they calculate EVA.
As it is stated before, there are more than 160 adjustments to calculate EVA, but it is not necessary for companies to implement all of them to calculate EVA. This is because accounting adjustments from GAAP is more expensive because of the following reasons;
“First, litigation risk is increased, because the adjustments can be interpreted by outsiders as an indication that the official financial statements are not really true and fair. Second, accounting systems become more complicated and costly to administer.
Third, the accounting system becomes more difficult for operating managers to comprehend. And finally, it undermines employee confidence in the veracity of the figures and reports produced by the accounting system” (Young, 1999,p.9).
Because of the criticisms stated above, companies must determine the suitable adjustments that give them the true EVA calculation with reasonable costs.
3.3. The advantages of economic value added:
EVA can generate several benefits for companies. It overcomes the problems in the traditional approaches such as return on investment (ROI). ROI encourages managers to focus on the short run at the expense of the long run. It also discourages them from investing in projects that would decrease their divisional ROI but would increase the profitability of the company as a whole. On the other hand, EVA corrects the accounting distortions by the accounting adjustments stated by Stewart. It encourages managers to think and act like owners and increase the profitability of their division as well as the company as a whole.
In principle, it is easy to calculate and simple to understand by non-financial managers. This is because it depends on simple concepts such as operating profits and the capital charging. Therefore, it is argued that EVA makes managers care about managing assets as well as income, and helps them to assess the tradeoffs between the two concepts.
Stewart considers that EVA is the only true indicator of business and management performance. It allows all financial decisions to be modelled, monitored, evaluated, communicated, and compensated in terms of single measure. It helps managers to incorporate two basic principles of finance into their decision-making. The first one is the maximisation of the wealth of shareholders. The second one is that the value of a company depends on the extent to which investors expect future profits to exceed of fall short of the cost of capital.
In his study, McLaren (1999) stated some reasons for implementing EVA, and asked a sample of companies to rank them according to their importance. The study gives the result that the most important factor for the introduction of EVA was found to be aligning managerial and shareholder objectives. Therefore, EVA is considered as a tool for reducing conflicts of interest between the principles outside the company and the agents within the company.
EVA is linked to managerial bonuses in order to provide managers with the incentive to behave and be paid like owners. Also, it gives them the incentive to take a corporate perspective. Therefore, EVA-incentive schemes are better tool in motivating managers to create shareholder value.
EVA can be used as a tool for planning purposes (capital budgeting and operations). Also, it can be used for control process by evaluating performance from operations and capital budgets and then determining remuneration.
EVA can be used to improve share price growth, explain stock returns and firm values better than traditional GAAP based accounting earnings.
It is argued that EVA is sensitive to all the decision within the company. For example, investment decisions affect EVA directly, and dividend decisions affect EVA indirectly through the cash balance. They are affecting the return on capital as a component of EVA. Also, the financing decisions affect the cost of capital.
Finally, EVA is used as a basis for decision making at all levels in the company. Dierks, et. al. (1997) argued that EVA provides a simplistic means of assessing the alternatives under review because they are three means of rising a company EVA:
1) Raise profit levels without raising the amount rising the amount of capital spend.
2) Use less capital by improving the way in which business run
3) Invest capital in high return projects.
3.4. The disadvantages of economic value added:
Despite EVA’s advantages as a performance measure, there are many disadvantages on implementing EVA. It is an absolute measure of profitability. It is more difficult to compare among companies or businesses units of different sizes or different levels of investment. Also, it does not control for size differences across divisions. In other ward, the large division will tend to have a higher EVA compared with the smaller one.
Calculating EVA depends on numbers that derived from financial accounting methods of revenue and expense recognition. Managers can manipulate these numbers in order to achieve specific results. For example, Brewer, et al. (1999) argued, “managers might decide not to replace completely depreciated assets. Keeping the outdated equipment on the accountant’s books lowers he asset base and ensures that no depreciation expense charges are recognised, thereby increasing EVA”. On the other hand, if the company use the outdated equipment, the production might be with low quality and not satisfy the customers’ satisfaction.
