Traditional Absorption Costing versus Activity Based Costing - Assignment Example

Traditional Absorption Costing versus Activity Based Costing Table of Contents 0 Introduction 1 Absorption costing 2 Activity Based Costing 2.0 Literature Review 2.1 Features of absorption and activity based methods of costing 2.2 Justification for different costing methods 2.3 Comparison of ABC and Absorption Costing 2.4 Advantages and disadvantages 2.5 Further analysis and discussion 3.0 Conclusion 1.0 Introduction The allocation of overheads has always been a matter of concern in manufacturing businesses especially in recent times. The method used in allocating overheads plays a role in the determination of the comparability of the costs of doing business vis-a-vis the cost to competitors. In fact Geri and Ronen (2005) indicate that cost accounting systems do not normally command a high ranking in the hierarchy of most organisations, it is the information that they generate that plays a critical role in the performance of organisations and in the decision making process. The range of systems available and the claims made by the proponents of each have led to several debates. However, some of the arguments have some merits in as much as they allow for a better understanding of the methods that are being utilised. Some of the techniques and systems in use are of traditional management accounting domain while others are of the more recent strategic management accounting domain. Some of the criticisms that have been put forward in relation to traditional systems are that they fail to provide the necessary information that would improve the strategic decision making process (Johnson and Kaplan, 1987; Bromwich and Bhimani, 1989; Roslender and Hart, 2003). Suggestions like these are based on the perceived inability of the traditional systems to provide information that would make the organisation more competitive and therefore improve long run performance. In fact, Benjamin et al (2009) indicates that the inefficiencies of traditional systems especially in the area of absorption costing in coping with modern business environments have been of great concern. The gaps that are thought to exist as well as changes in the manufacturing industry including the move from being labour intensive to being capital intensive have provided the impetus for innovation in this very critical area of business (Benjamin 2009; Chenhall 2003; Lukka and Shields 1999). Johnson and Kaplan (1987) indicate that this change can be found in the application of ABC to manufacturing concerns. This paper looks at two forms of full costing systems - traditional absorption costing and the more recent activity based costing (ABC). Both methods take a different approach in assigning cost to products. 1.1 Absorption costing Absorption costing has it roots in the manufacturing industry (Benjamin et al 2009). BPP (2011) indicates that the objective of this method of costing is to include an appropriate share of an entity’s overheads in the cost of a product. What is appropriate should be reflective of the time and effort that was used in the production of the product. The method becomes complicated when an organisation produces a mix of products and activities or resources used do not bear any relationship with the volume of items produced. Geri and Ronen (2002) indicates that the use of this method requires the allocation of a proportional rate of the fixed cost of production to units produced but which has not yet been sold (Geri and Ronen 2005). 1.2 Activity Based Costing Activity based costing (ABC) was developed as an alternative to absorption costing. (BPP 2011). This method of costing identifies the cost drivers of the activities of an entity’s production process. Overheads are then charged to products based on how they utilise a particular activity. 2.0 Literature Review This review while critically assessing the literature examines the features of two costing methods and looks at the justification for their use. It also provides a comparison while it examines the advantages and disadvantages of using them. 2.1 Features of absorption and activity based methods of costing This approach to costing requires three steps – allocation; apportionment; and absorption (BPP 2011; Horngren 2000). However, one of the criticism’s put forward is that too much is overheads may be allocated to products with high volumes and too little to those with low volumes. This is one of the issues that ABC seeks to address. BPP (2011) also identifies a four step process in the operation of an ABC system. Step 1 identifies the major activities of an organisation; Step 2 identifies the cost drivers that determine the size of the costs of an activity; Step 3 collects the costs of each activity and pools then into what is described as cost pools; Step 4 charges the supporting overheads to a product based on usage of the activity. The use of an activity by a product is based on the number of activity cost drivers it generates. BPP (2011) provides examples of how Steps 2 and 4 are applied. Using the activities provided earlier – ordering materials, handling materials, scheduling production, and despatching goods the cost drivers would be the number of orders, the number of times the production line is run, and the number of orders despatched respectively. Material handling and production scheduling relates to the same cost driver – the number of times the production line is run. An example is also provided for Step 4. If the cost pool for the ordering activity cost ?200,000 and 20,000 orders were received then the activity would cost ?10 per unit. This suggests that the higher the number of orders received then the lower the cost per activity will be. This obviously gives rise to a similar situation described in absorption costing as under or over absorption. If not then cost per unit of a product will vary in relation to efficiency levels. It goes without saying that the number of order received may or may not relate to efficiency levels as it impacts storage and handling costs. 