COSTING SYSTEMS: “THE PROCESS STEPS NECESSARY TO DETERMINE THE MOST SUITABLE TYPE OF COSTING SYSTEM FOR HALLBERT”

COSTING SYSTEMS:

“THE PROCESS STEPS NECESSARY TO DETERMINE THE MOST SUITABLE TYPE

OF COSTING SYSTEM FOR HALLBERT”

University of Groningen

Faculty of Economics and Business

MSc International Business and Management

Specialization: International Financial Management

Supervisor: drs. D.J.J. Heslinga

By:

Derk Lutgert (s1335537)

ABSTRACT

This thesis examines the process steps necessary to determine the most suitable type of costing system

for a small manufacturing company called Hallbert. Since the 1980s a lot of academic literature has

been published on the topic of costing systems, but almost all attention has been directed towards

activity based costing. As criticism on this costing system increased, various alternative systems have

been developed. This research takes into consideration these alternative costing systems and also a

wide range of external factors and firm characteristics to determine which costing system should be

designed and implemented at Hallbert. After an extensive assessment it appears that most costing

systems demand too many resources and are too complex, to be beneficial for Hallbert. To get more

insight in costing and pricing, it is therefore most suitable for the company to implement the simple

and transparent absorption costing method.

PREFACE

Introduction ... 1

Company profile ... 2

Problem indication ... 4

Structure of the paper ... 8

Theoretical framework ... 9

Management accounting ... 9

Costing system orientation ... 11

Costing system design ... 16

Costing system implementation ... 17

Conceptual model ... 18

Research question ... 20

Sub questions ... 21

Methodology ... 21

Orientation stage ... 24

Environmental scan ... 24

Organizational review ... 31

Costing system requirements ... 40

Literature review ... 43

Orientation stage conclusion ... 49

Development stage ... 52

Revision of costs per manufacturing process ... 52

Agreements with suppliers ... 55

Other changes in the enquiry calculation form ... 58

Development stage conclusion ... 60

Implementation stage ... 61

Conclusion ... 62

References ... 64

INTRODUCTION

With the rise of large companies in the 19

century, management accounting started to get attention.

However, development in this field stagnated in the 1920s and they lasted until the 1970s when

attention finally regained (Atkinson et al., 2006). The lack of innovation in more than five decades

became noticeable and resulted in a condition whereby companies were using irrelevant management

accounting systems. Therefore, the development of these systems and techniques has been ongoing

ever since the 1980s; with as main goal to make sure that the management accounting systems were

relevant again in the continuously changing business environment. Costing systems are tools designed

for managers to generate the most accurate cost price information and are considered a fundamental

part of management accounting (Cooper and Kaplan, 1988). Thus, the traditional product cost systems

were also abandoned by companies and the development and implementation of new more accurate

systems was initiated. Under academics there still remains ambiguity over the most suitable type of

costing system for companies. Various systems have been developed and all are considered useful in

certain situations.

In addition, costing systems and product costing are broadly discussed topics in the academic

literature. Nevertheless, studies for designing and implementing a new costing system in small

companies are still rare. Therefore, this thesis about costing systems is written in combination with an

internship at a small packaging manufacturing company called Hallbert SDN BHD

. The company is

rapidly expanding and hereby sales revenues are increasing. Individual orders appear to be profitable,

but looking at the result on the profit and loss account the company is losing money. Consequently,

this research is initiated by the general manager of Hallbert, who doubted the accuracy of the

company’s quotations and calculations. Further detailed information about the costing problems of

Hallbert can be found in the problem indication. Besides internal costing issues, the company received

complaints from valued customers, because of its inconsistent pricing. In order to solve these issues

the general manager decided that more insight needed to be gained in the costing of products and

processes.

Making standard agreements with suppliers and setting up a costing system seems to be the

most appropriate approach to stabilize the inconsistent costs prices of Hallbert. Most literature

published on the process of determining the most suitable costing systems describes the advantages of

the activity based costing system. The majority of academics state that this costing system is superior

to other costing methods (Bruns and Kaplan, 1987; Ostrenga, 1990; Brimso, 1991; Turney, 1991;

Brinker, 1995). However, an ABC system is mainly useful if a company experiences a relative high

amount of indirect costs and the problem that Hallbert is experiencing is more centered towards the

direct costs. Moreover, the studies in favor of the activity based costing system focus almost

exclusively on large firms with big budgets and manpower to implement the ABC system and this

makes its usefulness for a small manufacturer as Hallbert doubtful. Therefore, it is at this stage not

clear what costing system is most suitable for the company and further research is necessary. As a

result, this thesis aims to determine the most suitable type of costing system for Hallbert. The various

options that the company has regarding choosing the most desirable costing system will be further

discussed in the theoretical framework

COMPANY PROFILE

Hallbert was started in January 2006 and its main focus is on export of carton board packaging to the

European market. It is a daughter company of Firgos BV which has over 15 years of experience in the

paper and packaging industry in Asia. Customers vary from wholesalers like Bunzl BV, the world

leader in the packaging segment with total revenues of over € 4.7 billion in 2008, and end consumers

like Lidle. Nowadays, Hallbert has two sales offices whereby one is located in Zwolle, The

Netherlands and the other in Kuala Lumpur, Malaysia. Additionally there is a sourcing office in

Shanghai, China and a production facility for the carton board packaging in Penang, Malaysia. All the

packaging is manufactured under strict European standards, in order to comply with regulations in

countries of Hallbert’s largest customers and to ensure packaging of a certain quality. In addition, all

the raw material, which the company needs to manufacture the carton board packaging, is provided by

Firgos BV.