Keys et al. (1999) stated some limitations on EVA. It is argued that it does not measure economic value or economic profit as sated by Stern Stewart. This is because the meaning of each concept is differed from what measured by EVA. Economic value is the expected future cash flows discounted at the cost o capital, but EVA does not measure present or future cash flow, it measures only past accounting net income.
Implementing EVA requires over 160 accounting adjustments to GAAP. Therefore, EVA may require additional administration costs to calculate. Also, accounting systems will become more complex when considering EVA adjustments.
Another limitation of EVA adjustments is that they give managers the opportunity to manipulate. They will be able to “make accounting judgement that will enhance their performance evaluation” (Keys, et. al., 1999,p.32). Managers can capitalise, for example, some kinds of expenditures that might have no future value such as research and development expenditures.
EVA focuses only short –term profitability. This is because NOPAT is prepared for short period, such as one month, one quarter, or one year. Capital is measured at the historical cost and his cost may be irrelevant for decision-making process. Therefore, it is argued that EVA is inadequate as a single measure for any decision. Companies must use other techniques beside EVA to consider both short and long-term profitability.
Finally, “EAV does not account for real options (growth opportunities) inherent in investment decisions. The market value of a firm’s securities reflects the market’s perception of the value of those growth opportunities. But EVA does not reflect this information” (Dierks and Patel, 1997,p.55). Therefore, it is argued that managers can use both EVA and market value added (MVA) to evaluate performance. EVA and MVA will help companies to account for both short and long term change in value.
CHAPTER 4
INTEGRATED ABC WITH EVA
Product costing is needed to guide managers to make various decisions such as pricing, identifying product characteristics and so on. ABC traces only the manufacturing, administration, and selling cost to products. It provides companies with more accurate cost information than other absorption cost systems (traditional cost systems). On the other hand, it ignores the cost of finance. Therefore, when managers use ABC cost information alone, the product cost information may still incorrect. As a result, some authors have recently proposed that ABC can be integrated with the economic value added (EVA) in order to consider both the operating costs and the capital costs associated with each product or service.
To explain clearly the integrated ABC-EVA system, I will use a numerical example adopted from Hubbell (1996), with some changes when I feel appropriate.
4.1. The need for the integrated system:
In order to obtain an accurate product costing, some companies change their cost system to activity based costing (ABC). It is argued that ABC system corrects the arbitrary allocation of factory overhead to products and the failure to assign other indirect expenses to products and customers (Kaplan & Atkinson, 1998).
Unfortunately, ABC has been criticised because of the cost of capital. It seems that ABC emphasises only on operating cost and expenses given in the company’s income statement. It fails to account for the full cost of capital. However, many activities consume not only resources but also capital investment. Therefore, the actual cost for many activities will be higher than the cost calculated under ABC system. As a result, ABC tends to underestimate the product or service costs.
In other words, implementing ABC alone within the company will lead managers to make wrong decisions. This is because the resulting product costs under this system might be incomplete.
In an attempt to reduce the critiques over ABC system, Hubbell (1996), Anctil et al. (1998), Cooper & Slagmulder (1999), Kaplan & Atkinson, 1998), and Roztocki & Needy (1999) recommended that ABC can be integrated with economic value added (EVA) in order to help managers to manage costs and capital.
The basic ABC based EVA of a product is given by the following formula:
ABC-EVA = Revenue – [ABC cost +{capital employed *cost of capital}]
Cooper and Slagmulder (1999, p.16) give a simple example to illustrate the importance of the integrated system by considering two products. The first one has an ABC cost of £30 and it requires capital employed of £100. The second one has the same ABC cost, but it requires capital employed of £1000. Both of products are sold at the same price, which is £100. Assuming that the cost of capital is 10%, using the integrated system shown that the first product has a positive EVA of £60 [100-{30+100*.10}], whereas the second one has a negative EVA of £30 [100-{30+1000*.10}]. Although both products have the same ABC profit of £70 {100-30}, the integrated system shows that the first product creates wealth for the company and its shareholders, while the second one will destroy the company value.
