Reccomending the transition to Activity Based Costing

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The major distinguishing features of activity base costing (ABC) compared with traditional costing system are that activity based costing systems assign costs to activity cost centres rather than departments. (Drury, 2008) Although, ABC technique has been around most companies stick to the traditional absorption techniques which apparently seem to less complicated or tedious as opposed to ABC.

This report will not only show but recommend a move to an activity based costing as it's not only the more accurate but it's flexibility and adaptability are far more suitable for the company where technology increasingly has a major role to play .

Why does the company need either absorption costing or ABC?

The reasons why the company needs to employ either technique these include;

To identify product costs for pricing and/or cost control purposes

It's necessary for manufacturers to ascertain the cost of closing stock in order to measure and report profits to the shareholders, plus in the UK SSAP 9 IN 1975 has requires all companies to include manufacturing overheads in the cost of closing stock. (Drury, 2008)

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Helps managers see, where costs are and how they can manage them effectively

Helps with decision making by seeing which centres can be improved or removed.

Can act as measure of productivity.

Differences between Traditional Absorption Costing and ABC

The differences between absorption costing and ABC include the following:

"In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.

Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.

Traditional cost accounting is structure-oriented whereas ABC is process-oriented." (Emblemsvag, 2008)

"ABC brings detailed information from the processes up to and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations." (Emblemsvag, 2008)

"Traditional cost models apply resources to products in two ways. So called direct costs like material and direct labour are attributed directly to the product and other resources are arbitrarily allocated to the product, typically through the mechanism of direct labour hours, machine hours etc. Sales, marketing and administrative costs are not included in product costs." (James D. Tarr, 2004)

Activity based costing is more flexible as opposed to traditional techniques and therefore managers are able to target and reports for specific areas' cost activities.

Traditional techniques are considerably cheaper as opposed to activity based costing.

Traditional techniques are more widely used, and simpler to understand, whilst ABC is more complicated, therefore there is a reluctance in certain business to use it.

"The primary task of activity based costing is to break out indirect activities into meaningful pools which can then be assigned to processes in a manner which better reflects the way costs are actually incurred. The system must recognize that resources are consumed by processes or products in different proportions for each activity." (James D. Tarr, 2004)

Advantages and Disadvantages of Traditional absorption costing techniques

Advantages include the following: (College Accounting Coach, 2006)

"It recognizes the importance of fixed costs in production.

This method is accepted by Inland Revenue as stock is not undervalued

This method is always used to prepare financial accounts;

When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit and

Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation." (College Accounting Coach, 2006)

Disadvantages include the following:

Ignores the fact that different products make different demands on factory support services. (Drury, 2008)

As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control. (College Accounting Coach, 2006)

Emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision. (College Accounting Coach, 2006)

Lucey, lists the following Advantages and Disadvantages of Activity Based Costing (ABC)

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Advantages of Activity based costing:

"More realistic product costs are provided especially in, industries where support overheads are a significant proportion of total costs.

More overheads can be traced to the product. Activity based costing is concerned with all activities so takes product costing beyond the traditional factory floor basis.

It recognises activities which cause cost, not products and it is products which consume activities.

Focuses attention on the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product.

Activity based costing recognises the complexity and diversity of modern production by the use of multiple cost drivers, many of which are transaction based rather than based solely on production volume.

Activity based costing provides a reliable indication of long run variable product cost which is relevant to strategic making." (Lucey, 2002)

"Activity based costing is flexible enough to trace costs to processes, customers, areas of managerial responsibility, as well as product costs.

Activity based costing provides useful financial measures (e.g. cost driver rates) and non-financial measures e.g. transactions volume." (Lucey, 2002)

Disadvantages:

Even though ABC removes most the problems with traditional absorption techniques it's faced with the following criticism

"The choice of cost drivers. It is a simplistic assumption that a chosen cost driver is an adequate summary measure of complex activities

The assumption of a direct, linear relationship between the usage of a cost driver and the amount of overheads. Very few costs indeed are truly variable in this sense whether in the short or long term.

The problem of common costs. It is often difficult to attribute costs to single activities; some costs support several activities.

Tracing difficulties. It is not always apparent which product should carry the traced overhead.

Complexity. A full ABC system having numerous cost pools and cost drivers is more complex and consequently more expensive to operate." (Lucey, 2002)

Definitions:

An allocation: where discrete items of cost can be allotted to cost centres

An apportionment: this is where the cost has to be spread or shared over several cost centres

Absorption rates: Is the rate determined in advance for all cost centres for allocating fixed costs and variable costs (together or separately) to the output, in an accounting period.

Recommendation:

As the company's traditional absorption technique has been adequately measuring direct costs such as material and labour, we can therefore focus the use activity based costing on indirect cost such as overheads and selling, general and administrative costs.

I suggest that the company consider adopting the activity based costing technique as a supplement to traditional techniques as this will be much more suitable way to monitor costs especially in a company in where direct costs are a declining proportion of total cost and support overheads are a major proportion of costs in this company and is therefore of considerable importance that these support overheads are traced to product costs in a more realistic manner. Apart from the fact that activity based costing is more reliable and precise, it has the flexibility to adapt as technology advances/moves on to a more automated system.

Therefore even though activity based costing is cost considerably more as opposed to traditional absorption techniques, it's still a better technique for the business as we are in a world where technology is playing a major role in production and therefor need a technique that is adaptable and able to move at the same pace.