The company has two operating divisions, as can be seen in the organization chart:

Figure 1: Organization chart Hallbert

The first division is carton board packaging and this division manufactures carton boxes for the retail,

food and beverages, hospitality and industrial sector. A large part of the manufacturing process is

conducted in the production facility in Penang. In total 22 employees work on the production floor and

they are directed by a floor supervisor. To report to the sales office in Kuala Lumpur, there is also an

employee in Penang with an administrative function. The two internal sales employees are located in

Kuala Lumpur and their main goal is to maintain contact with production in Penang and communicate

with the sales office in The Netherlands. Thereby they process incoming enquiries and keep in contact

with suppliers of Hallbert. If any problem occurs throughout the process, the business unit manager

makes sure that these are solved and that customers remain satisfied. Besides this, the main function of

the business unit manager is to control and maintain current operations. With an almost complete in

house production process and 28 out of a total of 30 employees, the main goal of Hallbert is to

establish growth of sales and customers in the carton board packaging division. Besides this division

the company is also involved in exporting plastic bags. This second division does not manufacture the

goods, but only outsources production before exporting to mainly Denmark, Lithuania and other

European countries. From figure 1 it can be derived that the total plastic bags business of the company

is operated and controlled by a single person. The total sales revenues of the plastic bags division is

only 4 percent of total revenues of Hallbert. As the total production process is outsourced, the costing

structure is simple and transparent.

The manufacturing process in the carton board packaging division consists of printing,

die-cutting, stripping, window patching, gluing, heat shrink and packing. To get a clear overview of the

manufacturing process, a process flow chart can be found in Appendix A. Only stripping and packing

are done manually and the rest of the processes require machinery. Since its foundation in 2006,

Hallbert has invested more in equipment with as goal to have the total manufacturing process in house

and not to be dependent on suppliers. In 2006 their investment in equipment was only RM 6,000, but

in 2007 this increased rapidly by acquiring a die-cut machine of almost RM 850,000. In August 2008 a

gluing and folding machine was purchased which cost slightly more than RM 1,000,000, bringing the

non-current assets of machinery to a total of RM 1,850,000. In the summer of 2009 the company

desires to expend its machinery even further, by buying a printing and window patching machine at an

expected cost of RM 4,000,000. This means a growth in assets of more than 200% to total of RM

5,850,000. Furthermore Hallbert has shown continuous sales revenue growth, whereby revenues have

increased from RM 1,342,321 in the financial year

2006 – 2007 to RM 4,387,907 in 2007 – 2008.

Total revenues for the year 2008-2009 are RM 8,044,180 and this is a growth of almost 85%

compared to last year. These figures for sales revenue and investment in equipment indicate that

Hallbert is expanding at a rapid pace

.

A financial year starts on the 1st of April and ends the 31st of March. 3

With higher capacity utilization, more different custom products and more in house

production, the pricing of a product becomes more complicated. As a result, changes in the product

cost system are necessary if pricing decisions by management want to remain well informed. Since the

plastic bags division only contributes to the total revenues for a small part, the type of costing system

will be only determined by further researching and analyzing what would be the most suitable system

for the carton board packaging division. As stated above, this is also the division with the more

complicated costing structure which can more easily create distorted product costs for management.

As a result, my internship and this thesis consist only of researching and working in the carton board

packaging department.

PROBLEM INDICATION

Currently Hallbert enjoys 90% percent repeat orders indicating that customers are overall satisfied

with the products and service of the company. For keeping customers pleased and to expand their sales

network it is important for Hallbert to listen to the customer’s remarks and comments. When aspects

in which the company must improve are known, it is essential to undertake corrective action to prevent

further complaints and meanwhile improve customer satisfaction. In the last year the company

received some negative feedback from several customers regarding their inconsistent out pricing.

Since Hallbert wants to maintain its high percentage in repeat orders, and therefore needs to keep their

customers pleased, it is necessary that the company addresses the problem and searches for a solution.

Next to maintaining current customer satisfaction, another important goal that needs to be pursued in

dealing with this issue is that management needs more accurate cost price information to help in the

decision making process regarding costing and pricing. This can potentially lead to more competing

quotations that attract new customers and thereby the current customer base will be extended.

Hallbert’s inconsistent out pricing is intertwined with the fact that the company is experiencing high

fluctuating cost prices. In finding a solution to resolve the inconsistent out pricing it is therefore

essential to analyze the calculation of cost prices more in depth. Cost prices at Hallbert are calculated

by dealing with four cost entries: material costs, converting costs, consumable costs and freight costs.

customer and still make a good profit. Nevertheless, a certain order with a high quantity of products

indicates that total indirect costs are also higher. For example, more man hours are spend on a large

project increasing labor costs and the machines run longer increasing costs for interest and

depreciation. As can be seen, by not taking the indirect costs into consideration in the calculation,

distorted product costs can arise.

The material cost accounts for a percentage of approximately 60% of the total cost price, so

the influence of fluctuations in this expenditure are considerable. The price of raw material depends on

the quality of the paper that the customer desires and for what price it is supplied by Firgos BV.

Furthermore, the price of raw material of a certain order is dependent on the stock of Firgos. If a

customer needs paper with a certain GSM

or size and after checking the stock it appears not to be

available, the second best option to what the customers requires needs to be chosen. If the correct size

of paper is not available this results always in a higher waste level and thus a higher cost price. When

the needed GSM is not in stock this influences the total weight of the order, increasing or decreasing

the material cost price.

The converting costs are the costs with the highest inconsistency since the most variables

apply. Firstly, the specification of the order has an effect on costs as quantity, type of box, amount of

printing colors, type of varnish, etc. all play a role in determining the final converting cost. In addition,

the specification of the order determines the type of process steps the raw material needs to endure in

order to be ready for shipping. Secondly, not all manufacturing steps are conducted by Hallbert itself,

so for printing, die-cut moulds and window patching the company is dependent on the (inconsistent)

pricing of suppliers. Last of all, if it is a repeat order set up costs for the die-cut and gluing machine

will be lower influencing the costs.

The consumable costs have, with an average percentage below the 5 percent, the least impact

on the total cost price. These costs are partly supporting costs for the converting process, with film,

rubber, channel and glue costs. Nevertheless, they are mainly influenced by the method that the

customer requires the final goods to be shipped, because the cost of pallets or outer carton is also

included in this cost. Besides the way the finished goods need to be shipped, the consumable costs are

influenced by the bundle packing specifications of the customer and by the manufacturing processes

the product must undertake.