This example briefly highlights the two main advantages from the integrated ABC-EVA system as follows:
“First, the decision makers become sensitive to the economic return of products, customers, and channels. And second, it rewards the more efficient use of capital” (Cooper & Slagmulder, 1999, p.16).
4.2. Applying the integrated system:
The objectives of integrated EVA with ABC system are as the following (Hubbell, 1996)
1) To identify in which product categories, geographical areas, customer segments, distribution channels, business units, business process, or activities are EVA being created.
2) To link operational plans and budgets to strategies for increasing EVA.
3) To establish a framework for transfer prices that motivates improvement in EVA.
4) Finally, to drive EVA decisions down into the organisation to the operating level (because employees create EVA, they are the agent of value change).
Before implementing ABC-EVA system, it is essential to understand the concept of dedicated and non-dedicated capital. Dedicated capital can be easily allocated to products or services, while non-dedicated capital cannot.
Dedicated capital can be categorised into direct and indirect dedicated capital. Some assets, such as inventory, can be directly traced to individual products. Also, account receivable balance for a particular customer can be directly to certain cost object. In contrast, indirect dedicated capital, such as specialised production equipment, tooling and test equipment, is associated with multiple cost objects. Therefore, it can be traced to the narrow range of products that use those resources by two steps. Firstly, tracing this cost to activities, and then tracing the cost activities to products by capital drivers. Non-dedicated capital is the capital “employed to support the facility or the enterprise, but it is not directly associated with the manufacture of products, or the serving of customers, and channels” (Cooper & Slagmulder, 1999, p.16). These costs, such as short-term investment, are not traced to cost objects. Also, capitalised intangible assets can be assigned to each product.
To implement the integrated system, it is important to determine the capital employed for each product or service, and identify a risk-adjusted rate for that capital.
Capital charge is easy to calculate by multiplying the asset account balance times the cost of capital or the weighted average cost of capital. A risk –adjusted rate can be calculated by the capital asset pricing model (CAPM).
If the company has £10 million in account receivable, for example, and the cost of capital was 10%, the capital charge will be £1000000 {£1 million* .10).
In the next step, the company can trace these charges to each activity by using Activity- Capital Dependence (ACD) matrix analysis (Roztocki & Needy, 1999). In this matrix, the rows show the activities in the companies, while columns are the accounting balances stated in the balance sheet. All checkmarks in the ACD matrix replaced with values between 0 and 1 representing the percentage of capital demanded for each activity. For example, inventory account can be traced to three activities that are; receive and handle material, manage production, and store final products. Companies can determine, according its experience, the percentage that can be used to allocate inventory charge to each activity. The problem with ACD matrix is that it is subject to arbitrary judgement in determining the percentage of capital demand for each activity.
After that, the cost of each activity can be traced to each product or service by using capital drivers. There are some examples (Hubbell, 1996) of capital accounts and their capital drivers:
Accounts receivable; to trace the charge of the accounts receivable, companies can use one of the following capital drivers such as credit checking process, sales terms and conditions, follow up process (letters, phone, and collections), order lead time, and charge off policies.
Inventory; companies can use number and stages of product complexity (design for manufacturability), forecastability of demand, vendor selection process, vendor response (JIT), or vendor terms and conditions to trace the charge of inventory to each product.
Accounts payable; procedures for receiving and checking materials, paper work processing and approvals, market dynamics and forecasted demand, secular and cyclical trends, or competition (capacity, new product, and so on) can be used as capital drivers to trace accounts payable charges.
Property, plant, and equipment; tracing the charge for these assets to products may can be done by using one of the following drivers; technology trends, number and stages of product complexity, new product development, and future product substitutes.
Finally, company can calculate the total cost for each product, including the cost of capital.
4.3. Case study:
To illustrate the difference between the traditional cost systems, ABC system, and the integrated ABC-EVA system, I will analysis a case study for an imagining company. This case study has been conducted by Hubbell (1996) to illustrate the impact of including capital charges on product costs. The study demonstrated that when the company has analysed its product costs in the traditional systems, for example; indirect overhead costs in the plant are allocated based on direct labour hour, the income statement shows a negative profit contribution for some product lines.
