Traditional Absorption Costing

Costing systems enable firms to determine product costs in relation to the revenue generated. Traditional absorption costing and activity based costing (ABC) techniques are the two commonly used costing systems in the manufacturing sector. The two systems differ in the way they assign cost of production. The purpose of this report is to critically compare and contrast the two costing techniques.

Full Costing Techniques

Full costing technique is also referred to as absorption costing. Absorption costing ensures that all costs incurred during manufacturing are recovered by the products manufactured. To achieve this, both direct and indirect labour costs and fixed and variable costs are used to ascertain the cost of a product. The system involves identification and accurate assessment of all incurred costs . This is followed by classification of costs into cost categories.  All direct costs are then assigned to the production output while indirect costs are allocated to individual service departments. Production support service costs are then reallocated to production departments. This procedure is followed by accurate establishment of an overhead rate. Finally, all overhead costs (direct and indirect) are recovered from each product.

Absorption costing system consists of three types of costing. The first type is job order costing which entails assignment of costs to batches or lots of products.  The second type of absorption costing is the process costing which involves systematic assignment of costs to the product. The third type is the activity based costing which involves assigning of costs to the products on the basis of cost centres data.

 Determination of a product cost under absorption costing technique entails consideration of both variable and fixed costs. Products are directly charged variable costs such as direct labour and materials under the full costing technique. Various products manufactured at a certain period of time are apportioned fixed costs on arbitrary basis. This means that cost determination under full costing takes into account all costs: fixed and variable costs. The method treats both variable and fixed costs as product costs. The unit cost does not take into account the level of operation for the period considered. The interest of managers who use this technique is to ensure that each product recovers all costs incurred for its production and retains something in form of profit. This ensures that a reasonable profit is made on the investment. The recovery of full costs influences profitability under this method. Therefore, data presentation for net profit involves deduction of fixed overheads. Full costing technique allows a firm to conform to GAAP (Generally Accepted Accounting Principles) requirements when preparing external financial reports. In the US, the Tax Reform Act of 1986 requires firms to fill income tax returns using absorption costing. The main purpose of full costing techniques is cost control. The technique is however, likely to result in faulty pricing of products. Moreover, positive net operating income might be reported even before the breakeven point is attained.

Traditional Absorption Costing and Activity Based Costing Techniques

Traditional costing emerged around 1870-1920. It entails the assignment of manufacturing overhead on the basis of broad cost drivers.  Cost driver refers to any factor of production that has a direct impact on product cost. Cost drivers in the manufacturing sector may include direct material hours, direct labour hours and machine hours. Traditional costing initially allocates overhead costs to service and production departments. This is followed by reassigning service department costs to the production department. Overhead costs in traditional costing are usually pooled into cost centres. Thus, cost departments are essential for a firm.

The traditional absorption costing assumes that manufacturing overhead is driven by the volume metric. As a consequence of using broad cost drivers, cause and effect are not reflected by the traditional absorption costing. This implies that different activities performed in a specified duration of time differ in terms of their costs. The result of this variation is that cost targets may be lower especially when the activities involved are complex. On the other hand, cost target involving simple activities are likely to be overcosted. Traditional costing is thus suitable in cases where overhead costs form a lower percentage of total costs and where the product range is narrow. This shows that one has to control the activities that incur costs first before controlling costs. Traditional costing is valued for its ability to recognise the vital role of fixed costs in production. It also ensures that stock is not undervalued. The above said makes it the preferred method for financial accounts preparation. The method is also advantageous as it does not result in net profit fluctuation as sales fluctuate when production is constant. However, the method cannot be relied upon for planning, cost control and decision making because of its emphasis on total cost.

The ABC system was developed to overcome some of the weaknesses associated with traditional absorption costing. The activity based costing technique for manufacturing industry was devised by Cooper and Kaplan in 1988. The intent of the ABC technique was to provide more insight into product cost allocation. Unlike traditional costing in which direct labour and materials are the only costs that are directly traced to the product, the ABC traces more costs and hence provides more accurate cost information. Hence, it makes the ABC method instrumental for timely and reliable decision making in management accounting. The ABC considers the cost of activities undertaken within a firm. Activities are usually used to allocate costs, components and products. This system has shown that the cost of products is lower when products are produced on mass scale. This is contrary to what is reflected under the traditional costing where cost of production increases with increase in production volumes. ABC system requires managers to separate tracking costs for producing individual units.

 The ABC method is founded on the concept that costs are created by activities and that activities are consumed by products. The design of the ABC system entails major activity identification, cost assignment to activities, cost driver selection and assignment of activity costs to products. This enables managers to accurately price products. The system identifies main activities and allocates overhead costs to individual activity based on the resources utilised to complete that activity. The overhead costs for each activity translates to activity cost pool. Once the overhead costs are allocated, cost pool cost drivers are identified. Finally, the cost pool overhead costs are divided into product line in relation to the cost driver used by each product line.

Unlike traditional costing, activity based costing (ABC) assumes that manufacturing overhead is driven by both volume and non-volume cost drivers. In the ABC technique more overheads are charged to lower volume production and fewer overheads are charged to high volume production. This differs from traditional absorption technique in which high volume products are penalised. Due to increased automation in manufacturing firms in recent years, the ratio of overhead costs in relation to total costs has increased. This shows that traditional costing is no longer tenable in such cases. The ABC technique realises that activities can be used to analyse costs instead of production volume. Therefore, overhead costs can be allocated precisely using ABC technique on the basis of cause and effect relationship. This is attained by elimination of non-value added activities to enable the management to control the production costs. The elimination of non-value added activities reduces cost driver numbers.

