Absorption Costing vs Activity Based Costing - Essay Example

Finance and Accounting Topic: Critically compare and contrast absorption costing with activity based costing of Subject Name of Professor Date Introduction Is the use of absorption costing still applicable at this point in time when changes have happened in the business environment? Is ABC costing necessarily better than absorption costing? These and other questions will be answered as this paper critically compares and contrasts absorption costing with activity based costing. This paper will determine which came first for users, their similarities and differences as well as the benefits and limitations of each. Which came first between the two? Absorption costing came first before ABC costing. Because of the need to cost products and know what the proper price for each product or service up in the market, unit cost must be known. The absorption costing therefore is there use both for external and internal purposes. The need for better costing than absorption for internal or management has been a challenge for those wanting to price their products competitively (Atkinson, Anthony, et al. 2005; Bernstein, J. 1993; Emmanuel, et al 1990) . Thus before ABC costing was the used of variable costing, where cost that are controllable or variable was separated from fixed cost for management purposes. But variable costing had still some limitations particularly on the limited used of allocation bases particularly direct labour hours. With changes in the environment from labour intensive to capital intensive, activity-based costing (ABC) became an alternative. It may be worth highlight to mention a slight difference between variable costing and ABC, which is the possibility under the latter to convert fixed cost in to variable cost. The seeming advantage can be seen now in better information for decision-making by focusing on activities that consume resources under ABC. What are their similarities and differences? From the evolution of costing methods as discussed in the previous subsection, it should be easy to know the similarities. There are both for costing products. Both of them involve cost pool but more than one is for ABC. In the application of rate, both may still volume or direct labour hours, but under ABC there could be other cost pools and consume resources. From the same evolution of the costing methods, spotting the difference between absorption and ABC become easier. There difference lies in the number of cost pools, the applied rate, suitability on whether the industry is labour or capital-intensive and in terms cost and benefits of using either. The benefits of each method of each method can be demonstrated As ABC came after absorption costing, there is good reason discussed the benefits. These would include the following: Improve product cost or service data. Improve decisions about pricing, service mixes and product strategies based on the more accurate information, cost reduction by eliminating non-value added activities, greater control of costs because of its focus on behaviour of costs at their origination, both short-term and long-term, more accurate evaluation of performance by programs and responsibilities (Atkinson, Anthony, et al. 2005) The discovery of ABC costing must be credited with its extended use by management. At first companies moved from traditional absorption costing to ABC in their desire to produce more accurate cost information for their products. While looking for better costing, there is such a thing as serendipity or chance of accidentally finding something some good or useful than originally intended. The managers in some of these companies were astonished by the information revealed by the use of ABC. The new costing system gave companies a different perspective of the built-up of costs, which eventually s led them to fine-tune their pricing policies and to develop different products strategies. With the discovery that that previously high volume, long production run products had low cost than actual cost and low volume, short production run products lower units cost than actual, the use of ABC became attractive. When companies use ABC information for cost management it can be said that they have moved outside ABC to ABM. In doing the analysis necessary to establish an ABC products cost, they discovered, for example, that the current organisation of activities leads to doubling of activities and processes, and hence waste. The organisation and flow of processes can therefore be altered to eliminate repetition and achieve cost savings (Jo Avis, et al, 2008). Furthermore, by using ABC, firms also found themselves creating the basic building blocks of information in the form of activity cost drivers through the accumulated cost found in activities. The cost drivers incidentally provide a number of different sets of information. ABC was on customers or groups of customers. Its use was even extended research, improvement in organisational learning, and market development and others (Jo Avis, et al, 2008). Using a sample computation to show an advantage of ABC over absorption costing would make things clearer Theory becomes more convincing with an example. This section assumed as hypothetical accounting