The Real Option Approach to Adoption and Discontinuation of Management Accounting Innovation: The Case of Activity Based Costing

Posted: 8 Aug 2018

See all articles by Shu Feng

Shu Feng

Boston University

Chun-Yu Ho

State University of New York (SUNY) - Department of Economics

Date Written: 2016

Abstract

This paper employs the real option approach (ROA) to study the investment decision of a management accounting innovation—the case of activity-based costing (ABC)—adoption or discontinuation under uncertainty. We argue that investing in ABC is analogous to having the option rights in a financial (American) call option. We propose a model taking the firm’s total annual production as primary decision variable and using the added annual net profits after establishing ABC to identify the optimal threshold for adoption or discontinuation. We find that the optimal adoption (resp., discontinuation) threshold is higher (resp., lower) when obtained by the ROA than by the net present value (NPV) method; thus, the ROA is more conservative than the NPV approach. Their difference stems mainly from the ROA’s option value of delay before implementing the adoption/discontinuation decision. Further, recent empirical researches based on survey found inconclusive results about the adoption of ABC. For instance, there are studies found that manufacturing sector having a higher adoption rate of ABC than non-manufacturing sector, but the other studies find the opposite. Our theoretical model explains the inconclusive results from the empirical researches can be driven by the variations in mean and volatility of sectoral output growth, which are omitted in those studies.

Suggested Citation

Feng, Shu and Ho, Chun-Yu, The Real Option Approach to Adoption and Discontinuation of Management Accounting Innovation: The Case of Activity Based Costing (2016). Review of Quantitative Finance and Accounting, Vol. 47, No. 3, 2016, Available at SSRN: https://ssrn.com/abstract=3217669

Shu Feng (Contact Author)

Boston University ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

Chun-Yu Ho

State University of New York (SUNY) - Department of Economics ( email )

1400 Washington Ave
Albany, NY 12222
United States

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