In the past couple of months freight costs of the entire market have shown a significant fall.

This is mainly caused by the steep drop in oil prices. Moreover, the current recession forces companies

from all over the world to reduce production and shipments. Hereby overcapacity on ships is created

and as a result the freight price decreases. The height of the freight costs at Hallbert is of course

mainly dependent on market prices of shipping. In addition, shipping costs are depending on the

preferences of the customer regarding documents, risks and costs. Besides this, the freight costs per

order are now calculated by looking at their amount in kg’s for some orders and for other orders these

costs are derived by calculating the amount of cubic meters the order occupies in a container. In both

methods a safety margin is applied that guarantees that the whole order fits in the container. Also

orders from different customers are combined to get shipped in the same container influencing the

total cost price.

In the end there is one more important aspect that influences the total cost prices and these are

exchange rates. Since most of Hallbert’s customers are situated in European countries, 99 percent of

the prices of quotations are charged in Euro. However, the cost of raw material from Firgos and the

converting and consumer costs are charged by Hallbert’s suppliers in Malaysian Ringgit. Also, the

shipping costs need to be paid to freight companies in American Dollars. This means that the company

is dependent on multiple exchange rates in its pricing to the customer. To make sure that no loss is

generated on exchange rate differences, the company hedges fluctuations by calculating a safety

margin of 4 percent on top of the real exchange rate. For example if the rate is 5.00 RM/€ than for the

cost price calculations an exchange rate of 4.8 RM/€ is used. Every Monday the financial managers

hands over the exchange rates, which need to be used for calculations in that week, to the sales

division.

Now that the structure of the cost prices is overviewed, it becomes clear that there are numerous

variables affecting this and thereby directly influencing the price on the quotation to the customer.

With these variables known, the problems that cause the fluctuating cost prices and inconsistent out

pricing to the customer can now be discussed.

First, the variable responsible for the highest inconsistency in cost prices is the fluctuating raw

material price. For every incoming enquiry the sales division advices with the general manager what

material price they need to use for their calculation. This price is determined by the manager by

checking the prices of the desired raw material in stock at the warehouse of Firgos BV. If the material

is not in stock he estimates, based on historic figures, for what price it can be purchased. Since the

price of stock is dependent on the skills of the purchase division, this can vary throughout the month.

Furthermore, the time span between extending the quotation and receiving the confirmed order is on

average 24 days. It can therefore occur that the price as stated on the quotation is no longer applicable

and needs to be adjusted for an up to date material price. In principle, the customer agreed on the

selling price on the quotation and when this price needs to be revised this might lead to complaints.

Because the company is founded only 3 years ago, various adjustments and improvements are made

over time in the converting process. As could be seen in the company profile, multiple investments in

equipment have been made throughout the years with the most recent acquisition of a gluing machine.

Hallbert is still learning what the most effective and beneficial method is to manufacture its goods and

thereby costing calculations are also affected. Consequently cost price calculation adjustments for

customers have been made throughout the years.

Thirdly, there are two ways of calculating the freight costs and these are used next to each

other at the same time. One method is to calculate the shipping costs based on the amount of

kilograms that need to be shipped and the other method is to measure the amount of cubic meters that

the order occupies in a container. By randomly using both methods this can lead to freight cost

differences for identical projects. In order to decrease the fluctuations in cost price calculations, one

standard needs to be chosen.

The last variable that has an influence on the fluctuating cost prices and inconsistent out

pricing is the human factor in calculations. All quotations send to customers are calculated by two

employees of the company. They calculate the cost prices and final selling price by using Excel sheets.

However, no standard format for calculations exists so numerous formats are used next to each other.

Thereby, some cells need to be manually filled in and costs of other cells are generated by formulas in

Excel. By reviewing all the calculations of the months from June until October, I noticed that there are

various inconsistencies in these formulas in the different calculating formats. It appeared that for

random orders abnormal cells where linked to each other, creating a distorted view of the actual costs.

Moreover, I found some slight differences in several calculations between both employees, indicating

that not always the same methods of calculating are used. The human errors in the calculations need to

decrease as much as possible in order to generate more stable prices for customers.

STRUCTURE OF THE PAPER

THEORETICAL FRAMEWORK

In the theoretical framework, the published literature with the most significant impact on the topic of

costing systems is analyzed and discussed. This section starts with an explanation of management

accounting and its differences and similarities with financial accounting. After that the functions of

costing systems and the systems available are reviewed in the costing system orientation. Then the

academic literature on costing system design follows and this section is concluded with theory about

costing system implementation.

MANAGEMENT ACCOUNTING

“The process of identifying, measuring and communicating economic information to permit informed

judgments and decisions by users of the information”.

- Definition of accounting, American Accounting Association

As can be derived from the above stated definition, accounting provides information to people who

have an interest in a company; this includes managers, shareholder, employees, creditors, potential

investors and the government. Managers require information that guides them in their control activities

and decision making process. Employees want accounting information to determine if an organization

meets wage demands. Furthermore, creditors require the information to see if the company meets its

financial obligations. Shareholders need to know the value of their investment and governments

collect accounting information regarding regulations and taxes. It is clear that there are various parties

that are dependent on accounting information for making decisions. Therefore the objective of

accounting is to provide sufficient information to meet the needs of its various users at the lowest

possible cost (Drury, 2007).

is useful to distinguish the foremost differences between the two branches of accounting in the

following table:

