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The benefits and drawbacks of traditional Absorption costing techniques


Through the years as it pertains to planning Managers has developed techniques and methods of forecasting future costs. One of such methods is Absorption costing and activity founded costing (ABC)

What is Absorption costing?

Absorption costing is the traditional approach to costing and stock analysis, having been developed around the 1870s to 1920s is greatly used by the making companies. The theory behind absorption costing to disperse all overheads of the developing cost centers as well as the direct cost between your finished products, and treat all non-manufacturing over head as period costs. CIMA identified Absorption Costing as "a way of costing that, in addition to direct costs, assigns all, or a proportion of, creation overheads costs to cost products by means of one or more quantity of absorption rates. "

What is activity founded costing?

Is the modern method of cost management having been developed in 1980s. it is the preferred way for the services industry. The CIMA definition for activity established costing is ''an method of the costing and monitoring of activities that involves tracing resource use and costing final outputs. Resources are given to activities, and activities to cost items based on use estimations. The latter utilise cost drivers to add activity costs to outputs. ''

CIMA Standard Terminology, 2005 (http://www. cimaglobal. com/Documents/ImportedDocuments/cid_tg_activity_based_costing_nov08. pdf. pdf)


Why does the business need either absorption costing or ABC?

It's very very important to managers with an idea of the real cost of operations, departments, operations or product which is the foundation of the budget.

and to be able for doing that they have to have an expense accounting system; such as absorption coting or activity established costing. Here are the benefits of having such systems and their disadvantages

The advantages of Absorption Costing:

It recognizes the importance of set costs in creation;

is method is accepted by Inland Revenue as stock is not undervalued;

is method is always used to put together financial accounts;

When creation remains frequent but sales fluctuate absorption costing will show less fluctuation in online profit and

The disadvantages of Absorption Costing:

As absorption costing emphasized on total cost namely both variable and fixed, it isn't so great for management to utilize to make decision, planning and control;

as the manager's emphasis is on total cost, the cost volume profit romantic relationship is ignored. The supervisor must use his intuition to make the decision.

The benefits of Activity Founded Costing:

More appropriate costing of products/services, customers, SKUs, circulation channels.

Better understanding over head.

Easier to understand for all.

Utilizes product cost rather than simply total cost.

Integrates well with Six Sigma and other constant improvement programs.

Makes visible waste products and non-value added activities.

Supports performance management and scorecards

Enables costing of functions, source chains, and value streams

Activity Centered Costing mirrors way work is done

Facilitates benchmarking

The negatives of activity centered costing:

It costs too much to maintain it, it takes lots of time and resources to collect, check and get into it in to the system for the day needed to measure activity established costing.

Is not accepted by GAAP (accepted accounting principles) therefor companies need to have a new system when preparing external records.

What are the dissimilarities between Absorption costing and ABC?

There a wide range of dissimilarities between absorption costing and activity centered costing.

Difference in Approach

One of such dissimilarities is the way it contacted. Absorption costing allocates costs to product products, whereas activity structured costing traces the expenses of product devices.

Absorption costing is the original cost accounting method that targets the merchandise or service when correcting costs. It works under the easy methodology of assigning resources to products directly.

Activity based mostly costing is a modern cost accounting approach that focuses on activities as the essential cost. ABC presumes that products or services take in activities, and activities take in resources. It thus, works to convert indirect costs into immediate costs.

Difference in Methodology

Absorption costing divides equally the fixed overhead costs with the number of product devices whereas activity founded costing identifies the actual proportion of resolved overheads costs incurred by the product unit.

Comparing absorption costing and activity centered costing, the latter follows a more scientific way. Price fixation in absorption costing will depend on the inventory. The bigger the inventory, the lower the product cost and lower the inventory; or the higher per-product cost. Price fixation in activity based mostly costing bases calculations to derive the actual overheads incurred on a unit, and will not change with change in inventory levels.

Activity founded costing, however, faces serious obstacles in practical application, for appropriating a few of the fixed overheads such as the main executive's salary on a per-product use basis, is next to impossible. Moreover, procedure for data collection, data access, and data evaluation required to divide the fixed overhead costs among models based on usage, requires substantive resources and remains costly to keep. Absorption costing that divides all preset over head costs with the amount of products produced is a straightforward and easy procedure and clear of such complexities.

Legal Validity

Absorption costing complies with the generally accepted accounting guidelines (GAAP) whereas the Financial Accounting Criteria Mother board (FASB) and Internal Revenue Service (IRS) do not admit ABC for externally published financial statements. Firms that follow activity founded costing, therefore, need to keep up two cost systems and accounting books, one for interior use, and another for exterior information, filings, and statutory compliance.

Difference in Scope

Absorption costing helps ascertain the overall profitability or efficiency of the creation system but fails to supply the real cost of specific product devices.

Activity structured costing mirrors the working of the enterprise and plays a part in strategic decision-making operations. ABC supplies the real cost of specific product items and, in so doing, helps identify inefficient or non-profitable products that eat in to the profitability of other highly profitable products. ABC also helps price products equitably, allowing breaking down of product or service into sub-components or offering "top ups" based on customer needs.

Comparing absorption costing and activity based costing, activity centered costing improves the quality of management accounting information, especially in large and multi-product procedures where conventional overhead allocation methods such as absorption costing may produce misleading results. Absorption costing, however, remains more suited to small businesses and companies with homogeneous products.

Recommendation and implementation

I recommend to bring in activity established costing system as its more well suited for the general public service industry.

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