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This report is aimed at analysing the advantages and disadvantages of adopting traditional absorption costing or ABC in a chosen medium sized company of which I have been recently appointed a junior assistant management position and supplies services to government bodies. On this note I would be expected to identify with explanation which method will be most suitable in comparison to the other. So therefore, I shall start by talking about the Traditional costing and what it involves after which the ABC will follow, the analysis and then the conclusion.
Method of costing a product in which all fixed and variable costs (however remote) are apportioned to cost centres where they are accounted for (absorbed) using absorption rates. This method ensures that all incurred costs are recovered from the selling price of a good or service, (assuming the final price is acceptable to the customers). (CIMA, 2005)
This is the process of costing a product whereby all costs (both fixed and variable) are apportioned to cost centres to be absorbed using absorption rates.
Absorption Costing system has the following main advantages / benefits:
It is used to prepare financial accounts
It shows less fluctuation in in net profit as variation in sales occur while the production stays the same
Fixed overhead costs are included in production
This method is accepted by Inland Revenue as stock is not undervalued;
Higher income when production is above sale
Its emphasis on total cost makes it difficult to be used as a decision making tool, i.e planning and control.
Cost associated with a certain period is in most cases allowed to mix up with those from other and for this reason, cost to activities, products and services are not accurate.
Why the company needs Absorption Costing
Using this method ensures that all incurred costs are recovered from selling price, with the assumption that customers find the final price acceptable and resources are consumed by products or services.
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, 2005)
This is a method of allocating costs to services and products, that takes account of indirect cost and is ideal as a planning and control mechanism.
Activity based costing system has the following main advantages / benefits:
It reflects in actual sense how work is carried out, in other words costs are attributed more accurately to products and activities.
It encourages benchmarking as they information about profitability is more clearly represented.
Overheads are shown in such a way that they are easy to understand by everyone involved.
It encourages continuous improvement in the management process and facilitates delegation of decision making.
It makes it easier to spot less productive activities (problem child).
There are now ABC costing programs that are continuously developing (e.g clearcost ) that are easy to use and hastens the process.
It requires a lot of money and effort both in the introductory phase and during the cause of maintenance.
It can be time consuming to gather the information needed, access and input into the system.
Because of the complexity of the data produced by Activity based costing, managers when using it as a decision making tool can easily misinterpret and make costly errors, and so must identify what data is relevant for the decision they are about to make.
Some overheads can't be easily assigned to the products.
Most managers that use this method use it partially i.e still implement the traditional system on the side.
WHY THE COMPANY NEEDS ABC
As they operate in the public sector, which is according to research and current figures that which mostly embrace Abc in comparison to other sectors because the weight of benefits to be gained surpasses the loss and the need for them to stay competitive and identify clearly where most costs come from(cost driver), as oppose to the traditional narrow emphasis on cost centers and departments, it will help them manage these costs more efficiently to maximise profit or minimise costs.
Step to take if the company was to introduce ABC as they currently have absorption costing
There are five stages of ABC Costing (EZINE ARTICLES, 2006).
First step is the identification of the products and services
Then identify all the resources and process needed required for the production of the goods and services along with the cost of each.
Identify cost drivers and establish activity cost pool.
Assign other costs to activities and calculate to cost per out come
Use all the information and data to work out total costs of products and services.
So therefore for the company to successfully implement the ABC system, the have to make sure that the objectives are made with minimum cost in mind and with the most simplicity. There are some assumptions of the ABC system that could also be considered:
Consumption should be a basis for determination of the model rather than spending
Although cost pools are variable, they should be homogenous as well
The business activities which in this case is supplying government bodies must consume resources.
A broad mixture of activities can be identified and measured in any company, however consuming company resources can have numerous causes (Schurenberg 2004)
With all that being said, there is still a couple of measures that need to be taken before the business can adapt this system of ABC. They need to set up cost centres and allocate cost of their service, convert the accrual basis of accounting if using cash basis. They should also merge the centres with real life business activities which they are involved in and not treat them as individual entities. Absorption costing is in conformation with the SSAP9 on the valuation of stocks (ACCA Global 2010)
Describe and explain difference between the following:
This is the process by which direct overhead costs are charged to the relative cost centres or cost units.
This means to spread indirect revenues or costs over two or more cost units, centres, accounts or time periods.
Furthermore it is reasonable that they are associated to some extent in which the cost is incurred by individual centres. They must be clear and precise as to what the resources has been used for by the cost centre.
A means of attributing overhead to a product or service, based for example on direct labour hours, direct labour cost or machine hours.
Cost unit absorption rate : (production cost centre overhead/ number of cost unit)
Machine hour overhead absorption rate : (production cost centre overheads/ number of machine hours)
Direct labour hour absorption rate : (production cost centre overhead/ number of labour hours)
Describe and explain the differences between ABC and Absorption Costing and show which is better:
Traditional absorption costing system report distorted product costs whenever the cost of non-volume related activities is important, this system differs from ABC because it recognises activities which are unrelated by using allocation bases that are separate (DOPUCH, BIRNBERG, & DEMSKI, 1974).
However, Activity based costing takes absorption costing one step extra by attempting to absorb fixed production overheads on a more relevant and correct basis looking at each cost individually and seeing what drives or causes the cost to increase (DOPUCH, BIRNBERG, & DEMSKI, 1974). One of the upper hands in which ABC has is the way the costs incurred are traced to services and products according to the demand of the governmental bodies. It gives management a better understanding of how overheads work and how they relate to the services they offer to the government. (DRURY, 1988). It also facilitates the understanding of the factors that drive each major activity. This system will assume that cash outflows are incurred to acquire a supply of resources to the government bodied which are then consumed by the activities (DRURY, 1998). Traditional has its reasons for being preferred by most managers because of its clarity to stakeholders and whoever involved unlike the ABC which is more stashed with information and takes longer time. Nevertheless, my recommendation would stil be the ABC costing system as it is more technologically updated and also uses the coding system to allocate costs rather than the traditional system.
After being said that ABC would be the most appropriate, it should also be noted that it is a complex system that requires continuous management and review for its gains to be maximised. Cost management is a core part of business activity. Just assigning the drivers with the activities is not enough effort, as even thought this might prove expensive, there is a lot to be achieved from the proper implementation of this system as seen above.