Table 1: Characteristics of management and financial accounting

Management Accounting

Financial accounting

Goal

To provide information for internal

decision making, feedback and control

To provide financial reports with a

company’s results to external parties

Timeline

Present and focused on future

Historical

Limitations

No rules, the management decides

what system and information is used to

meet strategic and operational needs

Needs to obey laws and regulations

imposed by governmental agencies

Type of

information

Operational and financial information

about processes, suppliers, customers

and competition

Solely financial information

extracted from historical data

Focus

Detailed: Focus on parts of a company

The entire company

By the Institute of Management Accountants, management accounting is defined as “A continuous

improvement process for the planning, design, testing and applying of financial and non-financial

information systems. This process directs the management activities, motivates behavior and supports

the cultural norms and values that are necessary to achieve strategic, tactical and operational goals for

a company.” This definition indicates first of all that management accounting provides financial as

well as non-financial information and also that this information is important for the management to

support them in the decision making process. This includes decision making on a strategic, operational

and control level (Atkinson et al., 2006). Furthermore, one of the main responsibilities of management

accounting is to report product costs to managers who are faced with pricing decisions (Banker and

Hughes, 1994). Besides this, management accounting also focuses on the profitability of products,

services, customers and activities. In other words management accounting plays a key role for the

management in an organization.

published financial reporting to comply with strict regulations. The product costs used for financial

accounting purposes were also used for management accounting purposes. As a result, companies used

the same information for external financial reporting as for internal operations. In the 1960s

information systems were automated. However, this actually resulted in system designers automating

the old manual systems that were created in the 1920s. It was only in the 1970s, when U.S. and U.K.

firms were under pressure by competition of Japanese car manufacturers, that they regained attention

for the development of more effective management accounting systems (Atkinson et al.,2006). These

developments in the 1970s appeared to be insufficient, because in the 1980s an abundance of authors

publicized in the academic literature their criticism towards the current management accounting

systems (Borden, 1990). Johnson and Kaplan (1987) were seen as the pioneers in this field of study,

since they were one of the first to address the problem by claiming that the lack of management

accounting innovation over the decades and the environmental changes, in which companies needed to

operate, caused a condition in the 1980s whereby companies were using irrelevant management

accounting systems. Their book “Relevance lost: The rise and fall of management accounting” (1987)

generated an enormous amount of publicity and it activated other academics to further research and

analyze the situation, whereby the almost unanimous conclusion among them was that management

accounting was indeed in a crisis and fundamental changes were required (Drury, 2007). The further

development of management accounting systems has been ongoing since then.

COSTING SYSTEM ORIENTATION

Besides this, in the 1980s the innovation concerning costing systems started (Atkinson et al., 2006).

According to Cooper and Kaplan (1988), costing systems are an essential part of management

accounting and provide managers with accurate cost price information. These systems are useful for

managers by fulfilling several functions (Kaplan and Cooper, 1998):

1. Inventory valuation and cost measurement of goods sold for financial reporting.

2. Cost estimation of activities, products, services and customers.

3. Providing feedback to managers for decision making.

Back in the 1970s and earlier, companies tried to comply with these three functions by all using the

traditional costing system. This costing system is described by Cooper (1992) as a system that is

designed on the assumption that: “the activity required to produce each product is performed any time

a product is manufactured”. Logically Cooper concludes then that when a company has a wide range

of different products, this traditional costing system will be inadequate. Another imperfection is that

the traditional approach allocates the cost of idle capacity to products. Meaning, that those products

are charged with costs for resources they did not use. According to Kaplan and Cooper (1998), the

traditional costing system fails in providing relevant information for decision making based on three

limitations. Firstly, costing data is inappropriate due to errors caused by random allocation and

capacity use. Second, when marginal costing data is available this is insufficient due to inadequate

cost driver selection. Finally, the traditional system fails to trace non manufacturing costs to products

and customers. As can be seen, the costs derived from the traditional costing approach suffer from

several flaws that cause distorted costs used in the decision making process.

There were also external factors that caused the need for improving the accuracy of product

costing information. These factors were changes in manufacturing technology, global competition,

information cost, competitive landscape and customer’s demand for greater product diversity (Cooper,

1988b). It was argued that the higher demand for product diversity introduced the risk of severe

inaccuracies in product cost assignment using traditional costing systems (Cooper, 1988a). Also

companies needed to adjust their manufacturing process as changes in customer’s demand shifted

from the need of a standardized product at low cost towards greater differentiation between products.

Hereby the nature of overhead costs changed from mostly labor costs influenced by output volume to a

compilation determined largely by complexity and diversity of production (Kaplan, 1984).

to the particular topic (Cooper, 1990; Cooper and Kaplan, 1988; Turney, 1989). Some examples of

other widely used costing systems next to the activity-based costing system are: resource consumption

accounting (RCA), grenzplankostenrechnung (GPK), target costing and lean accounting. Lean

accounting is the application of lean principles to accounting processes, with the goal to eliminate

waste embedded in transaction processing, reports and accounting methods. It strives to achieve

one-piece flow through the value stream and to produce to actual customer demand, where eliminating

waste is kept in mind continuously. Hereby flexibility is created, providing value were customers are

willing to pay for (Grasso, 2005). Target costing can be described as a systematic process of cost

management and profit planning and consists of six key principles: price-led costing, focus on

customers, focus on design, cross-functional involvement, value-chain involvement and a life-cycle

orientation (Ansari & Bell, 1997). Grenzplankostenrechnung (GPK) is described as an alternative to

activity-based costing and is created in Germany. It assigns cost elements to cost centers, which are

determined according to several criteria. In the cost center the cost elements are divided into fixed and

variable components. GPK is often referred to in the USA as flexible margin costing (Sharman, 2003).

Van der Merwe and Keys (2002) take this one step further by proposing resource consumption

accounting (RCA), which is characterized by them as a mix between GPK and the ABC system. It

essentially maintains the resource-centric conceptual foundation and generates incremental

expenditure and marginal analysis. Hereby it has the capability to generate activity based, long-term

consumption model cost data. Besides these main costing systems also life-cycle costing, process

costing, absorption costing and variable costing have been developed to address the shortcomings of

the traditional costing systems. In the academic literature review section in the orientation stage all

available costing systems will be discussed in more detail.

governmental entities (Cross, 2002). Moreover, numerous case studies of companies adopting ABC

systems report remarkable beneficial differences in product costs. Especially for several U.S. firms,

changes in product pricing, promotion and mix decisions based on ABC costing systems led to serious

improvements in profitability and competitiveness (Grasso, 2005). In the academic literature the

success cases of large manufacturing companies implementing this costing system are numerous.