data from a company which can use either traditional costing under absorption or ABC as introduced. It can be demonstrated in Appendix A that the company can just get its unit cost from adding the material cost per unit, direct labour per unit and factory overhead per unit. Computation of the factory overhead per unit and it uses direct labour hours as basis. It is therefore so simple to get unit cost under traditional costing since by multiplying by 300 the direct labour cost per unit then, all the cost components is clearly identified. It assumed however in Appendix A that the company has that experience of having factory overhead as three times the direct labour cost per unit. Thus the estimate could be wrong since the same can be very arbitrary. To alternative use ABC there need to have cost pools consisting of the activities of setting up the equipments, inspecting the equipment and operating the equipments. The cost drivers need to be identified and they are no. of set ups, inspection hours and machine hours. See Appendix A. It can noted that to estimate how much activity based costing (ABC) is better than traditional costing, there is need to look at the difference in costing. It may be observed that under the ABC, the unit cost is £ 17,727.20 as against absorption costing at £18,500.00 or a difference of more than £1,000 per unit. See Appendix A. Under ABC, the appropriate activities are defined after carefully analysing the same and a cost driver rate is derived for each kind of appropriate activity by dividing estimated unallocated overhead costs to cost drivers that are properly identified. ABC brought unallocated fixed cost with the activities that consume resources, thus in effect redefining the behaviour of the fixed cost into variable cost. ABC expanded in effect to have more variable cost information. This would then afford the decision maker to know what are controllable and in effect helps the company in implementing responsibility accounting that could hold managers responsible for their decisions. Note the difference per unit cost may not be that material but if a company happens to manufacture a billion quantity of the product, the difference in unit cost may be material in knowing the correct information. However to use ABC given the complexity and cost issues, management must conduct a separate cost benefit analysis. Complexity should mean simpler way to prepare costing under the traditional way, and it costs fewer to do the same. Absorption costing can still be continued if the organization is not too big to engage services of certain personnel to get the ABC system operational still the advantages of simplicity and lower cost is all other things are assumed equal. It can be simple because the externally reported information on inventory cost as per the company’s published annual report and cost of goods sold will be the same as that used for internal purpose. What limitations of ABC should be taken into consideration Although ABC was the result for continuous search for better costing, it does not necessarily mean that it has addressed all the problems in costing. One of its limitations is the additional cost that would be involved in adopting the use of the same. Another limitation is the change of arbitrary allocations as in absorption costing may still be possible. However, the choice of using and not using would be a question of whether a decision must have basis or not and would be best addressed by the management. When it is justified to use ABC? Given there the benefits or advantage of ABC over that of absorption and with the given limitations, knowing when it is justified would be very relevant. There are certain conditions or factors that must be met before considering the choice to have ABC. One is product lines differ greatly in volume and manufacturing complexity. This means that if the there is only product line in the company, the principle of cost benefit analysis may not justify the same considering that it is generally more costly to have ABC over that of traditional costing. This would therefore in effect the size of the company and the volume that it may produce in terms of unit cost associated with the final product or service to be delivered. The second factor is when product lines are numerous, varied and would require differing degrees of support services. This second factor is different from the first which refers to variety in volume and complexity of processes involved in manufacturing while the second in on number of product lines. The presence of either the first and second could therefore justify the use of ABC. The other logical factor to justify use is the presence of having high overhead in relation to the total cost. This must be logical consequence of the inapplicability of labour hours as basis of allocation as overhead now is the bigger factor that could be best allocated by considering multiple cost pools along with applicable cost drivers. The third would be connected with the fourth factor, which is, that fact that there is evidence the business having shifted from labour-intensive to capital intensive nature of the business. This development can really hasten then the introduction and use of ABC as companies want to maximize