ABC analysis shows a result that is different from the result stated in traditional system. It is showed that some unprofitable products under the traditional systems become profitable when company use ABC system. For example, product line 1 in Hubbell’s case study produced a substantial profit with $ 234 million contribution margin, whereas it produced $ 18 million negative contribution margin under using the traditional cost systems.
The third method used in the case study is the integrated ABC system with EVA to calculate the actual cost for each product, including the cost of capital. This method traces capital cost to activities and products in the same way used in tracing operating costs.
It is important to assign capital charges to relevant activity. That is meant a relationship between these charges and activities must be existed. There are some examples for these relationships. Firstly, all the cash charge will assign to “provide financial and legal services” activity because all treasury expenses will trace to that activity. Secondly, all accounts receivable charge will assign to “invoice customers and collect cash” activity, because it responsible for managing receivables. Lastly, accrued expenses will assign to “employee development and compensation” activity because the account balance resulted from accrued wages and so on.
After tracing operating and capital costs to activities, it is observed that there are major changes between the three cost system alternatives, which can be seen from the data below: - (numbers in million)
Product line 1
|
Product line 2
|
Product line 3
|
Product line 4
|
Product line 5
|
Product line 6
|
Total
Company
| |
Profit margin using traditional system
|
$ (18)
|
$ (80)
|
$111
|
$ 14
|
$ (40)
|
$ 224
|
$ 211
|
Profit margin using ABC system
|
$ 234
|
$ (6)
|
$ 68
|
$ (6)
|
$ (125)
|
$ 47
|
$ 211
|
Economic profit using ABC-EVA system
|
$ 115
|
$ (57)
|
$ (1)
|
$ (23)
|
$ (102)
|
$ (23)
|
$ (91)
|
It can be seen that the company as a whole is showing negative EVA. Also, some product lines such as product line 3 and product line 6 produced a positive profit margin to the company according to both the traditional system and ABC system. However, the integrated ABC-EVA system shows that these product lines have a negative economic profit. On the other hand, if the cost of capital is correctly calculated to include shareholders expectations of growth, EVA of product 3 might be acceptable because it only represents a small percentage (0.01 % of total company’s EVA). Product 6 is considered unprofitable under the integrated EVA-ABC system, because it adds negative value to the company and its shareholders.
In contrast, product line 1 is considered not profitable when company used the traditional system, on the other hand, it added to the company’s profit by $ 234 million. Also, it has an economic profit of $ 115 million and it considered the best product in the company because it will create the shareholders’ value by producing a large amount of economic profit.
Finally, there are some products, which are unprofitable whatever the cost accounting system used. Product lines 2 and 5 have a negative profit margin either the company use traditional system or ABC system. Also, they have negative economic profit; therefore, they are not creating value for the company.
Although ABC system provides more accurate operating product costs, it does not determine which products are creating economic value and so contribute to maximise the shareholders’ value. Adding capital costs in product cost information will increase their cost, in some cases significantly. On the other hand, the managers will obtain powerful information that guides them to make appropriate decisions. For example, because of negative profit with product lines 2 and 5, producing these products may decrease the value of the company. As a result, managers can make one of the possible strategic decisions regarding these products include:
“* Increase the selling price, or
* Decrease it capital demand, or
* Reduce the operating costs, or
* Increase the output with only minimal additional capital investments, keeping operational cost in line, or
* Search for a replacement product having a better potential to be a value creator, or
* Drop it” (Roztocki & Needy, 1999, p.22).
Also, they can identify the most important activities to be simplified, improved, and possibly reengineered to increase product lines profit.