2.2 Justification for different costing methods BPP (2011) indicates that absorption costing can be justified theoretically and practically. The theoretical justification is that overheads incurred during production are part of the total costs of producing the products and therefore should be included. However, while this cannot be disputed the method or approach to allocating and apportioning costs is considered by many to be haphazard. The practical reasons for using absorption costing include the following. i. Valuation of inventory – Inventory is included in the financial statements and for this statement to be considered true and fair inventory should be valued at full factory cost. This requirement complies with IAS 2 – Inventories. IAS 2 is an international accounting standard and adoption in various countries through the process of harmonisation allows for comparability of financial statements among entities operating in the same industry. ii. Pricing decisions – In making pricing decisions most companies attach a mark-up on the full cost of the item. It is considered that if this method is not used then the full cost cannot be ascertained. iii. Determination of profitability – the greater the variety of products sold the greater the level of difficulty an entity will experience in the determination of the profitability of each product unless overheads are included. BPP (2011) indicates that this is a contentious issue. BPP (2011) indicates that absorption costing came into being when only a few products were produced by manufacturing companies and when overheads represented a relatively small proportion of total costs. At that time direct costs of mainly material and labour were the main components of cost. Therefore, the value of the over-absorbed or under-absorbed overheads was insignificant. The use of new and more advanced technology has resulted in production being more capital intensive. This meant that overheads became much more important and a very small proportion of labour was being utilised in the process. Additionally, advances in information technology has allowed for more efficient and effective methods of allocating overheads than previously encountered. Therefore, it was no longer appropriate in some instances to use direct material and direct labour as bases for the allocation of overheads. Although absorption costing accurately allocates to products the cost of resources used in proportion to the number of units produced many resources are used in support activities that are not related to number of units produced. Volume related resources include power and lubricants while resources that do not relate to volume but which has increased because of the now more capital intensive nature of production includes set-up costs, production scheduling, inspection of the first set of items and data processing activities. BPP (2011) further states that these support activities allows for efficiencies to be gained in manufacturing a range of products and are therefore not affected by volume changes. Instead they vary in accordance with how complex and wide ranging the products that are being produced really are. A more complex manufacturing process would require more support services while a less complex process may only require the bare minimum. The use of ABC accounting was therefore seen as a way to resolve the problems encountered with the use of absorption costing. Absorption costing assumes that products use resources in direct proportion to volume and so a large proportion of overheads were allocated to high volume products and smaller proportions to low volume process. This method completely disregarded any complexities in producing low volume products. BPP (2011) provides information on ideas behind ABC. Firstly, activities cause costs to arise. Some of the activities include ordering materials, handling materials, machine works, assembling items, scheduling production and dispatching items. Secondly, when goods are produced several activities are involved as the act in itself creates a demand for the activities that are required to get the job done. Finally, the cost of producing a product is assigned based on how much of the activities the product consumes. 2.3 Comparison of ABC and Absorption Costing In comparing ABC and absorption costing BPP (2011) points out that in the same manner in which there are no rules that can be used as the basis for the absorption of overheads in absorption costing there are difficulties associated choosing cost drivers. However, BPP (2011) points out that in ABC costs that varies with the volume makes use cost drivers associated with volume while those related to transactions use activity related cost drivers. Thus, Hundal (1997) indicates that a comparison of ABC costing with conventional methods such as absorption costing shows that ABC provides a more acceptable method of allocating overheads. However, there are disadvantages and advantages of using both methods. 2.4 Advantages and disadvantages Writers and researchers have focused the advantages and disadvantages associated with the use of ABC. While the advantages are associated with the benefits that can be derived from its use, the disadvantages are mainly associated with implementation - the costs versus benefits to be derived. Some of the advantages are included in the following list. It should be noted the advantage of one method represents the disadvantage of the other method and vice versa. According to BPP (2011) the following represents some of the advantages and disadvantages of ABC. i. The implementation of ABC is relatively easy as long as the information relating to cost drivers is available. ii. It is focused on the provision of product costs that are meaningful. iii. It is the only costing system that recognises that a number of overheads are a result of the diverse and complex nature of manufacturing and service operations. iv. ABC recognises that manufacturing is more complex now than previously due to an increase in the range of products, reductions in the life cycle of products, the increased need for quality and other complexities in the production process and has responded with the use of multiple cost drivers (BPP 2011). v. It provides a more realistic way of assessing the profitability of products by facilitating a better understanding of the drivers for overhead costs. This is necessary in a competitive environment. vi. It takes management accounting beyond the factory floor in consideration of all overhead costs including product design, quality control, customer service, production planning and sales order planning. BPP (2011) and others have levelled a number of criticisms against the use of ABC systems. In fact, BPP (2011) has noted that there are a number of serious flaws including: i. In pooling costs it may become necessary to arbitrarily apportion certain costs such as rent and depreciation. The amount of apportionment generally varies with the number of cost pools. Therefore, the greater the number of cost pools the greater the number of apportionments. ii. Questions have been raised about the ability of a cost driver to provide a full explanation of how the cost of all items behaves in the cost pool to which it is associated. iii. A usable cost driver requires costs that are the results of activities and that can be both measured quantitatively and can be associated with production output. However, not all costs can be treated in this way. iv. Organisations may introduce ABC because it is in fashion and not because it is useful in providing product costs that are meaningful or even for the fact that it provides more information. In this instance absorption costing would be more beneficial because of the simplicity with which it can be operated Although there are many instances in which the use of ABC is suitable there are some instances in which it is not. The instances that are suitable for its use and for which absorption costing would be more appropriate include instances when: the