There are advantages and disadvantages of absorbtion costing

October 7, 2017 History

There are two chief bing methods that this company can utilize, soaking up costing and Activity based costing. Absorption bing and Activity based costing ( ABC ) are two similar systems that are used to delegate indirect costs to be objects. Absorption costing is besides called ‘traditional costing ‘ ; it is more simplistic and uses arbitrary allotment. On the other manus, ABC is more sophisticated and uses cause-and-effect allotment. This study will cover with the different definitions, the history, the advantages and disadvantages of soaking up and ABC systems. Then finial a recommendation on which system is better suited for this company.

This company needs either of the two costing system because they are utile during planning and budgeting. Furthermore holding the systems in topographic point will let operating expenses to be charged to services.

ABSORPTION Costing

“ Absorption costing is a method of bing that, in add-on to direct costs, assigns all, or a proportion of merchandise operating expense costs units by agencies of one or a figure of overhead soaking up rates. ” Cima ( 2005 )

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“ Absorption bing systems is a costing system where fabrication costs are allocated to merchandises and non fabrication costs are non allocated to the merchandise but charged straight to the net income statement and excluded from the stock list. ” Drury ( 2008 )

“ Absorption costing is a system in which all the fixed fabrication operating expenses are allocated to the merchandises. ” Drury

From all these definitions the Cima definition is the better definition because it mentions most of the cardinal procedures that are involved in soaking up bing which straight away gives you an thought of what soaking up costing is. The other definitions are besides good as they province some procedures involved in soaking up but Cima puts the definition in a more apprehensible manner.

History

This costing system was developed decennaries ago when companies were much smaller and had less overhead costs. During the clip this system was developed there were largely industrial companies which made this system suited to delegate costs to be objects.

How it works

This company presently operates under soaking up costing system for working out operating expenses for their services. Working out soaking up bing involves a two phase procedure. Stage one sing the allotment and allotment of indirect costs to service and production cost Centres and so allotment of the service section to production section. Allocation is the procedure of gauging the cost of resources consumed by a merchandise that does non utilize direct steps. This procedure deals with operating expenses that can be straight assigned to be Centres without the demand to be apportioned. Cost allotment is a procedure of bear downing indirect costs to be Centres that ca n’t be straight allocated. Service section operating expenses are transferred to the production section so they can be covered.

Phase two works out the soaking up rates that are so used to bear down operating expenses to be objects. The soaking up rate worked out is used to cipher the entire operating expenses of a merchandise.

From all these three phases merely allotment is used in ABC.

There are advantages and disadvantages of soaking up costing:

Advantages

Cheap and simple to run. Absorption costing is simple to run which makes it less expensive to run. This is good for the company as it allows them to cut down their costs and understand what they are making.

Disadvantages

Less accurate. It ‘s good that the system is simple, but this makes it less accurate when bear downing costs to be objects because of the intensive usage of arbitrary allotment. Arbitrary allotment is when an allotment base used is non a considerable determiner of its cost. Not cognizing all the exact causes of certain costs will do it hard during planning and budgeting.

Absorption bing accents on variable and fixed costs. This makes it hard for the company to utilize information from this system for determination devising ; it ‘s non detailed plenty to assist the concern make anticipations or budgets.

ACTIVITY BASED Costing

Different beginnings define ABC in different ways:

“ An attack to the costing and monitoring of activities which involves following resource ingestion and bing concluding end products. Resources are assigned to activities, and activities to be objects based on ingestion estimations. The latter utilise cost drivers to attach activity costs to end products. ” Cima nomenclature

“ Activity based costing is a polish of soaking up bing that aims to bear down overhead costs in much more item so that the overhead cost can be charged on the footing of a cost driver. ” Drury ( 2005 )

Between these two definitions Cima definition clearly states what ABC is all about and references cost drivers which are a cardinal country of this system. While the other definition does non specifically province what is involved in ABC e.g. cost drivers though it does indicate out that it ‘s similar to soaking up bing. Overall, the Cima definition is better as it is a more detail account.

History

ABC system was developed when the current system so ( soaking up bing ) was going less utile for delegating costs to merchandises in the changing concern environment. In the 1980s companies begun to increase in size and bring forthing wider merchandise ranges and services. Information processing costs were high, which made it hard for sophisticated overhead allotment methods to be justified. There was an increasing demand for more accurate merchandise costs ; this led to the debut of the ABC system. Cooper and Kaplan conceptualised the thoughts behind this system as a manner of seeking to better the truth of the charge made to be objects in complex concern environments.

