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In management accounting there are three method/techniques of calculating a cost per unit that a business may use. The company can choose any type of method to use depending on a business. These are Absorption costing, Activity based costing, Variable or Marginal costing. Absorption costing is also known as traditional costing which was designed and developed in 1870 to 1920. In 1970's and 1980's Activity Based Costing was developed as the method of absorption costing, before ABC was developed most companies used absorption costing and marginal costing. Cooper and Kaplan conceptualized the ideas behind these systems as a way of trying to improve the accuracy of the charge made to cost objects in complex business environments
In this report will deal with the advantages and disadvantages of activity based costing and absorption costing and why the company need to use either of these methods, but will also look at the main difference between allocation, apportionment and absorption rates.
"In absorption costing the cost of a product or service is established by adding a share of fixed production overheads (indirect costs) to direct costs." Absorption costing is consistent with requirements for stock valuation in financial reporting. For manufacturing system, it is usual to absorb production overheads only into product cost. Administration, sales and distribution overheads are usually written off as an expense of the period in which they arise. Overhead absorption is also known as overhead recovery". (CIMA)
"Under absorption costing method a full production cost per unit is calculated by including in the cost of the cost unit a proportion of the production overheads from each of the production and service cost centers. This is done by allocating, apportionment and absorbing the overheads". (AAT)
When you compare these two definitions CIMA definition is the best because it explains more in details. It explains the processes involved in absorption costing, which gives an idea of what it is. The other definition from AAT is also good but not lot of information is given.
Stages in Absorption Costing
An allocation it's one of the first stages in absorption costing. It's the method of assigning costs into the cost centres, the appropriate basis needs to be used when allocating overheads.
An apportionment is the second stage in absorption costing. In this stage the total of each service department is used to spread the costs into the production departments by using the appropriate basis.
An absorption rates is the last stage in absorption costing in which the total of each production department is divided by either direct labour hour or machine hour.
Using the information given in example 1.1 is to assign all overheads to production and service centres. Exhibit 1.2 shows all three stages of absorption costing starting from allocation to absorption rates.
Advantages of Absorption costing
Ideal for smaller businesses because they don't have many overheads to distribute.
Most suitable for the companies that makes products rather than services.
This method is used to prepare financial accounts.
The absorption will show less changes in net profit when production when sales changes but production stays constant.
Used for tax reasons in order to value the stock so it reflects the true valuation.
Disadvantages of Absorption Costing
Not suitable for the company that does services because absorption costing based more in products.
Not ideal for management to use for making decision, planning and control as its highlighted on total costs both fixed and variable cost and it is not accurate.
Not suitable for the larger companies as it can be misleading.
In absorption costing the cost of production can be determined after the service or product have been produced
Activity Based Costing
"Activity based costing is an alternative approach to product costing. It is the form of absorption costing but its approach is to link overhead costs to the products or services that cause them by absorbing overhead costs on the basis of production volume." (CIMA)
"Activity based costing is the method of absorption costing which uses more sophisticated methods of allocating overheads to cost unit than the normal methods of overhead allocation and apportionment." (AAT)
Between these two definitions, again CIMA definition explains more about ABC, they explain the basics things that its approach is to link overhead costs to the product or service on the basis of production volume. The AAT definition just defined partially which if reading first time will be hard to understand.
The diagram below illustrates in outline how ABC works:
Cost pool 1
Cost pool 2
Cost driver 1
Cost driver 2
Cost pool 1 total / no. of cost driver
Cost pool 2 total /no. of cost driver
Use of cost driver *cost driver rate
Use of cost driver *cost driver rate
Identifying activity causing overheads
Gather all costs for each activity
Identify what causes the cost
Calculate cost driver rates
Apply to individual cost unit
Activity cost is the first thing that needs to be worked out, example of these activities is receiving goods, inspecting, and storing goods. Using information given in example 1.1, Exhibit 1.3 it shows step by step on how ABC is worked out. All the stages shown on the diagram above are calculated.
Advantage of Activity Based Costing
In ABC the cost of production can be firmly decides through customer feedback before the product/service is produced
ABC technique helps either to raise or lower activities to win customers.
It is more accurate than absorption costing
ABC can be applied to production and other overhead costs
Easy to be used in service costing than product costing
ABC can be applied to get realistic costs in a complicated business environment
It is suitable for bigger companies.
Suitable for future planning
Disadvantages of Activity Based Costing
ABC is designed for larger companies because of many overheads included.
May be difficult to operate
Time consuming, takes time in collecting datas and its got long process.
Many cost drivers needed so ABC would be too complex and expensive
I recommend that the company should change from absorption costing to ABC system because the company is based on services rather than products so this is best method for the company. Not only that but also it's a medium sized company, a lot of overheads are involved, if the absorption costing is to continue be used then it will be so hard for management to make decision, planning and control.
The company can introduce ABC system by setting up a team that will be dealing in identifying which activities are required for the service. Experts from different area of the company and outside consultant must be included in that team.
After the team is joined together and all materials and information are collected, then can decide the basics of each activity that costs money. It is very important to have attention to details in this stage because a lot of these costs may not be clear and not easy to see.
As soon after the costs are determined and well known, all the gathered facts must be saved into a computer (ABC software, data base or customized software). This will finally help the company decide whether to increase the profit margins and make the activity more organized.
After the company had examine the data obtained using ABC and decide which activities are officially in force, it can then choose what ways to use to increase profit. All activities that are considered to be very expensive can then be reduced or rejected to make them more profitable.
The company needs to use these methods/ techniques because of the three main things, these are decision making, planning and control and product costing. It is very important for the company to identify if they are making profit or loss. For them to make decision whether to drop the service or keep doing, they need to know which services are more profitable and which one are not. After the decision is made the company must plan and control their spending.
Taking into account everything that is explained in this report, the ABC system is the best. The company needs to know what is going on within a business, whether is going up or down. ABC system will help management to make decisions of whether to continue doing the same service or provide another that can make the business more profitable. It is very important to have accurate figures for making decisions planning and control. The absorption costing method is not accurate especially if a business has many overheads, only ABC system is accurate.