Nevertheless, studies about choosing and implementing an ABC-system for small

manufacturing firms are less common. However, Needy and Bidanda (2000) describe a model to

develop and validate an ABC-system for smaller manufacturers and their results also show an

improvement in the company’s performance as a direct effect of the system. Also Baxendale (2001)

has demonstrated the benefits of the implementation of ABC systems in smaller companies.

Furthermore, Roztocki, Porter and Thomas (2004) claim that the traditional costing system has lost its

relevance in a manufacturing environment and thereby describes a procedure for the successful

implementation of activity-based costing in manufacturing companies with less than 100 employees.

made various academics doubt the efficiency of the new system in generating more accurate product

costs (Noreen, 1991; Datar and Gupta, 1994; Yahya-Zadeh, 1997; Maher and Marais, 1998). By these

studies it is argued that the costing system itself creates product cost distortion and measurement

errors when costs are indivisible, non-linear or unavoidable. The doubt of ABC systems creating more

accurate product costs is one direction of literature dedicated to challenge its usefulness. Since the

development of the ABC system, supporters claim that this system is superior above other costing

system when a company has product diversity, a certain cost structure and uses advanced

manufacturing technology. However, another direction of critics cites that they are unable to link ABC

adoption with these particular firm characteristics (Murphy & Braund, 1990; Bjornenak, 1997;

Krumweide, 1998; Primrose, 1998). Recently a third path of criticism regarding the heavily discussed

ABC system emerged, examining the organization’s broader contextual factors and their influence on

adoption and implementation of ABC systems (Shields, 1995; Malmi, 1997; Anderson & Young,

1999).

COSTING SYSTEM DESIGN

In the existing literature which covers the topic of costing systems, numerous articles can be found

that address the design and implementation of ABC systems (Shank & Govindarajan, 1993; Alan,

1995; David & Robert, 1995; Booth 1996). Articles about an approach on the process of designing a

costing system in general are far less common. However, in making decisions for the most effective

costing system design for a certain company, the level of sophistication is an important aspect

(Abernethy et al., 2001). The level of sophistication indicates the complexity of the costing system.

Abernethy et al. (2001) conclude in their study that it is useless to implement a highly sophisticated

and complex costing system in a company that is not able to work with it. It is more important that a

new system can be properly used by a company instead of providing an overflow of costing details.

Therefore by creating a new system, the size of a company also needs to be taken into consideration.

Large manufacturers have sufficient funds and other resources to create a costing system as

sophisticated as needed. Thereby these companies also have the workforce and expertise to make the

new system work on a desired level. Nevertheless, large firms differ in a lot of aspects from small

firms. These aspects include customer distribution, workforce, risk and ratio of fixed to variable costs

(Keats & Braker, 1988; Needy & Bidanda, 1995; Shrader et al., 1989; Welsh & White, 1981). The

different characteristics and operating environment of small companies thus requires a different design

of costing system compared to large companies. It must at all time be kept in mind that the costing

system of a small company should be simple, flexible, dynamic and sustainable with a minimal

amount of resources. Thereby the new system must be easy to understand, implement, operate and

maintain. In order to decrease the costs it is also beneficial if the system uses commercially available

software instead of expensive custom made software. Besides the size of a company there are also

other contextual factors that influence the costing system design (Cooper, 1988a) and these are: the

importance of cost information, extent of use of innovative management accounting techniques, the

intensity of the competitive environment, the use of JIT production techniques and the type of business

sector (Omiri & Drury, 2007). In addition, Drazin & Van de Ven (1985) state that the contextual

factors should not be underestimated in the design of a new costing system. According to their article a

certain design is expected to create high performance in a given context. However, if a company

diverges from the advisable design by a fraction, this will immediately result in lower performance

than before the implementation of the new system. In choosing the right costing system design, it is

therefore of high importance that a solid analysis of multiple aspects is conducted.

COSTING SYSTEM IMPLEMENTATION

Besides choosing the right costing system one also needs to determine the correct way to implement it

in the organization. In other words, correct implementation is as important as choosing the right

system. However, the various costing systems that exist nowadays all have other approaches on how

to successfully implement them in a company. A simple direct costing system can be implemented

relatively easy, because it is not complex, easy to understand, relatively cheap and does not need a lot

of development and testing. This as opposed to a highly sophisticated activity based costing system

which is costly, complex, takes developing time and might take months to learn for the management

and its other users before it can get implemented in a company (Needy et al., 2003).

As is stated above the implementation process for the various costing systems varies great. There are

however some general aspects which should be taken into consideration by a company for every

costing system that is being implemented. An aspect that is of importance is the fact that the

management needs to be fully committed to the implementation of the new system and understands its

advantages and required development effort. They have to provide feedback to the other employees in

the company and be committed in using the information that is provided by the new costing system. In

order to establish this management should be closely involved in the development of the costing

system (Needy and Bidanda, 2000). Hereby, the system must be continuously reviewed, critiqued and

refined. Otherwise, the changes of the new system being successful and beneficial are slim. Also the

time span that is reserved for the implementation is an aspect that always needs to be considered. A

costing system with low complexity can replace an old system from one day on the other. If a complex

systems needs to be implemented it is possible that both the new and old system need to run parallel to

each other for employees to get used to the new system. The time span for full implementation can

vary from a day to several months.

CONCEPTUAL MODEL

By examining the theoretical framework, it becomes clear that although the majority of researchers

lean towards the use of an ABC system, there still exists ambiguity with academics about the most

suited costing system for small manufacturing companies. However, most of the studies that criticize

activity based costing do have matching outcomes. The results indicate that the different costing tools

that exist nowadays are suitable for different business issues and different business environments.

Since no company is the same, the criteria that a costing system must meet differ as well.

