The advantages and disadvantages of traditional Absorption costing techniques

Introduction

Through the years when it comes to planning Managers has developed techniques and methods of forecasting future costs. One of such methods is Absorption costing and activity based costing (ABC)

What is Absorption costing?

Absorption costing is the traditional method of costing and stock evaluation, having been developed around the 1870s to 1920s is widely used by the manufacturing companies. The idea behind absorption costing to spread all overheads of the manufacturing cost centers as well as the direct cost between the finished products, and treat all non-manufacturing overhead as period costs. CIMA defined Absorption Costing as “a method of costing that, in addition to direct costs, assigns all, or a proportion of, production overheads costs to cost units by means of one or more number of absorption rates.”

What is activity based costing?

Is the modern method of cost management having been developed in 1980s. it is the preferred method for the services industry. The CIMA definition for activity based costing is ”an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.”

CIMA Official Terminology, 2005 (http://www.cimaglobal.com/Documents/ImportedDocuments/cid_tg_activity_based_costing_nov08.pdf.pdf)

Analysis

Why does the company need either absorption costing or ABC?

It’s very important for managers to have an idea of the actual cost of processes, departments, operations or product which is the foundation of their budget.

and in order to achieve that they need to have a cost accounting system; such as absorption coting or activity based costing. Here are the advantages of having such systems and their disadvantages

The advantages of Absorption Costing:

It recognizes the importance of fixed costs in production;

is method is accepted by Inland Revenue as stock is not undervalued;

is method is always used to prepare financial accounts;

When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit and

The disadvantages of Absorption Costing:

As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control;

as the manager’s emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision.

The advantages of Activity Based Costing:

More accurate costing of products/services, customers, SKUs, distribution channels.

Better understanding overhead.

Easier to understand for everyone.

Utilizes unit cost rather than just total cost.

Integrates well with Six Sigma and other continuous improvement programs.

Makes visible waste and non-value added activities.

Supports performance management and scorecards

Enables costing of processes, supply chains, and value streams

Activity Based Costing mirrors way work is done

Facilitates benchmarking

The disadvantages of activity based costing:

It costs a lot to maintain it, it takes a lot of time and resources to collect, check and enter it into the system for the date needed to measure activity based costing.

Is not accepted by GAAP (accepted accounting principles) therefor companies need to have a different system when preparing external reports.

What are the differences between Absorption costing and ABC?

There are many differences between absorption costing and activity based costing.

Difference in Approach

One of such differences is the way it approached. Absorption costing allocates costs to product units, whereas activity based costing traces the costs of product units.

Absorption costing is the traditional cost accounting method that focuses on the product or service when fixing costs. It works under the simple approach of assigning resources to products or services directly.

Activity based costing is a modern cost accounting approach that focuses on activities as the fundamental cost. ABC presumes that products or services consume activities, and activities consume resources. It thus, works to convert indirect costs into direct costs.

Difference in Methodology

Absorption costing divides equally the fixed overhead costs with the number of product units whereas activity based costing identifies the actual proportion of fixed overheads costs incurred by the product unit.

Comparing absorption costing and activity based costing, the latter follows a more scientific approach. Price fixation in absorption costing depends on the inventory. The higher the inventory, the lower the product cost and lower the inventory; or the higher per-product cost. Price fixation in activity based costing bases calculations to derive the actual overheads incurred on a unit, and does not vary with change in inventory levels.

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Activity based costing, however, faces serious challenges in practical application, for appropriating some of the fixed overheads such as the chief executive’s salary on a per-product usage basis, is next to impossible. Moreover, process of data collection, data entry, and data analysis required to divide the fixed overhead costs among units based on usage, requires substantial resources and remains costly to maintain. Absorption costing that divides all fixed overhead costs with the number of units produced is a simple and easy approach and free from such complexities.

Legal Validity

Absorption costing complies with the generally accepted accounting principles (GAAP) whereas the Financial Accounting Standards Board (FASB) and Internal Revenue Service (IRS) do not accept ABC for externally published financial statements. Firms that follow activity based costing, therefore, need to maintain two cost systems and accounting books, one for internal use, and another for external reports, filings, and statutory compliance.

Difference in Scope

Absorption costing helps ascertain the overall profitability or efficiency of the manufacturing system but fails to provide the real cost of individual product units.

Activity based costing mirrors the functioning of the enterprise and contributes to strategic decision-making processes. ABC provides the real cost of individual product units and, thereby, helps identify inefficient or non-profitable products that eat into the profitability of other highly profitable products. ABC also helps price products equitably, allowing breaking down of product or service into sub-components or offering “top ups” based on customer needs.

Comparing absorption costing and activity based costing, activity based costing improves the quality of management accounting information, especially in large and multi-product operations where conventional overhead allocation methods such as absorption costing may produce misleading results. Absorption costing, however, remains more suitable for small firms and enterprises with homogeneous products or services.

Recommendation and implementation

I recommend to introduce activity based costing system as its more suitable for the public service industry.