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Absorption Costing: Advantages and Disadvantages

There are two main costing methods that company may use, absorption costing and Activity established priced at. Absorption costing and Activity established priced at (ABC) are two similar systems that are being used to assign indirect costs to cost items. Absorption costing is also called 'traditional costing'; it is more simplistic and uses arbitrary allocation. On the other hand, ABC is more superior and uses cause-and-effect allocation. This report will deal with the different definitions, the history, the advantages and down sides of absorption and ABC systems. Then finial a advice which system is way better suited for this company.

This company needs either of the two costing system because they are useful during planning and budgeting. Furthermore getting the systems set up allows overheads to be recharged to services.


"Absorption costing is a way of priced at that, in addition to direct costs, assigns all, or a percentage of product overhead costs units through one or a number of over head absorption rates. " Cima (2005)

"Absorption priced at systems is a priced at system where making costs are assigned to products and non processing costs aren't allocated to the merchandise but charged right to the profit declaration and excluded from the inventory. " Drury (2008)

"Absorption costing is a system where all the resolved production overheads are assigned to the merchandise. '' Drury

From all these meanings the Cima explanation is the better description because it mentions the majority of the key techniques that are involved in absorption costing which straight away gives you an idea of what absorption costing is. The other meanings are also good as they state some processes involved in absorption but Cima places this is in a far more understandable way.


This charging system originated decades back when companies were much smaller and got less over head costs. During the time this system originated there were largely commercial companies which made this system appropriate to assign costs to cost items.

How it works

This company presently runs under absorption priced at system for working out overheads for their services. Training absorption costing entails a two stage process. Stage one considering the allocation and apportionment of indirect costs to service and creation cost centres and then apportionment of the service department to production division. Allocation is the process of estimating the expense of resources consumed by a product that does not use direct procedures. This process deals with overheads that can be directly designated to cost centres with no need to be apportioned. Cost apportionment is a process of charging indirect costs to cost centres that can't be straight allocated. Service team overheads are transferred to the production office so they can be covered.

Stage two computes the absorption rates that are then used to bill overheads to cost objects. The absorption rate exercised is utilized to calculate the full total overheads of something.

From all these three phases only allocation is used in ABC.

There are advantages and disadvantages of absorption priced at:


Inexpensive and simple to operate. Absorption costing is simple to operate which makes it less expensive to operate. This is best for the company as it allows them to lessen their costs and understand what they are really doing.


Less accurate. It's good that the system is easy, but this helps it be less accurate when charging costs to cost objects due to rigorous use of arbitrary allocation. Arbitrary allocation is when an allocation bottom part used is not really a significant determinant of its cost. Being unsure of all the exact factors behind certain costs will make it difficult during planning and budgeting.

Absorption costing emphasises on adjustable and set costs. This helps it be difficult for the company to use information out of this system for decision making; it isn't detailed enough to help the business enterprise make predictions or budgets.


Different sources define ABC in different ways:

"An approach to the costing and monitoring of activities that involves tracing resource intake and costing last outputs. Resources are given to activities, and activities to cost objects based on utilization estimates. The second option utilise cost drivers to attach activity costs to outputs. " Cima terminology

"Activity centered costing is a refinement of absorption costing that goals to charge over head costs in much more detail so the overhead cost can be incurred based on a cost driver. '' Drury (2005)

Between these two definitions Cima definition clearly declares what ABC is all about and mentions cost drivers which are an integral area of the system. As the other definition does not specifically state what is involved with ABC e. g. cost individuals though it does point out that it is a lot like absorption costing. Overall, the Cima description is better as it is a more detail reason.


ABC system was developed when the current system then (absorption costing) was becoming less great for assigning costs to products in the changing business environment. Within the 1980s companies started to upsurge in size and producing wider product amounts and services. Information processing costs were high, which managed to get difficult for sophisticated overhead allocation solutions to be justified. There is an increasing demand for more accurate product costs; this resulted in the benefits of the ABC system. Cooper and Kaplan conceptualised the ideas behind this technique as a way of seeking to improve the exactness of the fee made to cost items in sophisticated business surroundings.