Summarizing, there is not a general costing tools or implementation methodology that fits in every

organization. Before determining which tool is most appropriate for a company, it is important to

know about the characteristics and applicability of every costing tool that is around (Gurowka &

Lawson, 2007). Many factors like product diversity, level of sophistication, budget and requirements

of the desired system should all be of influence in the costing system decision-making process. Thus,

in choosing the most useful costing system one should look at a range of characteristics, variables and

requirements that apply to a company.

Therefore, in choosing the correct costing system for Hallbert I will make use of the

“roadmap” as described by Gurowka and Lawson (2007). Their article describes the current disorder

in costing and then provides a step-by-step process for finance and accounting professionals to help in

deciding which costing system to use in what situation, and how to recognize when it is time to change

or set up new a system. The authors look at a wide range of aspects that have an influence in choosing

the right costing system. The first step in the process is making an environmental scan. This is

followed by an organization review with an emphasis on its structure and characteristics. Then the

requirements of the costing system must be determined. The last step is a review of the potential

costing tools available to a company and needs to be evaluated against the first three process steps in

order to choose the most appropriate costing system for the company. The described process is

extensive and covers all, and maybe even more, aspects that are cited as important by ABC critics in

making the right decision regarding costing systems. For that reason, I will use this process as a

guideline in order to come to the final conclusion which costing system must be implemented at

Hallbert. In the methodology section the exact content of the process steps will be further explained.

RESEARCH QUESTION

Looking at the literature, the majority of academics believe that the activity-based costing system is in

general the most suitable costing system for companies (Johnson and Kaplan, 1987; Cooper, 1990;

Grasso, 2005; Needy and Bopaya, 2000; Roztocki, Porter and Thomas, 2004). A significant amount of

articles are devoted to the advantages of the ABC system and studies focusing on the benefits of other

costing systems are rare. However, since its creation in the 1980s the system has raised an increasing

amount of criticism. Opponents of the heavily discussed system believe that it is too costly and

complex for most, especially small, companies to implement. Their views are supported by numerous

case studies that show low adoption rates mainly caused by implementation difficulties. Furthermore,

the ABC system is particularly beneficial for companies with high overhead costs, where the

fluctuating cost prices at Hallbert seem to be a result of direct costs. This raises the question if the

activity based costing is the most useful costing system for a company as Hallbert. In the literature

various other costing systems are presented as alternatives to the ABC system, but none of these have

gained a wide range of support. Out of the academics that criticize activity based costing, the majority

believes that for choosing the most effective costing system one should look at a wide range of

characteristics, external factors and requirements that apply to a company. So far, no articles are

devoted to making an assessment for the most appropriate costing system for small manufacturers. In

current literature only the ABC system is covered on this topic without regarding other costing

systems. An extensive evaluation of all the available costing systems, combined with requirements of

the company and an analysis of external factors should result in a valid and reliable solution for

Hallbert in deciding what type of costing system is most suitable. As no other research is conducted by

looking at this range of variables this indicates a clear research gap that makes this research useful and

contributing to the existing literature on the topic of costing system.

Therefore next to providing a solution to the current problems of Hallbert, the goal of this

thesis is that it can be used as an example to assist other small manufacturing companies in their

decision making process regarding what type of costing system needs to be implemented. In order to

achieve that goal I will use the article of Gurowka and Larson (2007), which provides a guideline for

choosing the right costing system for a company. When examining the issues at Hallbert regarding

their fluctuating cost prices and combining them with the academic literature the following research

question can be formulated:

“What type of costing system needs to be designed and implemented at Hallbert?”

Nevertheless, in order to make the research more reliable and useful for further studies these three

stages also need to be included.

SUB QUESTIONS

In order to give a reliable answer to the research question a solid analysis must be conducted by

answering six supporting sub questions. By formulating these questions the conceptual model was

used as a guideline.

-

In which context does Hallbert operate?

-

What does the organization look like?

-

What are the requirements of the new costing system?

-

Looking at the academic literature, what types of costing systems are available?

-

What is the most suitable design of the new costing system?

-

What steps need to be taken to smoothly implement the new costing system?

METHODOLOGY

This section describes the process steps for formulating answers to the sub questions and how these

answers support in giving an answer to the research question. The first four questions correspond with

the orientation phase of the conceptual model and are sufficient to give a reliable answer to the

research question. After the type of costing system is determined the development stage describes in

more detail the design of the actual system. Then the most suitable implementation strategy is

stipulated in the implementation stage. These last two stages are as important as the first, because the

costing system will only be beneficial to the company if the design and implementation are properly

executed. To make the research more reliable and useful for other companies to use as a guideline, a

critical review of the process needs to be conducted in the end to establish if the chosen costing system

is indeed improving the company’s performance. Only after the review a conclusion can be formulated

that states if the applied process is a suitable method to determine the type of costing system for small

manufacturing companies.

In the problem indication the reason for the price fluctuations is explained. There it is

concluded that a mixture of changes in cost price calculations and no standard agreements with

suppliers is the cause of inconsistent out pricing to customers. The costing system that needs to be set

up must ensure that the calculation of costs of the converting process, executed at the production

facility of Hallbert in Penang, is conducted in one consistent way. With knowing the cause of the price

fluctuations and the main goal of the costing system, it is more feasible to find a useful answer to the

research and sub questions.

company, first all the external factors need to be analyzed. Therefore this scan has to include a review

of the current business issues facing Hallbert, the competitive landscape, the available budget for the

new system and at last the evaluation of the current costing system. In the case of Hallbert the system

that needs to be set up is new and no fixed old costing system exists. In finding an answer to this sub

question general information about the packaging industry needs to be obtained. The answers that are

found by looking at the context in which Hallbert operates will provide useful background information

that is necessary for moving on to the next step.

Secondly, a review of Hallbert’s characteristics, needs and its ability to implement the change

is required. This section gives an answer to the sub question “What does the organization look like?”.

