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

This paper employs real option approach (ROA) to study the decision of ABC adoption and discontinuation under uncertainty. The general idea behind is that investing in ABC system is an option-rights as in financial American call option. The proposed model takes the total annual number of production of a firm as the primary decision variables. The added annual net profits after establishing ABC are considered in deciding the optimal threshold for adoption or discontinuation. Moreover, the difference between the ROA and the net present value (NPV) method is compared. We found that the optimal entry threshold for adoption obtained by the ROA is higher than that obtained by the NPV method. Conversely, the optimal exit threshold for discontinuation obtained by the ROA is less than that obtained by the NPV method. Thus, ROA is more conservative than the NPV method. The difference between these two methods is primarily driven by the option value of waiting before implementing the entry/exit project in the ROA.