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The purpose of this report is to discuss the advantages and disadvantages of Traditional absorption and Activity based costing. In addition, analysis will be carried as to why a company needs either the Traditional based costing or the Activity based costing. Differences between both steps will be looked into.
Moreover, this report will also consider, explanations of an allocation, an apportionment, absorption rates and suggestions will also be made as to what method is suitable.
This report has been put together to analyse the advantages and disadvantages of ABC and absorption costing. Research have been thoroughly done to solve the problem arising from the use of absorption costing, coupled some few illustration as to how ABC works.
Why ABC was implemented.
Activity based costing was implemented in the United states in the year 1890, by Robert Kaplan and William Burns, who brought the concepts of ABC to existence. It was implemented to tackle problems faced with traditional absorption costing, which is unable to recognize precisely the factual cost of processes for strong management decisions. (Naron, D.2009). Originally, ABC's area of specialisation was the manufacturing industry, where, technological development and productivity improvements reduced the percentage of direct, labour and material costs. However, it caused an enlargement in the percentage of indirect or overhead costs (CIMA global, November 2008).
"An Activity based costing is said to be a type of system which allocates overhead to each main activity in an organisation, thereby resulting to numerous cost pools. It then allocates the cost of activity to the product, services or other cost objects that caused the activity".
On the other hand, "Traditional absorption costing technique is the type which at first allocates all overhead to the production and service cost centres department of an organisation and then reallocates service department costs to the production departments," (Drury,2006, p.349)
However, there are points to note, in determining the most suitable.
Why does the company need either absorption costing or ABC
Why company need Absorption Costing
Absorption costing is essential for a company, because all cost are aimed to be recovered and identified into product or service as to form the basis for the valuation of inventory and pricing. However, only overheads that are directly connected to the production of inventory can be recovered. In a company, total absorption costing will recover all cost from each department that are involved in production, and manufacture. One of the major problems that might occur is that all cost might not be identified until the end of the accounting period.
Why companies need Activity Based Costing
Activity based costing are needed, to produce a perfect cost for each product. The understanding behind this method is that, necessary calculation is expected to be accurate in order to control cost. In other words, managers do not want to take the risk of having to make decisions based on imprecise data provided by the absorption technique, as competition is increasing. Recently, absorption costing has failed to accomplish the expectation of the new manufacturing industrial environment. However absorption costing also lacks sophistication, while allocation of direct cost has failed to reflect the original distribution of cost, so activity based costing is aimed to remedy this defect. Furthermore, ABC, has been brought into existence to for better allocation of costs, for expenses to be traced easily and directly to products or services, and measurement for quality enhancement opportunities. (Narong, D.2009)
What are the differences between Absorption costing and ABC
Absorption costing makes use of direct labour and machine hour to allocate their costs while ABC makes use of cost pools and cost drivers as basis of allocation. Under ABC technique, "cost pools are allocated to objects based on how much of the activity is consumed by the objects", ( Stratton,W.et al.2009) while cost driver is any form of activity that drives cost.(Drury,C.2006)
Furthermore absorption costing uses a lone accumulation of cost, this cost are not identifiable directly, being part of cost of labour or product. Examples of this cost include, allocation of management wages, cost of maintenance and expenses and finally depreciation. Activity based costing consume smaller targeted cost that increases based on activities. In service operations, such as Bank, Accountancy, Administration, Architecture and Insurance complex companies make use of Activity based costing since their services are not of volume.
3. What steps would the company need to take if it was to introduce an ABC system (currently has absorption costing)?
A company needs to apply five steps in order to complete the aim of cost recovering. Step 1 is to avoid keeping separate record for financial accounting and management accounting because many businesses have integrated financial accounting and management accounting systems. A company can easily trace individual product or service towards direct cost such as direct material and direct labour.
The second step is to classify all cost into certain groups and categories these costs before allocating them into separate departments. An example involves the requirement of calculating total cost for light and heat or rent.
The third step is for a company to allocate indirect cost to departments. Furthermore, direct cost can be directly traced to goods and services. In the case of overheads, the applicable process is indirect while the main point is to find the appropriate part for allocation.
The fourth step is to reallocate all the cost to production departments because this cost must be recovered into specific products which are only made in product department. At the fifth step cost are absorb into final product while a suitable recovery rate is chosen. The nature of activity will be reflected by the chosen rate.
Step six is about applying the absorption cost into production.
Steps Required in ABC
In ABC the three steps are the same as traditional costing. Meanwhile the third step is to identify those activities that determine the overhead cost such as production. Step four is to identify all cost drivers, and appropriate allocation should be made to this cost drivers. In step five all activity cost driver rate are calculated, this method involve, the division of number of activity by the total cost for a cost driver. Step six is to absorb both direct and indirect cost into a product or service.
Differences between an allocation, apportionment and absorption rate.
According to (Drury,C 2006), an allocation is said to be a procedure for assigning cost, when there is no existence for a direct measure for a quantity of resources used up by a particular cost object. That is, cost that cannot be traced directly, to a particular object will be assigned to a cost object. The assignment of indirect costs to a cost object with the help of a particular base is known as an allocation base
According to (Lucey, T.2009) an apportionment, is when cost is been distributed under a number of cost centres.
According to (Drury, C.2006) an absorption rate is also described as a blanket overhead rate. An absorption rate is a particular overhead rate used by an entire organisation or company for charging their overheads or indirect cost to production, for an accounting period. As overhead absorption is been calculated earlier than the accounting period, budgeted cost tends to be over or under absorbed. By over absorption, we mean that overhead absorbed in the cause of production is greater than the actual overhead. On the other, under absorbed is when overhead is lower than actual overheads.
In conclusion to the all the above analysis, ABC is the most suitable type of costing because:
Research and survey has proved that it is best method, adopted by most manufacturing and service companies. It is as well useful for making management decisions such as planning, budgeting and to review the performance of an organisation.
Drury,C.(2006) Cost and Management accounting. Sixth edition. Bedford Row, London: Thompson Learning.
Jones, M.(2006) Management Accounting, Second Edition. British Library Cataloguing -in-Publication Data
Proctor, R.(2009). Managerial Accounting for Business Decisions, Fourth Edition. FT Prentice Hall. Pearson Education.
Narong,D(2009)Activity-Based Costing and Management Solutions to Traditional Shortcomings of Cost Accounting. Cost Engineering.Morgantown.51 (8)August,pp.11-22.
Stratton,W.et al(2009)Activity-Based Costing: Is It Still Relevant? Management Accounting Quarterly, 2009.Vol. 10, Iss.3, spring, p. 31-40