How it works

ABC system is worked out otherwise compared to absorption bing. They both use the two phase allotment procedure to delegate operating expenses to be objects. First phase operating expenses are assigned to be Centres and in the 2nd phase the cost accumulated in the cost Centres are allocated to be objects. ABC differs from soaking up costing by holding more cost Centres in the first phase and a greater assortment of cost drivers in the 2nd phase.

Exhibit 1 shows an illustration of a company ‘s one-year operating expense costs which i will utilize to how ABC works. Similarly to soaking up costing, an overhead analysis sheet is produced where operating expenses are allocated to be Centres. This is shown in exhibit 2. Then activities are identified for each cost. From exhibit 3 column A, you can see that there are tonss of activities that have been identified from major activities e.g. General mill support. The costs created over a specific period have to be assigned to the activities. When costs are accumulated by activities they are called activity cost drivers. Activity cost drivers have to be selected for each activity Centre in order to delegate the cost attached to merchandises. In exhibit 3-column C and D you can see the activity cost drivers and the cost they each accumulate. Cost driver rates are worked out for each activity. Finally, the cost driver rates are applied to merchandises. In exhibit 4 there is an illustration of Product G that is produced and uses assorted activity cost drivers and cost driver rates are applied.

There are advantages and disadvantages of holding ABC in topographic point, these are:

Advantages

Helps place unprofitable points from the merchandise line. This will let the company to do alterations to their production, and better their efficiency. Removing these unprofitable points reduces un-necessary costs the company possibly meeting. Besides it enables the company to increase its net income without the demand to increase monetary values.

Provides quantifiable figures for planning and estimations. ABC identifies all the different cost drivers that contribute to the entire operating expenses of bring forthing a merchandise or service. This will assist when giving quotation marks to clients every bit good as for the concern to see if taking up a certain undertaking will be profitable to them.

ABC uses a big figure of cost Centres in the first phase and a greater assortment of allotment bases in the 2nd phase. This makes the system accurate at bear downing operating expenses to merchandises. Accurate cost charges to merchandises or a service reduces the hazard of doing a loss if the right sum is non charged.

Disadvantages

Expensive to run. The complexness of this costing system makes it expensive to run compared to other options. The concern will hold to put clip and resources in order for them to place the cost drivers. E.g. one of the stairss needed to place cost drivers is to interview staff and have them make full in clip sheets. This procedure will cut down the production clip available to the company.

Time devouring. Using ABC is a really long procedure and requires a batch of information to implement ; this is clip devouring for the company and its staff.

There is excessively much attending to detail and command. Sometimes paying close attending to detail might do it hard for the company to see the bigger image or do the house lose sight of strategic aims merely to seek for little nest eggs.

It may be hard to implement. In service companies there are costs that are hard to apportion to specific service units and service section, staff frequently get involved in many non informal activities which may be disputing to enter cost informations.

Recommendations

Given that the company supplies services to authorities organic structures and operates under soaking up costing, I recommend that we should alter the costing system to ABC as it will be more suited for the company. This bing system may be hard to implement in service companies but it shows the company more item of the assorted costs involved in each service they provide which is indispensable during determination devising and planning.

To implement ABC there certain things the concern will hold to make:

Proper planning and committedness from staff, transporting out a pilot survey foremost may be critical. This will supply information about whether holding ABC will be a benefit to the company.

A squad will hold to be set-up that will be responsible for finding which activities are necessary for the services. The squad should be made up of experts from different sections of the company and a adviser from outside can be used. Having persons from different allows accurate designation of operating expenses involved.5

When a squad has been assembled, elements of each activity that cost money are determined. Attention to detail is critical as some costs are hidden.

Once all the costs have been identified and recorded, they have to be put in a computing machine system.

After the concern has had adequate clip to analyse the informations they can utilize the information in assorted ways e.g. working out entire operating expenses for each service.

Decision

Absorption costing has been around for a long clip, ABC was developed as an betterment of soaking up costing. ABC is a more accurate costing system compared to absorption bing as it looks at single activities that contribute to the entire operating expenses, while soaking up bing expressions at sections. Having looked at both advantages and disadvantage of the two bing systems it is clear that even though they are similar they have important differences. I have recommended that we introduce ABC, it will be a immense benefit for the company as it will diminish the figure of mistakes made during costing.

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