Similarities and Differences of ABC Costing and Traditional Absorption Costing - Essay Example

Critique of the rise of ABC

1. Introduction

This first section of this part of the paper will compare and contrast ABC costing and traditional absorption costing, identifying the arguments used by its supporters and determining to what extent ABC costing is taken up by the industry. The second section will analyse the impact of ABC, whether it had the desired affects and knowing the arguments against held by detractors.

2.1 The similarities and differences of ABC Costing and Traditional absorption costing are as follows

Both are costing method used by companies. As costing methods, both could be used for pricing products of companies and both still include cost of materials, direct labour cost and overhead. It is however their differences that matter most for decision makers (Bernstein, 1993; Edwards, Miles, and Winterfeldt, 2007).

To appreciate their differences, knowing which comes first may put the proper context. At this point, it may be said that ABC costing comes after absorption costing. From the same evolution of the costing methods, spotting now difference between absorption and ABC become easier. In terms of number of cost pools, ABC has more than absorption costing. Necessarily ABC have more number of the applied rate since there would be more bases using activities that are more or less controllable on the part of management. In terms of, suitability on to the industry, ABC costing is more applicable to capital-intensive while those of traditional costing, labour intensive are its match. Lastly in terms cost and benefits, the same must be computed and considered, but since ABC is more complex than traditional costing, it is cost more but the benefits could be more in properly made applicable to user. .

2.2 Advantages and arguments for its use

The benefits of each method of each method can be demonstrated. As ABC evolved from absorption costing, this should interest the reader to know good reason or benefits offered by ABC. The claimed benefits include improve product cost or service data. Necessarily, this would bring improved decisions about pricing, service mixes and product strategies. These would be the effect of course of more accurate information since there would be cost reduction by eliminating non-value added activities. It would also afford greater control of costs because of its focus on behaviour of costs at their origination (Atkinson, Anthony, et al. 2005)

The innovation of ABC costing came as a matter to need to find an alternative to absorption costing. As business decision need to know whether it goes to making or doing products or service that would generate profit, the cost of the same becomes important. Errors or mistakes in costing necessarily lead to wrong decision in pricing.

Thus, initially business entities moved from get puzzled or problematic with the limitation of traditional absorption since they could miss important control that is available to them. Thus they found costing using ABC in their desire to have more accurate cost information for their products. While looking searching for some good or useful than originally intended, the managers in some of these companies surprised by the information revealed by the use of ABC. The new costing system provided these entities a new perspective of the built-up of costs, which eventually led them to improve pricing policies and to develop different products strategies.

High volume production due capital intensive investments necessitated the search for alternative costing method of costing. It was discovered in the course of search that long production run products produced the effect of low cost than actual cost. It was also found that low volume, short production run products lower units cost than actual. The results of these are attraction to the use of ABC cost.

In the desire of research to establish an ABC products cost, it was found the current organisation of activities leads to repetition of activities and processes, which means waste. It was therefore theorized that the organisation and flow of processes can be changed to eradicate repetition and attain cost savings (Jo Avis, et al, 2008).

2.3 Is there evidence of its use by the industry?

The evidence of its use is clear on companies using the same. Reported of use of ABC by several Eurpean Companies, proves its use by the industry is beneficial (Major, 2012)

Using a sample computation to show an advantage of ABC over absorption costing would make things clearer. To provide a concrete evidence of applicability of ABC and its advantage over absoprtion of traditional costing is to use an illlustration.

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 alternatively use ABC costing, there is 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 number 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 £ 18,247.00 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. Based on the illustration made, ABC extended in effect to have more variable cost information. This would then afford the decision maker to know what are manageable and in effect helps the company in executing responsibility accounting that could hold managers accountable 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 (Weygandt, Kieso & Kimmel, 2005; Emmanuel, C., D. Otley & K. Merchant, 1990).

3.2 What are the arguments of the detractors of ABC.

The detractors are course referring to the disadvantages or limitations of ABC costing. 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.

4. Conclusion

ABC costing has provided a better way of helping management make decisions because it considers what are relevant cost for decision making over that of absorption cost which are basically prepared using the external standards. Given the good differences between activities based costing compared and absorption costing , infavor of the former, there is basis to use ABC in certain cases. The difference justifies the search for alternative costing system from absorption or full cost accounting. To be blind in subscribing to the use what is theoretically deficient could only result to mistaken information and eventually to wrong decision. Activity based costing are not without drawbacks 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.