This paper attempts to link the benefits of Activity-Based Management and Activity Based Costing to the strategic success of the air transportation industry. The paper hypothesizes that the failure or suffering of the air transportation industry is connected to its use of an unfitted traditional cost accounting method.
The resolution to the situation is to apply activity based accounting methods in the management of aviation related industries to produce a strategic, competitive advantage and resurrect the industry from bankruptcy. Strategic Applications of Activity Based Management in Air Transportation Business strategy, until twenty years ago, was usually based upon the idea of doing things “the way they’ve always been done. ” Business strategy today, however, is based upon Total Quality Management (TQM), constant evolution, and a company’s need to establish a long-term competitive advantage.
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Just as the dynamics of business have changed since 1988, it logically follows that so should the operations of business. However, the air industry seems to be stuck in the last century. Although, the air transportation industry is going through a major international and economic re-engineering process, the air industry is struggling to make a profit; this may be in part to their use of conventional cost accounting methods, instead of a more contemporary cost accounting method.
To develop and establish a competitive advantage, strategic managers utilize cost/resource analysis tools to help them make decisions about the best uses of company resources. Conventional, or traditional cost accounting (TCA), methods, used primarily until the 1980s, allocates all costs to one primary cost driver and one specific product or service. As effective as this system is for a simple, or single-product manufacturing company, its effectiveness is lost when applied to business conditions outside these parameters, as many 21st century aviation organizations have become.
Traditionally, cost accountants arbitrarily add a broad percentage of expenses onto the direct costs to allow for the indirect costs. However, as the percentages of indirect or overhead costs rise, this technique becomes increasingly inaccurate because the indirect costs are not caused equally by all the products. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognized when the same broad ‘on-cost’ percentage is added to all products.
Consequently, the “true” cost of business cannot be accurately calculated, costs are inflated and vague, and this type of irrelevant information provides no value to decision-makers trying to develop a competitive strategy. The need for a different costing in today’s business system is apparent. One alternative to the traditional costing system is a costing method that allocates costs according to the company’s value-chain functions instead of its products. This type of cost system is known as Activity Based Costing (ABC).
ABC is the systematic assignment of costs from resources to activities and then from activities to cost objects. In Garry Bradley’s analysis, he states more specifically “Activity Based Costing (ABC) is an approach to costing that considers the resources consumed by activities in order to create and deliver a product or service. Whereas the underlying assumption of a conventional costing system is simply that products cause costs, an activity based costing system assumes that cost objects (e. g. a subject) creates the demand for activities (e. . teaching), which in turn causes resources to be consumed (e. g. academic time, lecture space, etc. ) and causes costs. Cost objects are the reason for performing activities and activities are the processes or procedures that cause work and create costs” (Bradley, 2002, p. 2). Although, originally conceived from a manufacturing background, activity-based costing has evolved to apply to manufacturing, service companies, utilities, logistics, telecommunications, government bodies, and many more sectors. ABC is applicable when overhead is igh, products and services are diverse, competition is stiff, and costs of errors are high; consequently, these are the same attributes of today’s air industry. Based upon these premises, it is easy to see why using TCA in a complex, multifaceted, technology-infused, industry, such as today’s air industry, can be problematic and disastrous. Airlines and airports are committing their resources towards security-related solutions, passenger and baggage processing systems, self-service kiosks, in-flight technology, aircraft communications, and many similar projects.
Airframe manufacturer, Boeing, is often faced with the decision to buy, make, or outsource parts, labor, or technology. Operational managers of air carriers, like Delta Airlines or Southwest, must make specific decisions about opening or closing routes, the use of idle planes, or offering discount fares. In order to make these decisions, they all must understand costs, their company’s cost structure, and the dynamic role they play in making these decisions. An ABC system can be the number one tool strategic managers can utilize to accurately determine the most profitable decision for the company.
It provides visibility in the way costs flow through the business. It establishes the links between activities and those factors, internal or external, that drive the level of activity up or down. It eliminates the false divide between direct costs and overheads. It separates out those costs that deal with today’s business from those that secure the future. It ignores gross margin and uses accurate product and customer contributions as the basis for comparing product and customer profitability.