Most businesses have an overall goal of maximising shareholder wealth. Firms using ABC system have reliable cost figures that enable them to undertake strategic planning to ensure shareholder wealth is maximised. This emanates from elimination of non-value added activities and allocation of more resources to value added activities, which implies that ABC reduces overheads. It is on this basis that Ahmed et al. argue that ABC is positively related to financial performance improvement. They state that this relation is more apparent when ABC is used in combination with other strategic management initiatives such as just-in-time (JIT), total quality management (TQM), flexible management systems (FMS) and business process reengineering (BPR). General Motors Company is said to have realised this advantage when it implemented the ABC system in fifty of its 193 factories.  The firm is said to have successful reduced its overhead costs in factories with production. The Doig Corporation is another firm which implemented the ABC system. The latter enabled the firm to categorise its activities into value added and non-value added activities. In addition, the system enabled Doig to get reliable data for timely decision making process and to improve its costing documentation.

Ahmed et al. further reiterate that use of technology in manufacturing sector reduces activity costs. The fact that ABC deals with costs which are not related to volume as seen in traditional costing, enables it to provide cost of products that are accurate. In addition, the management is in a better condition to take control over decision making process because indirect costs are allocated to total cost of products under ABC costing.

Traditional costing is ineffective in improving the competitiveness of a firm on global arena. This makes many firms to hesitate using it. On the other hand, production and managerial efficiency is enhanced by ABC costing since it allows a firm to deal with hidden factors that are likely to impact on the manufacturing and industrial expenses. The ABC technique rises managers efficiency in creating value. It becomes possible because ABC takes into account resources consumption rate and capital demand when calculating cost of activities. Ahmed et al. argue that ABC acts as a guideline for manager’s action for attaining increased profits. In addition, ABC enables managers to support continuous improvement both at organisational and individual level through generative and adaptive learning. ABC also enables a firm to overcome distortion of cost estimates associated with traditional costing.

ABC is said to be a powerful tool for making marketing decisions, as it recognises that cost varies with volume and some other activities such as batch level activities, unit level activities and product level activities. ABC also allows firms to consider price negotiation. This is important for marketing decision making process.

Traditional absorption costing and ABC system differs in terms of approach, methodology, legal validity, and scope. In terms of approach, traditional costing appropriates costs to product units while ABC tracks the costs of product units. Moreover, cost fixation in traditional costing lays focus on the product while ABC focuses on activities. In addition, the traditional approach directly assigns costs to products while ABC seeks to convert indirect costs into direct costs.

In terms of methodology, fixed overhead are divided equally among product units in the traditional costing while in the ABC system fixed overhead costs are assigned in actual proportion to what each product unit incurred. It is argued that ABC is more scientific than traditional costing. The traditional approach pricing is based on inventory while in ABC price fixation is based on calculation. Consequently, price varies proportionately with inventory under traditional costing while under ABC system inventory does not affect price variation. Even though ABC system is scientific in nature, it is not possible to appropriate some fixed overhead costs. For instance, it is challenging to assign the salary of the chief executive on the basis of per product usage. Another limitation of ABC system that arises due to its methodology is its overall cost. The ABC system is expensive because extra costs are incurred to collect, enter and analyse data when dividing the fixed overhead cost to different activities. On the other hand, traditional costing has a simple and easy methodology that does not incur extra costs.

Although the methodology and the approach of ABC system makes sense scientifically, it is not legally recognised especially when publishing external financial statements. For instance the GAAP recognises traditional absorption costing but does not recognise ABC. In addition, the Internal Revenue Service (IRS) and the Financial Accounting Standards Board (FASB) do not recognise external financial statements published using the ABC system. This implies that organisations which use ABC system have to maintain two systems of costing. Therefore, traditional costing is legally advantageous for it enables a firm to publish external reports, file tax returns and comply with statutory requirements.  

In terms of scope, traditional absorption costing enables a manufacturing firm to ascertain its general profitability or efficiency. However, the traditional costing system is not able to ascertain the real costs for each product unit.  On the other hand, activity based costing reflects the true functioning of the firm and aids in the strategic decision-making processes. ABC is able to ascertain the real cost of each product unit. Consequently, ABC system is capable of identifying non-profitable or inefficient products that impact negatively on other highly profitable products.  Unlike traditional costing, ABC system enables a firm to price its products equitably. This allows a firm to break down the product into sub components to meet the needs of consumers. The ABC system is suitable for large firms with many products. This is because it improves management accounting information quality. On the other hand, traditional costing is suitable for small firms with single product.

Summary and Conclusions

This report has critically compared and contrasted the traditional absorption costing and activity based costing (ABC) techniques. Traditional costing is valued for its ability to recognise the vital role of fixed costs in production. It also ensures that stock is not undervalued. Furthermore, traditional absorption costing enables a manufacturing firm to ascertain its general profitability or efficiency. However, the method cannot be relied upon for planning, cost control and decision making because of its emphasis on total cost. On the other hand, ABC provides more insight into product cost allocation. In addition, ABC allows overhead costs to be allocated precisely on the basis of cause and effect relationship. Furthermore, ABC system provides firms with reliable cost figures which enable them to undertake strategic planning to ensure shareholder wealth is maximised. Activity based costing also reflects the true functioning of the firm and aids in the strategic decision-making processes. However, ABC is not legally recognised especially when publishing external financial statements. From the discussion, it can be concluded that all manufacturing firms need to adopt both methods in order to ensure they comply with regulations and are both effective and efficient. This kind of strategy will allow them to remain competitive.

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