proportion of overheads are high compared to direct costs; the range of products is wide and diverse; there are variations in the amount of overhead resources; the main driver of the resources consumed is not volume. Based on the aforementioned points it is suitable in modern organisations where high levels of overhead costs, particularly those relating to support services. It is considered to be more logical in how it assigns overhead costs. It also provides a means of both measuring and improving the efficiency and effectiveness of supporting departments. It improves product costing as many of the costs that are arbitrarily allocated in absorption costing can be traced to the relevant products. It also helps in answering a number of questions relating to whether a particular activity adds value which is an important question in cost and management accounting. If an activity does not add value then it is considered a waste of resources and should be eliminated (Horngren et al 2000). This results in increased efficiency and effectiveness in the operation of the entity concerned. Fritzsch (1998) indicates that by introducing ABC an attempt was made to improve the way in which the cost of a product was built up and in so doing to overcome the problems associated with absorption costing. In stating the major advantages of using ABC the indication is that it is easier to find a cost driver that is related to an activity than under absorption costing. Additionally, ABC provides a better way of applying costs that are associated with activities that are related to transactions rather than production volume. However, Fritsch points out that the ability of a cost driver to trace the amount of resources consumed declines as more and more actions are included as part of an activity. Fritzsch (1998) points out that the success of ABC is dependent on how cost drivers and activity pools are selected. Additionally, defining a cost pool that is reasonably small without violation of the assumptions of ABC can be problematic. Furthermore, the costs associated with a given activity pool should vary proportionately with the cost driver that relates to that pool. The implication of this is that all costs are variable in relation to the activity that is used as a driver. Originally it was not meant for facility level costs to be allocated. Copper (1990; cited in Fritzsch 1998) found that all manufacturing costs pools are being allocated. As a direct result of this Fritzsch points out that in addition to the failure of ABC to distinguish between fixed and variable cost it absorbs cost that are partly sunk costs. This is seen as a continuation of the issue of how to treat fixed and variable costs. That is, the same issues affecting the use of traditional absorption costing also applies to ABC. 2.5 Further analysis and discussion In summary ABC requires the factors which results in costs of major activities in an entity to be identified. Support activities are then charged to a particular product in accordance with the way in which that product utilises support activities. Whereas, it may be assumed that low volume products cause greater diversity and so use more support service, it may be true to say that setting up the production line to produce a different product may not be necessary in all circumstances as some manufacturing entities plan their production in such a way that different products are produced on different days. In this case the machine hour rates would apply. Additionally, in order to prevent unnecessary break downs and too much time setting up, different machines are used for different products or groups of products. Therefore, despite the more capital intensive nature of modern production systems it still facilitates the use of absorption costing. In fact, the people involved in setting up a production line and inspecting products are usually paid an hourly rate and therefore labour hour rates which is a method of allocation is in order. Where, the method breaks down is when there is a high level of under and over absorbed overheads. What would be required under absorption costing is a regular review of absorption rates. Additionally, efficiency levels are subject to change and this play a role in whether are not there is under or over absorption. One of the problems with absorption costing is the use of sunk costs which does not contribute to the decision making process. In fact, Rao (1997; cited in Fritzsch 1998) indicates that although ABC deals with the ‘lousiness’ in relation to the use of absorption costing it only improves the allocation of costs which are not relevant. Therefore, ABC has not contributed anything towards improving the quality of the decision making process in this regard. In spite of the seeming approval of absorption costing in IAS 2, Stevenson and Cabell (2002) indicates that the ABC approach provides justification for the transfer prices the multinational corporations (MNC’s) utilises in the transfer of products and services among its divisions in different countries. This justification assists in the obtaining agreements on prices in advance as well as reduces the possibility of tax audits which can be very costly. This is an indication that an MNC might not be so lucky using absorption costing. 3.0 Conclusion It is clear that ABC provides a more efficient and effective approach for allocating resources. In fact, Benjamin et al (2009) has also cited major concerns in relation to traditional absorption costing. However, a cost benefit analysis needs to be carried out before changing form one system to the next. Although the disadvantages of absorption costing in relation to its more modern counterpart - ABC have been touted about, it is clear that there are also advantages that are associated with its continued use in many organisations. Management accountants employed to manufacturing concerns as well as service organisations are required to have sound knowledge of product costing in order to be effective at setting prices. Both methods have advantages and disadvantages. Those advantages and disadvantages are factors that should be considered when making the decision on which method is more appropriate. The method that is considered appropriate must be suited to the circumstances of the business. Suffice it to say, studies have shown that decision outcomes which tend to vary bears some level of relationship to the method used to allocate costs to products and services (Bloom et al 1984; Barnes and Webb 1986). Though there appears to be a level of bias towards ABC, absorption costing still has it place in some manufacturing environments. References Barnes, P and Webb, J. (1986). Management Information Changes and Functional Fixation: Some Experimental Evidence from the Public Sector. Accounting, Organization and Society, 11(1), p. 1 – 18 Benjamin, S.J., Muthaiyah, S and Marathamuthu, M.S. (2009). An Improved Methodology for Absorption Costing: Efficiency Based Absorption Costing (EBAC). 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