In this organizational review, aspects as management style and work environment, the current

information technology environment (platforms, applications, software, hardware, data storage etc.),

organizational size and diversity, level of centralization, product diversity and complexity, customer

and channel diversity, number of employees working for the organization and lastly the manufacturing

process are analyzed. All the data that is needed to give a reliable answer to this second sub question

can be obtained from company information. Consequently I need to interview the management and

look into the documentation of Hallbert. Moreover, to get more insight into the converting process and

the products manufactured it is useful to spend time at the production facility in Penang. Once this

organization review is finished a complete picture of the organization, the products and services

provided, its customers and the critical issues facing Hallbert can be put together.

Thirdly, the purpose of the costing information should be determined, because this information

is only useful if it is properly applied. Therefore an answer to the sub questions “What are the

requirements of the new costing system” must be found. In order to do so, an analysis of the

requirements and outputs of the costing system is needed. Requirements for the costing system will

differ among each organization. The requirements of the generated cost information can be on the

topic of product costing and pricing, service costing, budgeting, inventory valuation, performance

measurement, product and customer profitability, cost reductions, compensation systems, process

costing, continuous improvement tracking and the cost of quality. It is important for Hallbert to list its

main requirements of the system and then rank the importance of them from highest to lowest. No

costing system will exactly meet all the requirements of an organization. Therefore, after consultation

with the management a costing system must be chosen that best meets the main requirements and has

the ability to support other requirements.

requirements can only be completed if knowledge is obtained about the strengths and weaknesses of

each of the costing systems available. As a result, each of the costing systems must be researched in

more depth. After that the answers found in the first 3 sub questions must be matched against the

available costing systems and then it is possible to determine the most appropriate costing system.

Information of academic journals and books described in the theoretical framework can be used to

answer this sub question. Also more information on the different type of costing systems and their

specifications can be found at the website of the Institute of Management Accountants

(

http://www.imanet.org

).

The answers to the four sub questions should be sufficient to determine what the most suitable type of

costing system is for Hallbert. When the type of system is known, it now needs to be customized to

exactly meet Hallbert’s demands and maximize its usefulness. Therefore an answer to the next sub

question “What is the most suitable design of the new costing system?” must be generated.

Organizations all have different structures and operate in different business environments. Therefore

after choosing the most suitable type, the custom design of the system is also an important aspect to

make implementation successful.

ORIENTATION STAGE

ENVIRONMENTAL SCAN

The first step of the orientation stage is describing the context in which an organization operates. By

doing this background analysis, the foundation for the rest of the research is laid out. The

environmental scan gives the management insight if the change in costing system is feasible and must

provide a platform for moving on to the next step. As already indicated in the methodology section,

issues that are discussed in the environmental scan are:

¾ Review of current business issues.

¾ Competitive landscape.

¾ Budget of the new costing system.

¾ Evaluation of the old costing system.

According to Gurowka and Lawson (2007) the environmental scan must also include the desired

outcomes of the new costing system. However, in my view the requirements of the new costing system

and desired outcomes are very much intertwined. As can be seen in the conceptual model, the

requirements of the new costing system are a separate step in the orientation stage. For that reason it is

clearer to discuss the desired outcomes of the costing system in that section.

Review of current business issues

Hallbert’s core business is manufacturing and exporting carton board packaging for the food industry

to the European market. Also orders for other industries as gift and clothing packaging are accepted,

but these are not common. Moreover, the company sometimes accepts completely different projects as

for example outsourcing the manufacturing of calendars. Nevertheless, Hallbert’s main focus is on the

carton board packaging market in Europe with an emphasis on the food sector. Consequently issues in

this market have the most significant impact on the company.

The ECMA, European Carton Makers Association, is an association which was founded in the

1960s to promote the interests of the carton board packaging sector and is nowadays the officially

approved umbrella organization for carton associations in Europe. A report published by the ECMA in

2008 states that the total value of folding carton sales in Europe was 9,17 billion Euros in 2007, an

increase of 4,7% compared to the year before. The report also shows that the balance between food

and non-food packaging sales is gradually changing in favor of the food sector, this sector has

increased its total market share from 50,5% in 2005 to 53% in 2007. Thereby, annual sales of carton

packaging for the food sector grew with 12.5% in 2007. According to the ECMA annual report the

growth in figures is an effect of the significant improvements in economic prospects for the years 2006

and 2007.

the course of 2008, conditions worsened significantly in the European packaging market. Customer

demand was under pressure in the first three quarters of last year and tumbled in the fourth quarter as a

direct result of inventory reduction throughout the industrial sector. According to estimations by the

RISI

in a European paper packaging forecast report, the demand for carton board decreased with

6.5% in 2008 and this is the first decline since 2005. Hereby selling prices also decreased for 2008,

although the manufacturing costs increased for the first three quarters. Suppliers to packaging

companies also suffered from the worsening economy and were obligated to lower their prices in order

to keep their sales up. This directly resulted in a sharp decrease of production costs in the fourth

quarter, leading to a recovery in profitability for packaging companies. Nevertheless, the profitability

did not last long, because the companies passed the lower costs along to their customers while trying

to get demand for packaging products up again. As consumer confidence and spending was

decreasing, food prices were raising and this resulted in lower consumption. As a result, an even more

challenging market is created for all companies operating in the packaging sector.

In this new business environment, companies need to review and adjust their strategies

drastically to keep their sales at a profitable level. In the industry a shift can be identified at the largest

companies from using mainly plastic as packaging to using carton board. Since climate change and

energy consumption are major issues in the world, this shift is the effect of customers who now put an

emphasis on the usage of environment friendly packaging. Therefore companies are now using carton

board of higher quality in the manufacturing of their products.

This demand for the best quality at the lowest possible cost is also one of the major difficulties

of the packaging industry. Packaging has three main functions: It needs to be eye-catching so that it

attracts the end user’s interest, it needs to be informative so that the users now what they are buying

and packaging needs to provide a certain level of strength so that the product inside arrives at the

customer in its intended state. Besides these functional and visual aspects, a customer will never buy a

product because of its packaging but for its content. Therefore the majority of product manufacturers

are very eager in choosing packaging that covers the three main functions at the lowest possible cost.