How it works

ABC system is exercised differently in comparison to absorption costing. They both use both level allocation process to assign overheads to cost items. First stage overheads are allocated to cost centres and in the next stage the cost accumulated in the cost centres are allocated to cost items. ABC differs from absorption costing by having more cost centres in the first level and a greater variety of cost individuals in the next stage.

Exhibit 1 shows a good example of a company's annual overhead costs which i will use to how ABC works. Much like absorption costing, an over head evaluation sheet is produced where overheads are assigned to cost centres. That is shown in display 2. Then activities are determined for each and every cost. From exhibit 3 column A, you can view that there are lots of activities that contain been discovered from major activities e. g. General factory support. The expenses created over a particular period have to be assigned to the activities. When costs are accumulated by activities they can be called activity cost drivers. Activity cost individuals need to be selected for each and every activity centre to be able to assign the price mounted on products. In display 3-column C and D you can see the activity cost individuals and the price they each gather. Cost drivers rates are worked out for each activity. Finally, the price drivers rates are put on products. In exhibit 4 there is an example of Product G that is produced and uses various activity cost individuals and cost drivers rates are applied.

There are advantages and disadvantages of experiencing ABC in place, these are:


Helps identify unprofitable items from the product line. This allows the company to make changes with their production, and enhance their efficiency. Eliminating these unprofitable items reduces un-necessary costs the business maybe encountering. And yes it enables the business to increase its revenue with no need to increase prices.

Provides quantifiable figures for planning and estimations. ABC recognizes all the several cost drivers that contribute to the full total overheads of producing a product or service. This will help when giving quotations to customers as well for the business enterprise to see if taking up a certain task will be profitable to them.

ABC uses a huge number of cost centres in the first level and a larger variety of allocation bases in the second stage. This makes the machine accurate at charging overheads to products. Accurate cost charges to products or something reduces the chance of making a reduction if the right amount is not costed.


Expensive to use. The complexity of this costing system helps it be expensive to operate in comparison to other alternatives. The business enterprise will have to make investments time and resources in order for them to identify the price drivers. E. g. one of the steps needed to identify cost individuals is to interview staff and also have them fill in time sheets. This technique will certainly reduce the production time open to the company.

Time consuming. Using ABC is a very long process and takes a great deal of information to use; this is frustrating for the company and its staff.

There is too much attention to fine detail and control. Sometimes paying close attention to detail will make it problematic for the business to see the dilemna or make the organization lose vision of strategic goals just to seek for small cost savings.

It may be difficult to execute. In service companies there are costs that are difficult to allocate to specific service products and service department, staff often try many non informal activities which might be challenging to record cost data.


Given that the company provides services to specialists and operates under absorption costing, I recommend that we should change the charging system to ABC as it will be more ideal for the company. This costing system may be difficult to implement in service companies but it shows the company greater detail of the various costs involved with each service they offer which is essential during decision making and planning.

To implement ABC there certain things the business will have to do:

Proper planning and determination from staff, conducting a pilot research first may be essential. This provides information about whether having ABC will be a benefit to the business.

A team should be set-up that'll be responsible for deciding which activities are necessary for the assistance. The team should be made up of experts from different departments of the business and a consultant from outside the house can be used. Having individuals from different allows correct recognition of overheads included. 5

When a team has been assembled, components of each activity that cost money are established. Attention to information is essential as some costs are concealed.

Once all the costs have been identified and recorded, they need to be put in your personal computer system.

After the business enterprise has had enough time to investigate the info they may use the information in various ways e. g. training total overheads for each service.


Absorption costing has been around for a long time, ABC originated as a noticable difference of absorption costing. ABC is a more correct costing system compared to absorption costing as it talks about specific activities that contribute to the full total overheads, while absorption charging looks at departments. Having viewed both advantages and drawback of the two priced at systems it is clear that even though they may be similar they have significant differences. I have recommended that we introduce ABC, it will be a huge benefit for the company as it will decrease the variety of problems made during costing.

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