profit by changing a large part of its labour with machines. Maximizing profit is of course guided by wealth maximization objectives (Brigham & Houston, 2002; Carroll, 1983; Edwards, et al, 2007; Van Horne, 1992). Of course the an common justification to use ABC is when there is no sense to use the traditional costing method because of the practice of managers to ignore data provided by the existing system and instead use illicit costing date or other alternative data in making their pricing and other product decisions (Weygandt, et al, 2004). Of course the use of ABC in a complex environment should be a warning for extra caution for financial managers to be very care and deliberate when they will initiate changes towards ABC costing. They will surely need the support of top management (Helfert, 2001; Meigs, et al, 1995; Cooper, 2000; Droms, 1990) if they have to do their functions (Weygandt, et al, 2004). Conclusion This paper has found that there are good differences between activities based costing compared and absorption costing. The difference may justify the evolution of costing system as absorption or full cost accounting came earlier. Sticking to use what is theoretically deficient could only result to erroneous or deficient information and eventually to wrong decision. Activity based costing are not without disadvantages and one of which is the cost of adopting and implementing the same. The choice of which method to use could still be best evaluation in terms of cost benefit analysis since they are means to an end as far as the business decision makers are concerned. The need for a new approach in the form of ABC costing appears to have come as a result of the deficiency of traditional costing. This exactly what happened in recent years, as manufacturers and service providers would have to experience remarkable changes in the economic and business environments (Samuelson and Nordhaus, 1992; Slavin, 1996; Dornbusch and Fischer, 1990). Changes in environment are evident in advances in computer systems, global competition, technological innovation, and automation that changed the manufacturing environment significantly. The shift from labour intensive to capital intensive industries the amount of direct labour used in many industries has to great decrease and total overhead costs, resulting from depreciation on expensive equipment and machinery, utilities, repairs, and maintenance would have to significantly increase. Good and scientific management dictates that a lack of correlation between labour and overhead should convince decision-makers that it is unsuitable to apply plant-wide predetermined overhead rates based on direct labour any more. If these companies continue the use overhead rates based on direct labour, despite the absence of connection, they could expected to experience significant product cost distortions and therefore wrong decisions on many aspects of business including on pricing and evaluating the departments or managers’ performance (Johnson, et al, 2003; Ross et. al, 1996; Avis, et al, 2008). To avoid such distortions, companies should rather use machine hours as the basis on which to allocate overhead in automated manufacturing environment allocation all overhead. However if the manufacturing process would become so complex, ABC costing could only be the most appropriate method in providing multiple allocation bases for more accurate product-costs computations (Weygandt, et al, 2004). References: Atkinson, Anthony, et al. 2005. Management Accounting. New Jersey: Person Custom Publishing Bernstein, J. (1993). Financial Statement Analysis, Sydney: IRWIN Brigham, E. and Houston, J. (2002). Fundamentals of Financial Management, London: Thomson South-Western Carroll, Thomas (1983). Microeconomic Theory Concepts and Applications. New York: St. Martin Press Edwards, Miles, and Winterfeldt. (2007). Advances in decision analysis: from foundations to applications. Cambridge University Press Emmanuel, C., D. Otley & K. Merchant (1990). Accounting for management control. Cengage Learning EMEA. From Practice to Theory. Springer Helfert, E. (2001). Financial Analysis: Tools and techniques: a guide for managers. McGraw-Hill Professional Meigs, R, Meigs, W., & Meigs, M. (1995). Financial Accounting. New York: McGraw-Hill Cooper, L. (2000). Strategic marketing planning for radically new products. Journal of Marketing, Vol. 64 Issue 1, pp.1-15. Dornbusch, R. and Fischer, S. (1990). Macroeconomics. New York: McGraw-Hill Publishing Co Droms (1990). Finance and Accounting for Non-Financial Managers. England: Addison-Wesley Publishing Company Meigs, R,. Meigs, W., & Meigs, M. (1995) . Financial Accounting. New York: McGraw-Hill Johnson, et al (2003). Financial Accounting. Tata McGraw-Hill Ross et. al (1996). Essentials of Corporate Finance. London: IRWIN Samuelson, P. and Nordhaus, W. (1992). Economics, London: McGraw-Hill, Inc Slavin, S. (1996). Economics. Fourth Edition. London: IRWIN Van Horne, J. (1992) Financial Management and Policy. Prentice-Hall International. Weygandt, Kieso & Kimmel. Managerial Accounting: Tool for Business Decision Making. John Wiley & Sons, Inc, 2005 Avis, et al (2008). CIMA Official Learning System Management Accounting Decision Management. Elsevier Read More