The BENEFITS AND DRAWBACKS Of Traditional Absorption Costing And Activity Structured Costing

The major distinguishing top features of ABC weighed against traditional costing system are that ABC systems assign costs to activity cost centres alternatively than departments. (Drury, 2008) Although traditional absorption techniques may obviously seem to simpler or tedious instead of ABC, the report will show why, ABC is the better most accurate strategy. The traditional technique used to determine which technique is way 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 business needs to make use of either technique included in these are;

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

It's necessary for manufacturers to see the price of closing stock to be able to measure and report earnings to the shareholders, plus in the UK SSAP 9 IN 1975 has requires all companies to add making overheads in the expense of concluding stock. (Drury, 2008)

Differences between Traditional Absorption Costing and ABC

There are three major dissimilarities between absorption costing and ABC

In traditional cost accounting the assumption is that cost objects consume resources whereas in ABC it is assumed that cost items ingest activities.

Traditional cost accounting largely utilizes level related allocation bases while ABC uses individuals at various levels.

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

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

ABC brings detailed information from the processes up to examine costs and deal with capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be appropriate, down onto the price items without considering any 'cause and effect' relations (Emblemsvag, 2008).

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

Traditional cost models apply resources to products in two ways. So called immediate costs like materials and immediate labour are attributed right to the product and other resources are arbitrarily assigned to the product, typically through the mechanism of direct labour time, labour dollars or machine time. Sales, marketing and administrative costs aren't included in product costs.

Activity Based Costing (ABC) does not change just how material and immediate labour are attributed to manufactured products with the exception that immediate labour loses its special place as a surrogate application method for overhead resources. Direct labour is considered another cost pool to be given to operations and products in a important manner, no unique of any other source.

The primary activity of activity based costing is to use indirect activities into important pools which may then be allocated to techniques in a way which better demonstrates just how costs are in reality incurred. The machine must recognize that resources are used by operations or products in several proportions for every activity.

With ABC, all costs reside in resources, that are such things as materials, labour, space, equipment and services. Resources are consumed by activities without any inherent cost. The cost associated with activities represents the quantity of resource they take in per product of activity. Resources and activities are then applied to cost objects, that is, the purpose for which the reference is consumed and the activity is conducted.

Each source of information and activity has a product of strategy which defines the amount of the resource consumed or activity required by a product of demand for it. Resources can be used by resources (e. g. work place resource is consumed by an employee source), by activities (e. g. phone resource is used by a person service call activity) or by cost items (e. g. materials resource is consumed by a product cost subject).

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

Building a network of resources, activities and cost items defines the functional flow of the process or operations to be costed. Each learning resource and activity has a unit of strategy which converts them at a product of demand rate. If a cost model is usually to be useful and effective in deciding process and product costs, it is critical that the business enterprise process be determined and understood first. Only then can costs be attached to determine the cost of the defined process. (James D. Tarr, 2004)

Advantages and Drawbacks of Traditional absorption charging techniques

Advantages: (College Accounting Trainer, 2006)

It recognizes the value of fixed costs in creation.

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 charging where fixed costs are agreed to change into adjustable cost, it is cost into the stock value hence distorting stock valuation.

Disadvantages

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

As absorption charging emphasized on total cost namely both adjustable and fixed, it is not so great for management to make use of to make decision, planning and control. (College Accounting Trainer, 2006)

As the manager's emphasis is on total cost, the cost volume profit marriage is ignored. The manager must use his intuition to consider. (School Accounting Trainer, 2006)

Lucey, lists the next Advantages and Disadvantages of Activity Based Costing (ABC) (Lucey, 2002)

Advantages

More realistic product costs are provided especially in, business where support overheads are a significant percentage of total costs.

More overheads can be followed to the merchandise. ABC is concerned with all activities so takes product costing beyond the traditional stock floor basis.

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

Focuses attention on the real characteristics of cost behaviour and helps in minimizing costs and determining activities which do not add value to the product.

ABC recognises the complexity and diversity of modern creation by the use of multiple cost drivers, many of which can be transaction based rather than based only on production volume level.

ABC offers a reliable indicator of long haul variable product cost which is pertinent to proper making.

ABC is adaptable enough to track costs to operations, customers, areas of managerial responsibility, as well as product costs.

ABC provides useful financial procedures (e. g. cost drivers rates) and non-financial methods (e. g. deals volume)

Disadvantages

Even though ABC takes out most the problems with traditional absorption techniques it's faced with the next criticism

The selection of cost drivers. It really is a simplistic assumption that a chosen cost driver is an ample summary way of measuring complex activities

The assumption of a primary, linear relationship between your usage of a cost driver and the quantity of overheads. Hardly any costs indeed are truly changing in this sense whether in the brief or long term.

The issue of common costs. It is difficult to attribute costs to one activities; some costs support several activities.

Tracing difficulties. It isn't always visible which product should bring the traced over head.

Complexity. A full ABC system having numerous cost pools and cost motorists is more technical and consequently more costly to operate. (Lucey, 2002)

Definitions:

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

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

Absorption rates: May be the rate determined in advance for all those cost centres for allocating set costs and changing costs (collectively or separately) to the productivity, within an accounting period.

Recommendation:

I suggest that the business consider implementing the ABC approach as this is a lot more desirable way to monitor costs especially in a business in where direct costs are a declining proportion of total cost and support overheads are a major proportion of costs in this company which is therefore of substantial importance these support overheads are traced to product costs in a more natural manner.

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