The Advantages And Disadvantages Of Traditional Absorption Costing And Activity Based Costing

The major distinguishing features of ABC compared with traditional costing system are that ABC systems assign costs to activity cost centres rather than departments. (Drury, 2008) Although traditional absorption techniques may apparently seem to less complicated or tedious as opposed to ABC, the report will show why, ABC is the best most accurate technique. The traditional technique used to determine which technique is better of the two will be absorbing indirect costs on a labour hour basis.

Why does the company need either absorption costing or ABC?

There are two main 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)

Differences between Traditional Absorption Costing and ABC

There are three major differences between absorption costing and ABC:

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)

This is further illustrated in the figure below (Emblemsvag, 2008)

ABC brings detailed information from the processes up to assess costs 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).

Further differences include; (James D. Tarr, 2004)

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, labour dollars or machine hours. Sales, marketing and administrative costs are not included in product costs.

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Activity Based Costing (ABC) does not change the way material and direct labour are attributed to manufactured products with the exception that direct labour loses its special place as a surrogate application method for overhead resources. Direct labour is considered another cost pool to be assigned to processes and products in a meaningful manner, no different than any other resource.

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.

With ABC, all costs reside in resources, which are such things as material, labour, space, equipment and services. Resources are consumed by activities which have no inherent cost. The cost associated with activities represents the amount of resource they consume per unit of activity. Resources and activities are then applied to cost objects, that is, the purpose for which the resource is consumed and the activity is performed.

Each resource and activity has a unit of measure which defines the amount of the resource consumed or activity required by a unit of demand for it. Resources can be consumed by resources (e.g. office space resource is consumed by an employee resource), by activities (e.g. telephone resource is consumed by a customer service call activity) or by cost objects (e.g. material resource is consumed by a product cost object).

Activities can be performed in support of another activity (e.g. invoice printing activity supports the billing activity) or in response to a cost object (e.g. purchase orders are issued to support the material acquisition process). A cost object can be a process or product and either an interim cost object or an end user (customer) cost object. For example, hiring personnel may be a cost object of Human Resources Department utilizing space, utility, telephone, supply and labour resources and performing advertising, calling, interviewing and orientation activities. That cost object may be a resource used by other departments to secure labour resource for their department.

Building a network of resources, activities and cost objects defines the operational flow of the process or processes to be costed. Each resource and activity has a unit of measure which converts them at a unit of demand rate. If a cost model is to be useful and effective in determining process and product costs, it is imperative that the business process be identified and understood first. Only then can costs be attached to determine the cost of the defined process. (James D. Tarr, 2004)

Advantages and Disadvantages of Traditional absorption costing techniques

Advantages: (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.

Disadvantages:

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)

As the manager’s 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) (Lucey, 2002)

Advantages:

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. ABC 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.

ABC 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.

ABC provides a reliable indication of long run variable product cost which is relevant to strategic making.

ABC is flexible enough to trace costs to processes, customers, areas of managerial responsibility, as well as product costs.

ABC provides useful financial measures (e.g. cost driver rates) and non-financial measures (e.g. transactions volume)

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:

I suggest that the company consider adopting the ABC technique as this is 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.