The exceptions are of course producers of high quality and expensive products will choose for more

expensive packaging of a higher quality. However, the largest part, and also the market in which

Hallbert operates, of the packaging market is highly focused on pricing. Moreover, the amount of

packaging companies compared to demand is high. This results in a very competitive market, in which

customers easily swap between suppliers to find substitutes at a better price for their packaging. This

makes it important to make a good first impression on customers and to supply packaging at a constant

level of quality.

Another business issue concerning the packaging market is the development of more strict

legislation. Under what conditions packaging is manufactured and what kind of material is thereby

used is being more controlled and regulated. Various European countries have issued new legislation

in the last couple of years. For example, the new German Packaging Ordinance came into effect on the

1

of January 2009 in Germany. Since this date any producer and distributor of packaging to the

German market is enforced to participate in a collection and disposal system for their products.

Moreover, companies which put large amounts of packaging on the market must submit annual

declarations detailing the amounts of packaging placed on the German market. In addition, since 2007

new regulation has come into effect in all European countries which are a member of the European

Union. The regulation Registration, Evaluation, Authorization and restriction of Chemical products, or

shortly REACH, is developed to control the risks that are involved with chemical products. REACH

provides a list of 16 high concern chemicals and among companies that need to comply are packaging

manufacturers. Every company that is affected by the new legislation needs to make sure that none of

the chemicals on the list has a higher concentration than 0,1% in their products otherwise notification

is required. As explained by the European Commission, the aim of REACH is to improve the

protection of human health and the environment through better and earlier identification of intrinsic

properties of chemical substances.

It can be concluded from the described business issues, that the packaging industry is very

competitive and challenging. The main focus in the industry is on pricing, as customers are in total

control and demanding. The industry has experienced constant growth until 2008; the year in which

the economic downturn accelerated and had a major impact in every industry. The worsened economic

circumstances make it even harder for packaging manufacturers to compete in the market, because

margins in sales were already small. Nowadays, the demand of customers is shifting towards the use

of more “green” packaging, making the manufacturing process more costly. To comply with the newly

created legislations brings even more costs to companies, making this a difficult time to survive.

Competitive landscape

Almost all of Hallbert’s customers are located in Europe and more specifically in The

Netherlands. Other European countries to which Hallbert frequently delivers are Germany and

Denmark. As a result, the main competitors of Hallbert are the packaging manufacturers located in

these countries, because of the convenience and control that customers have if they choose for them. If

an order is placed with a local manufacturer the customer can keep close track of the manufacturing

process. Thereby is the communication easier, since there is face-to-face contact, no language

distortion and no time difference. Also when samples are printed or problems occur, the packaging

company can contact the customer and invite them over for advice. So the advantages of a local

packaging manufacturer for companies are numerous and on firsthand the only leverage an exporting

company has is the price that they offer. Therefore the main goal for Hallbert is to quote the most

competitive price possible, so that first time customers consider that the extra effort is worth the lower

price. Later when it appears that the quality of the packaging delivered from Malaysia is similar to that

of local suppliers, the barrier to again choose for imported packaging is lower. Next to local

manufacturers, Hallbert also has competitors located in Eastern Europe. These packaging

manufacturers compete with Hallbert in price.

Budget for the new costing system

By examining Hallbert’s most recent profit and loss account it appears that there is not a separate entry

for IT development or software expenses. In a meeting with the financial manager, he stated that

expenses for the development and purchase of new software will be assigned to the entry research and

development. The financial documents of the year 2008-2009 shows, that the total budget for research

and development is small

. Consequently, based on these figures, the budget for the development of

the new costing system is also assumed to be slim. In the profit and loss account, expenses are divided

over the costs of goods sold and other expenses. The costs of goods sold contain the cost of raw

material for carton board and retail bags, the shipping costs, the direct converting costs of the carton

board packaging division and the consumable costs of this department. Total expenses for costs of

goods sold are in 2008 RM6.692.561,30 and since these costs can be directly appointed to all the

different projects that are manufactured for that year, they are considered the total of direct

manufacturing costs. The other expenses are a total amount of RM1.212.159,50 for the financial year

2008-2009 and the largest cost entries are depreciation with RM151.000, management fees

RM155.000, salaries and wages RM560.000 and travelling expenses RM50.000. These four indirect

cost account already for more than 75% of total indirect costs. The entries that include the costs for

research and development add up to a total of RM11.662 which means not even 1% of the total

indirect costs and only 0.1% of total cost. Moreover, these research and development expenses for the

year 2008 were solely used for the development of a new website of the company. In addition, by

checking the profit and loss accounts for the financial years 2006-2007 and 2007-2008, it shows that

the total expenses for research and development in these years have been zero.

Since the historical costs for research and development show that the budget so far for this

entry has been small, I decided to interview the general and financial manager of Hallbert to clarify

what their thoughts are on the budget of the new costing system for upcoming year. In the interview

they state that in the financial year 2009-2010 a large part of the available budget goes to the

investment in machinery. The company’s short term goal is to carry out the total manufacturing

process in-house and therefore the investment in the necessary equipment is the primary objective.

However, in the year 2010 also generated profit is set aside to make an investment in software. Total

cost of this investment will be RM400.000 and further discussed in the organizational review. So at

this moment, it is estimated that there becomes a large budget available for investment in software that

can be used for the new costing system. The general manager did also declare that he will appoint an

employee of the management team of Hallbert to design, develop and control the new system. In the

future when all the needed equipment for in-house manufacturing is obtained, there will be a budget

available for custom software to support the new costing system. Until then a decent system needs to

be build with Microsoft Excel and all the shortcomings must be noted and stored so that in the

development of the new software these issues can be taken into regard.

Evaluation of the old costing system

The evaluation of the old costing system is part of the environmental scan to provide useful

information for the new costing system. Hereby, strong and weak points of the current system are

overviewed in order to support the set up and design of the new costing system. The problem

indication already pointed out that so far there has not been a fixed costing system. Over the past two

years different ways to calculate prices for enquiry purposes are used. Taking that into account, this

section will outline the strong and weak points of the calculation methods used in the past year.