Absorption Costing and Activity Based Costing: Advantages and Disadvantages

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It is vital to have a proper costing system in place to offer services at competitive prices. This is all the more important in the current economic environment as the UK government is likely to curtail public expenditure in the future to rein in the fiscal deficit and this will increase the competition for public sector contracts. There are two important costing systems - absorption costing and activity based costing (ABC). This report analyses the usefulness of a costing system by highlighting the benefits that accrue to a company by using either of them.

The report compares the advantages and disadvantages of both costing systems. The company currently uses absorption costing. As the ABC is based upon a number of cost drivers and collection of data associated with them, a section of this report analyses the major steps that will be required if the company was to introduce an ABC system. There would be costs and resources associated with the implementation of an ABC system and a preference of one costing method over another will take those into account along with their benefits. Some of the key terms/concepts used in this report are also explained for better understanding.

Benefits of a costing system

A good costing system gives the management of company correct information required for pricing of a product. Management makes strategic pricing decisions based on the nature of various costs. This is important for success of the company to win orders in today's competitive world where lower economic growth has reduced the avenues for increasing sales.

The UK government has borrowed a large amount of money to prop up the balance sheets of the commercial banks. In order to rebalance its financial books, the government will have to reduce expenditure in the future. The government is unlikely to cut expenditure on health or education. But other services will be hit hard. Lesser number of contracts will result in higher competition and companies with relevant and proper costing systems will have competitive advantage to win more orders in a low profit margin environment.

Absorption costing and Activity based costing

Absorption Costing

Absorption costing is a technique that calculates unit cost of a product or service by including both fixed and variable costs. Variable costs are easy to identify and allocate but fixed costs are associated with more than one service or cost centre and have to be allocated on the basis of different assumptions.

With absorption costing, the company does not have to use separate internal and external financial reporting systems. Absorption costing includes all costs in a product thereby meeting the external financial reporting systems requirement of matching costs with the sales in a period. The company saves significant costs and resources by using one financial reporting system only.

As absorption costing includes all fixed costs, it is a better judgement of a firm's profitability in the longer run. A company has to recover all fixed costs in the medium to long-run and exclusion of them in pricing decision may lead to business failure over the long run.

But absorption costing has its drawbacks also. The fact that the fixed costs are allocated on the basis of various assumptions may lead to different costing standards within a company and prevent benchmarking of processes.

Activity Based Costing

ABC is a system that assigns the overhead costs for each activity of an organisation to the products, services or other cost objects that caused that activity (Horngren et. al, 1999: pg. 136).

ABC can be used for benchmarking and improving processes. The use of standard activities and data collection processes can enable a company to benchmark activities across plants and drive improvements. (Kaplan and Cooper, 1998, pg. 143).

The major drawback of ABC is that the costs of implementing and operating it are significantly more than that of an absorption costing system (Drury, 2004, pg. 389). As data collection about different costs has to be done in various departments, the costs associated with training of personnel and software installation makes an ABC system prohibitive especially for smaller organisations. Smaller organisations also normally do not have enough manpower to assign for ABC system.

Steps needed to implement an ABC system

The steps that the company would need to take if it was to introduce an ABC system are as follows:

Educating employees.

Employees involved in collating activity and cost information and their analysis should be educated about the process. Even though training employees requires resources and costs, starting an ABC system without proper education may result in collection of incorrect data and its wrong interpretation. Also educating employees about the benefits of an ABC system will help them overcome their initial inertia. Without proper understanding of the benefits of an ABC system, the demand for additional resources for data collection and associated additional costs can make the process painful (Weil & Maher, 2005: pg. 233).

Identify the cost objectives and activities.

The objective of implementing an ABC system is to establish costs of services being delivered by the company to various government bodies. To meet this objective the company needs to identify activities involved in completing those services. A process flowchart is a good tool for identifying main activities (Rozrocki et. al, 2004, pg. 20).

Identify cost drivers.

The company should select cost drivers on the basis of the following criteria:

A reasonable cause-effect relationship between the cost-driver unit and consumption of resources.

Availability of quantifiable and measurable data on the cost drivers.

Collection of relevant data concerning costs.

The company should collect all costs associated with the above identified activities and divide them by the cost driver units to arrive at cost per cost-driver unit.

Calculate service costs.

The cost per cost-driver unit should be multiplied with number of cost driver units required for completing each activity used in a service. Summing the above costs for each activity in a service will give the cost of each service provided by the company.

Allocation, apportionment and absorption rates

Allocation of an expense takes place when it can be specifically charged to a cost centre. Apportionment of an expense happens when it cannot be identified to a specific cost centre. The main difference between allocation and apportionment of costs is that the allocation deals with the entire costs but apportionment deals with proportion of items of costs. This means that allocation is a direct method whereas apportionment is an indirect method as it uses some indirect basis to allocate costs. As an example, the salary of a worker in a maintenance department will be allocated fully to the maintenance department. But as the maintenance department services are used by other departments, the salary of a maintenance worker will be apportioned to those departments.

The absorption rate is a rate used in an accounting period to charge overheads to the production in that period. Absorption rates are calculated by dividing the overhead expense by the total production of goods or services.

Costing most suitable for the company

The choice of a costing system by the company should be based on cost versus benefit considerations. There could be a number of cost drivers because of the nature of activities performed in providing various services to government bodies. Adding all unallocated costs in to a cost pool and then absorbing them on the basis of some method will not result in true representation of costs. Instead the service firm should use ABC to analyse different causes of the additional costs incurred and allocate costs on the basis of these cost drivers. An ABC system will generate more accurate data for pricing of company's services in an increasingly competitive environment. Establishing cost drivers will not only help in proper costing of different services but also reducing costs through benchmarking of standard activities.

As the company is a medium sized business, the costs of implementing an ABC system are not prohibitive in relation to this size. It also has the manpower resources as employees working in different departments have process knowledge and can be trained and assigned to record cost data without causing a significant business disruption. Hence in light of intensifying competition, the company should implement an ABC system to maintain or increase its competitive edge.