4.4. Benefits from the integrated system:
In addition to the benefits from both ABC and EVA, there are several benefits can be obtained from the integrated system. Firstly, it provides more accurate product cost information, which reflects both operating costs and capital charges. This information will guide managers to make their decision in an accurate way. It helps them to determine which products create wealth for the shareholders and which one destroyed it. Secondly, tracing asset costs to activities by focusing on capital drivers provides managers with an opportunity to improve asset management. Thirdly, integrated ABC with EVA guides companies to determine the economic return of products, customers, and distribution channels. Fourthly, it helps managers to manage both costs and capital. Finally, it motivates managers to create shareholder value by linking EVA with incentive scheme.
4.5. The disadvantages of the integrated system:
In addition to the arguments against ABC, and EVA, there are also many disadvantages of implementing the EVA-ABC system. Firstly, this system only overcomes on one problem inherent in ABC system, but it ignores the other problems. It helps managers to take into their consideration the cost of capital, but it is not mentioned to the other problems of ABC system, such as the allocation of joint or sunk costs to products. Secondly, the integrated ABC-EVA system directs management attention internally rather than externally. It is an internal measure of operating performance that best reflects the success of companies in adding value to their shareholders’ investment. But it does not take into account the customers’ needs. Finally, implementing the integrated system is not as easy as stated in the literature. This is because implementing ABC requires a lot of time and money to identify the activities of a specific company, and determine the suitable cost drivers. Also, although the calculation of EVA is, in principle, very easy, it is not enough to create shareholders value. This is because implementing EVA requires a comprehensive financial management system. That is meant “all policies, procedures, measures, and methods companies use to guide and control their operations and strategy” must be taken into consideration when companies calculate EVA.
CONCLUSION
Product costing is important for many decisions such as pricing, product design, identify product characteristics, and so on. The method used in calculating product costing is a very controversial topic. The controversy centres on whether product costing should be calculated by variable cost or by full cost system.
In variable cost system, the separation between fixed and variable costs will provide managers with relevant cost information. This information may help managers to do a variety of short-term decisions.
In full absorption cost systems, all variable and fixed costs are included in product costs. In my opinion, this method is more appropriate than variable cost method for certain purposes. This is because each product requires variable and fixed costs to produce. Also, some companies need to calculate the full cost for each product in order to determine the actual price for them.
Companies use traditional full costing, which based on volume, such as direct labour hours, to allocate overhead costs to individual products. Traditional systems are suitable for companies that are produced one product or a limited number of products.
Because of today’s highly competitive environment, companies use new manufacturing technologies, such as automated production line, and they produce a wide range of products. As a result, the indirect cost has increased, its nature has changed, and direct labour or material costs became a small percentage of corporate costs. Therefore, if companies continue to use the traditional cost systems, it may produce distorted cost information.
In order to overcome the inadequacies of traditional absorption costing methods, some companies change their cost accounting to activity based costing (ABC) system. ABC is better than the traditional cost systems in that it provides more accurate information about product costing. Companies need ABC system when the percentage of overhead costs to total production costs is significant within the cost structure of the company. ABC is valuable system in tracing overhead costs to products in an appropriate proportion with an accurate way.
Implementing ABC generates many benefits for any company; however, it may produce distorted cost information. This is because it ignores the cost of finance. Therefore, product costing may be still underestimated.
To overcome this problem, it would necessary for companies to link ABC system to economic value added (EVA). Kaplan and Atkinson (1988, p.520) argued “many expenditures such as for plant and equipment and to acquire materials, are temporarily classified as assets before they flow through the income statement as expenses”. Therefore, it is necessary to assign expenditure for acquiring assets to products as well as operating expenses.
The integration between ABC and EVA may improve cost information further by calculating the actual cost for each product, including the cost of capital. As a result, managers can use this information to manage both operating and capital costs.
However, some companies with the reason of the complex and costly procedures to implement it may reject the integrated ABC-EVA system. Also, it depends on arbitrary numbers such as the capital consumption rate for each activity.
After all, I agree that, anyway, subjectivity is involved in every attempt made to calculating product cost. One thing that I will emphasise here that there is no cost system, which can give the actual cost for each product. No one can know exactly what the overhead cost per each product is.
This might be one reason why product cost is still being a “hot topic” in accounting literature.
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