It exchanges functional myopia for a cross-functional process view of the organization; and exchanges the stilted definitions of value-added and non-value-added for sensitive categories that highlight the subtle impact of internal process failures and external customer behavior. It provides strategic and operational decision-makers with highly accurate information for benchmarking capabilities to keep them on track towards meeting corporate strategic goals. Highly accurate cost allocation information provides managers the ability to make and answer theoretical “what if” questions.
ABC also supports other profit improvement initiatives such as Business Process Reengineering (BPR), Shareholder Value Added, and Customer Relationship Management (CRM). Creating value builds shareholder and customer value, which in turn builds market share, and consequently, higher profit margins. One important thing to remember is that even though not all costs can be assigned, because some overhead costs are just difficult to assign to products or customers, it is important to realize that the only purpose of ABC is to provide information to management.
Therefore, there is no reason to assign any cost in an arbitrary manner. When ABC methodology is applied, the once ambiguous “overhead” costs, are given value. When the value of the resources is analyzed, decision-makers can rapidly act to either improve or omit the resources’ value to or from the process or service being offered. This strategy reduces excessive costs and lean’s organizational productivity. Understanding where resource costs are derived forms a basis, a foundation, from which operational and strategic managers can make operational and strategic decisions.
With a firm ABC system in place, activity based management can occur. Activity based management (ABM) is a defined as the “discipline that focuses on the management of activities as a way to improve the value received by the customer and the profit achieved by providing this value. It includes cost driver analysis, activity analysis, and performance measurement. This discipline draws on activity based costing as its major source of information to provide accurate financial information in a form that mirrors the day-to-day activities of people and equipment” (Saferpak. om, n. d. ). By understanding how resources are transformed into products or services, and by focusing on the cost of activities, ABM helps an organization to obtain a greater understanding of how costs behave in their organization and which activities create significant amounts of cost. Organizations can then begin to control their costs based on tangible activities rather than relatively uninformative general ledger or cost centre reports. The battle to sustain and increase corporate profitability grows ever more arduous in most sectors of the economy.
Margins are met by steady improvement in competition, and the increasing awareness of customers. The aviation industry needs to grasp every opportunity to not only to be ever more effective at what they do, but also to be truly competitive, winning more market share of the customers both nationally and globally. For success, a full understanding of costs and cost structures is necessary. Establishing an effective cost accounting system for the specific organization is the foundation from which all other decisions will be made.
Aviation related industries could benefit more from the use of an ABC system than traditional cost accounting systems, due to their complex nature. Traditional accounting and management reporting display a vague conclusions on the real cost dynamics in a business. As a result, managers are not in control of profitability at a level of detail that supports substantive decision-making. References Activity Based Costing (ABC). (n. d. ). Retrieved January 30, 2008, from http://www. itt. edu/~roztocki/abc/abctutor/sld001. htm Bradley, G. & Mozjerin, C. (2002). An Introduction to Activity Based Costing and Activity Based Budgeting. Retrieved January 30, 2008, from http://www. tefma. com/infoservices/papers/2002_AAPPA_Brisbane/G_Bradley. pdf Develin and Partners. (n. d. ) The Basics of Activity Based Management. Retrieved January 30, 2008, from http://www. saferpak. com/abm_articles/Basics %20of%20ABM %20Word. pdf Horngren, C. T. Sundem, G. L. , & Stratton, W. O. (2005). Introduction to Management Accounting (13th ed. ). Pearson Prentice Hall: Upper Saddle River, NJ Saferpak. com. (n. d. ). Activity-Based Management (ABM). Retrieved January 30, 2008, from http://www. saferpak. com/activity_based_management. htm Tsai, W. -H. & Kuo, L. (2004). Operating Costs and Capacity in the Airline Industry. Retrieved January 30, 2008, from http://www. pitt. edu/~roztocki/abc/abctutor/ sld001. htm