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In recent years increased relevance of cost allocation. Nowadays, there are different costing techniques. Significant changes have taken place in the manufacturing environment over the years. Costing systems can vary in terms of which costs are assigned to cost objects and their level of sophistication. Typically cost systems are classified as follows:
Direct costing systems;
Traditional absorption costing systems;
Activity-based costing systems
In this essay I will look into two methods - Absorption costing and activity-based costing, known as ABC. These are the most common methods of full costing.
Traditional absorption costing evolved in the early 1900s. Traditional absorption costing normally uses labour hours as a basis for absorption. Absorption costing allocates all manufacturing costs, variable and fixed, to products and any unsold inventory is valued at the total cost of manufacture.
In absorption cost system the cost of production consist of:
Prime costs - direct material (raw) and direct labour (manwork and total factory hours)
Production overheads - fixed overheads (rent of factory, amortization of factory building) and variable overheads (the general and administrative expenses in the manufacturing process).
There are three main steps in the process: allocation, apportionment, and absorption.
The first step in absorption costing is allocation. It is the process by which whole cost items are charged direct to a cost unit or cost centre. The second step is apportionment. This involves apportioning general overheads to cost centres and then reapportioning the costs of service cost centre to production departments. A number of overheads tend to vary more with time than with output and will have to be shared out between the cost centres using some method of apportionment. Following figure shows the apportionment of overheads:
Advantages of absorption costing:
The apparent advantage is that all the costs are covered;
It helps to calculate Gross Profit and Net Profit separately in the Income Statement;
It helps to prevent losses in seasonal business companies;
Under absorption costing, the inventory can be valued at the total cost.
Disadvantages of absorption costing are as follows:
Absorption costing does not provide adequate guidance on the relationship between cost, volume and profit or on the pricing decisions;
Fixed costs are carried forward to the next period as the closing inventory is valued at the total cost which includes a proportionate fixed costs;
It is not helpful for managerial decisions;
Unit costs are determined under different levels of output, hence are different. It is difficult to compare between the process of cost and cost control.
Activity based costing (ABC) was developed in the USA by R.Cooper and R.S.Kaplan during the late 1980s. Furthermore, the intense global competition of the 1980s has made decision errors, due to poor cost information more probable and more costly. Over the years the increased opportunity cost of having poor cost information, and the decreased cost of operating more sophisticated cost systems, increased the demand for more accurate product costs (Holzer and Norreklist, 1991). And ABC has emerged against this background. ABC is a relatively new method. ABC is aimed at the absorption of overheads. Activity based costing is a development of the traditional full-costing approach. Today the companies produce the wide range of products. The terminology of CIMA defines activity-based costing as "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 utilize cost drivers to attach activity costs to outputs." Activity based costing can be described as technique which involves costs of each cost-driving activity. ABC is founded on the belief that activities cause the overhead costs. This means that all indirect costs (overhead costs) are to be identified with each such activity that acts as a cost driver - which is mainly responsible for the incurrence of such indirect costs. ABC systems use both volume-based and non volume-based cost drivers. The number of activities depends upon two factors: (1) number of products produced and (2) the complexity of operations. A cost driver is any factor that influences the cost of a cost object. There may be many cost drivers in a process. Any change in a cost driver will directly change the total cost of its cost object.
Cost driver is
Variable (such as level of activity)
that casually affects costs
Over a given period of time.
In contrast, in traditional product costing, the number of cost drivers used are few such as direct labour hours, direct labour cost, units produced. But ABC may use a variety of cost drivers that relate costs more closely to resources consumed and activities occurring. Costs that are fixed in the short run have no cost drivers but may have cost drivers in the long run. For example, take the cost of testing new brand cars X. These costs consist of testing department equipment and technical staff and cannot be changed. They are fixed in the short run. However, in due course, that is, in the long run, the testing department will increase in proportion to volume of production. Hence, in the long run, volume of production is a cost driver of testing goods.
These are some more examples of cost driver in ABC:
Number of setup hours;
Under ABC, an overhead cost pool is established for each cost driver in which all of the costs caused by that driver placed. All costs associated with any activity would be allocated to the cost pool.
Activity based system have four levels of activities:
Product - costs related to a product. Expenses in this category include direct labour, direct materials, energy costs and machine processing time.
Batch - costs related to batches produced.
Product sustaining - costs to support particular product. Costs include maintaining and updating product specifications and the technical support provided for individual products and services (example provided by Kaplan and Cooper (1998)).
Facility sustaining - costs to support activities of whole organisation. Include administrative staff, plant management and property costs.
These levels of activities are used to identify cost allocation bases.
The following are advantages of ABC system:
Once the concept is clear, it is simple to apply;
Traceability: overhead costs can be traced easily. Hence, cost data are more reliable and accurate;
Makes visible waste and non-value added;
Utilizes unit cost rather than just total cost;
Moves beyond traditional "factory" boundary.
The disadvantages of ABC:
Activity based costing data can be easily misinterpreted and must be used with care when used in making decisions;
Not all cost drivers are measurable;
Problems of implementation;
Cost may exceed benefit.
Introducing activity-based costing system
Introducing activity-based costing is not a simple task. One of the problems arising in the calculation cost of production (services) is the adoption of right method of indirect costs allocation. For example, a trading company uses absorption costing system in one of their stores. Costs are allocated in proportion to the purchase price of goods sold. Suppose that company decided to expand the store. Therefore, company needs accurate information of individual products profit. Hence, decided to introduce ABC system. Instead of one category of indirect costs it will introduce cost centers. Cost centre involves 4 levels which later will become the basis of indirect cost allocation.
Differences between absorption costing and ABC
Both systems include the two - stage allocation process. In the first stage absorption system allocates overheads to production and service departments and then reallocates service department costs to the production departments. An ABC system assigns overheads to each major activity. In ABC many activity - based cost centres are established, whereas with absorption costing overheads tend to be pooled by departments. ABC has more a greater number of cost centres. The second stage of allocation process allocates costs from cost pools to products. Absorption costing system place overheads to products using a small number of second stage allocation bases which shows the volume produced. Term cost driver is normally used in ABC system, instead of allocation bases. Direct labour and machine hours are the allocation bases which use absorption system. However, ABC uses many different types of second-stage cost drivers. Absorption costing system normally allocates service costs to production centres. Their costs are absorbed with the production cost centre costs and are included in production centre overhead rates. It is distinguishing feature, because ABC systems tend to establish separate cost driver rates for support centres, and assign the costs directly to cost objects without any reallocation to production centres. The using of ABC system helps more accurately measure the resources because they rely on greater number of cost centres. Absorption costing systems shows less accurate costs because they use cost drivers where is no cause and no effect to assign support costs to cost objects.
The optimal costing system is different for different organisations. Traditional absorption costing system may be optimal for companies having the following characteristics:
Low levels of competition;
Non-volume-related indirect costs that are a low proportion of total indirect costs;
Company is based on production of low product diversity.
ABC system may be more suitable for the organisations with following characteristics:
Non-volume-related indirect costs that are a high proportion of total indirect costs;
Company is based on production of high product diversity. Organisation is producing the wide range of products.