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Traditional absorption costing method and ABC method

Traditional absorption costing method and ABC method are used to allocate overhead costs to products. Both systems have twostage allocation process. In the first stage, both approaches assign overhead costs to cost centers or cost pools. In the second stage of the traditional costing system, costs are allocated to products using machinehours or other appropriate allocation basis. In part A, for example, the traditional absorption costing system allocates the total overhead cost ($941,000) of all five cost centers (machining services, assembly service, setup cost, order possessing, and purchasing) of the two departments (machine and assembly), to the three products (XYI, YZT, and ABW) using machine hours (420,000 hours). As a result, the overhead cost per unit equals $2.24 per machine hour.

In the second stage of the ABC system, costs are traced from activities to products using many cost drivers. Part B shows that each department overhead costs are assigned to its related cost driver to calculate the overhead cost per unit. For instance, the overhead cost per unit ($0.85 per machine hour) for the machine services is calculated by dividing the overhead cost of machine services ($357,000) by machine hours (420,000 hours).

Comparison of Traditional (A) and ABC (B) costing system

A) Traditional absorption cost method (sumlump)

Stage 1: overhead assigned to production department------------- Stage 2: overheads allocation to products

-- Production department---------------------- Departmental overhead ------------------ products

---- allocation rates

B) Activity based cost method (Multiple cost drivers)

Using cost driver rates

Activity cost pools------------------ ----------- Activity cost drivers rates------------ products

Source: Innes and Michell (1990)

The next summary table for the three products XYI, YZT and ABW shows product costs according to the two approaches. Under traditional absorption costing system, product XYI was undercosting by $ 138,000 resulting inflation in profit for this product by $135,500 ($426,000$287,500), while products YZT and ABW are overcosting by $127,000 and $11,500 respectively. Therefore, in traditional absorption costing product YZT reported a loss ($8000). But in fact, in ABC this product is achieving a profit ($119,000). Moreover, using traditional absorption costing system, product ABW has inflation in losses. For example, the loss is $28,800. In contrast, the loss is $17,500 by using ABC.-

This result because traditional costing method is taken to account the volume or unit based allocation (lumping different activities together), ignoring the likelihood that some of the activities of a service department may benefit other service departments in addition to the production departments. In contrast, ABC tries to aligning individual costs with the factors that are creating them. The end result is that ABC tends to eliminate the cost distortion that sometimes arises with traditional absorption method. More specifically, the under or overcosting products. Nevertheless, using multiple cost drivers help users to better consider variations in consumption ratios that may exist among products.- -

Products------------------------------------- XYI------------------------ YZT---------------------- ABW

1 Traditional Absorption cost------------- $ 224,000-------------- $448,000---------------- $ 269,000

2 ABC--------------------------------------- $ 362,500-------------- $321,000---------------- $ 257,500

Difference------------ ---------------------- $138,500------------- +$127,000---------------- +$11,500

Strengths of ABC:

Traditional absorption costing system fails to recognize that nonvolumerelated costs vary with such transactions as the number of order processing, the number of setups and the number of purchasing. ABC does overcome distortions inherent in traditional cost information based on step down allocations using only volumedriven drivers. Moreover, ABC recognizes the causal relationship of cost drivers to activities. Companies with high overhead cost and a diversity of products are most likely to benefit from ABC. ABC method yield much information about activities and resources required to perform these activities. By providing this information, ABC offers assistance in improving work processes by providing better information to help identify which activities require much work. Thus, managers have improved data that reveal what products and services really cost. Furthermore, ABC information encourages companies to evaluate activities to see which are nonvalued and can be eliminated.

Manager's responsibility is to understand cost structure better. Because, in resources allocation, costs will be allocated according to real economic benefit. Also, knowing the real cost will be useful in:- (1) Marketing decision (skimming or expanding), (2) Bidding decision (pricing) and (3) product line decision (performance measurement).