Phase 2: Qualitative Study
3.6 PERFORMANCE MANAGEMENT MODELS
3.6.2 Activity-Based Costs (ABC)
Cardos and Pete (2011, p.155) describe ABC as “one of the most important innovations in cost calculation and managerial accounting”. According to these authors, “ABC was developed as an approach to address problems associated with traditional cost management systems”. These problems, according to these authors, related to their inability to “accurately determine actual production and service costs, or to provide useful information for operating decisions” which could expose “managers to making decisions based on inaccurate data”.
According to Cooper and Kaplan (1992, p.1), ABC systems “estimate the cost of resources used in organisational processes to produce outputs”. Specifically, according to these authors,
“resources are assigned to activities, then activities are assigned to cost objects based on their use”. Hughes and Gjerde (2003, p.23) say that ABC recognises the causal relationships of cost drivers to activities, which “begins with the companies’ products, determines the activities used in the production and delivery of those products, and computes the costs of various activities”.
According to these authors, “the costs of the activities used in the production of a product are then assigned to that product in a manner that approximates a causal relationship”. This relationship, according to Hughes and Gjerde (2003, p.23), causes ABC supporters to insist that “ABC systems provide more useful information for cost management purposes than traditional systems do”.
Companies that do not use the ABC, normally make “simple adjustments to allocate overhead costs that do not accurately fit elsewhere” (Johnson et al., 2007, p.6). According to these
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authors, companies that use the ABC, link related expenses to “resources supplied to the company to the activities performed within the company”. As a result of ABC, “expenses are allocated from resources to activities and then to products, services, and customers” (Johnson
& Beiman, 2007, p.6).
According to these Johnson and Beiman (2007, p.7), firms that “implement an ABC methodology are able to:
1. Identify the most and least profitable customers, products, and channels 2. Determine the true contributors to (and detractors from) financial performance
3. More accurately predict costs, profits, and resource requirements associated with changes in production volumes, organisational structure, and resource costs
4. More easily identify the root causes of poor financial performance 5. Better track costs of activities and work processes
6. Provide front-line managers with cost intelligence to drive improvements”.
According to Cooper and Kaplan (1992, p.12), “ABC systems contain two important insights, firstly the activities performed by many resources are not demanded in proportion to the total volume of units produced (or sold) i.e. the demands arise from the diversity and complexity of the product and customer mix; and secondly the ABC systems are not models of how expenses or spending vary in the short-run i.e. ABC systems estimate the costs of resources used to perform activities for various outputs”. According to these authors, at any given time, “the production of products and services, and their marketing, sale, and delivery to customers, create a demand for organisational activities”. The capacity of the individual activity supplied to outputs is valued by activity cost drivers, and by adding across the costs of all resources supplied to achieve activities for individual outputs; thus the costs of resources used during the period are estimated by the ABC model by all the organisation's outputs (Cooper & Kaplan, 1992).
59 3.6.3 Economic Value Added (EVA)
EVA was developed by US-based business consultants, Stern Stewart and Company, who stated that “Earnings, earnings per share, and earnings growth are misleading measures of corporate performance and the best practical periodic performance measure is economic value- added. EVA is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. EVA is also the “performance measure most directly linked to the creation of shareholder wealth over time” (Stewart, 1991, p.66). Stewart (1994, p.64) suggested that “the EVA is the single best measure of wealth creation on a contemporaneous basis and is almost 50% better than its closest accounting-based competitor in explaining changes in shareholder wealth”.
According to Johnson and Beiman (2007, p.8), the EVA is a “financial performance metric”
that is most specifically associated to the “creation of shareholder value over time”. These authors suggested that the EVA calculation is the “net operating profit less an appropriate charge for the opportunity cost of all capital invested in an enterprise”, with it’s the calculation being “EVA = NOPAT-(CC x IC), Where EVA = Economic Value Added, NOPAT = Net Operating Profit after Tax, CC = Cost of Capital, and IC = Invested Capital”. These authors suggested that “the EVA is designed to give managers better information and motivation to make decisions that will create the greatest shareholder wealth”.
Worthington and West (2001), suggested that the EVA system is widely used in many countries, as well as being adopted for use in performance measurement and/or incentive compensation packages. According to these authors, “Fortune Magazine has called the EVA system today’s hottest financial idea, the real key to creating wealth, and a new way to find bargains” (Worthington & West, 2001). Worthington and West (2001, p.5), cited an article by Peter Drucker (1998) in the Harvard Business Review that suggested that the “EVA’s growing popularity reflects, amongst other things, the demands of the information age for a measure of total factor productivity”.
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There are certain criticisms to the EVA process. According to Johnson and Beiman (2007, p.8), the “EVA may cause managers to invest in less risky, cost-reducing activities rather than in growth activities”. Also, according to these authors, “because it is a pure financial model, EVA does not serve as a vehicle for articulating a strategy”. However, when the EVA is tied with the BSC, it is suggested by these authors, that the adjustments between long-term growth goals and short-term productivity improvements can be achieved. Finally, these authors suggested that the “EVA is that it is a very complex framework” that relies on “complicated calculations”, and this is mostly difficult to calculate and prone to errors that can lead to misleading results.
According to these authors the EVA may not be “easily understood by the majority of employees” because of its multifaceted calculations and framework.