Absorption Costing and Activity Based Costing: Advantages and Disadvantages

It is critical to hold a proper costing system in topographic point to offer services at competitory monetary values. This is all the more of import in the current economic environment as the UK authorities is likely to restrict public outgo in the hereafter to harness in the financial shortage and this will increase the competition for public sector contracts. There are two of import bing systems – soaking up costing and activity based costing ( ABC ) . This study analyses the utility of a costing system by foregrounding the benefits that accrue to a company by utilizing either of them.

The study compares the advantages and disadvantages of both bing systems. The company presently uses soaking up bing. As the ABC is based upon a figure of cost drivers and aggregation of informations associated with them, a subdivision of this study analyses the major stairss that will be required if the company was to present an ABC system. There would be costs and resources associated with the execution of an ABC system and a penchant of one bing method over another will take those into history along with their benefits. Some of the cardinal terms/concepts used in this study are besides explained for better apprehension.

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Benefits of a costing system

A good costing system gives the direction of company right information required for pricing of a merchandise. Management makes strategic pricing determinations based on the nature of assorted costs. This is of import for success of the company to win orders in today ‘s competitory universe where lower economic growing has reduced the avenues for increasing gross revenues.

The UK authorities has borrowed a big sum of money to shore up up the balance sheets of the commercial Bankss. In order to rebalance its fiscal books, the authorities will hold to cut down outgo in the hereafter. The authorities is improbable to cut outgo on wellness or instruction. But other services will be hit hard. Lesser figure of contracts will ensue in higher competition and companies with relevant and proper bing systems will hold competitory advantage to win more orders in a low net income border environment.

Absorption costing and Activity based costing

Absorption Costing

Absorption costing is a technique that calculates unit cost of a merchandise or service by including both fixed and variable costs. Variable costs are easy to place and apportion but fixed costs are associated with more than one service or cost Centre and have to be allocated on the footing of different premises.

With soaking up costing, the company does non hold to utilize separate internal and external fiscal describing systems. Absorption bing includes all costs in a merchandise thereby run intoing the external fiscal describing systems demand of fiting costs with the gross revenues in a period. The company saves important costs and resources by utilizing one fiscal coverage system merely.

As soaking up bing includes all fixed costs, it is a better opinion of a house ‘s profitableness in the longer tally. A company has to retrieve all fixed costs in the medium to long-term and exclusion of them in pricing determination may take to concern failure over the long tally.

But soaking up costing has its drawbacks besides. The fact that the fixed costs are allocated on the footing of assorted premises may take to different costing criterions within a company and prevent benchmarking of procedures.

Activity Based Costing

ABC is a system that assigns the operating expense costs for each activity of an administration to the merchandises, services or other cost objects that caused that activity ( Horngren et. Al, 1999: pg. 136 ) .

ABC can be used for benchmarking and bettering procedures. The usage of standard activities and informations aggregation processes can enable a company to benchmark activities across workss and drive betterments. ( Kaplan and Cooper, 1998, pg. 143 ) .

The major drawback of ABC is that the costs of implementing and runing it are significantly more than that of an soaking up bing system ( Drury, 2004, pg. 389 ) . As informations aggregation about different costs has to be done in assorted sections, the costs associated with preparation of forces and package installing makes an ABC system prohibitory particularly for smaller administrations. Smaller administrations besides usually do non hold plenty manpower to delegate for ABC system.

Stairss needed to implement an ABC system

The stairss that the company would necessitate to take if it was to present an ABC system are as follows:

Educating employees.

Employees involved in collating activity and cost information and their analysis should be educated about the procedure. Even though preparation employees requires resources and costs, get downing an ABC system without proper instruction may ensue in aggregation of wrong informations and its incorrect reading. Besides educating employees about the benefits of an ABC system will assist them get the better of their initial inactiveness. Without proper apprehension of the benefits of an ABC system, the demand for extra resources for informations aggregation and associated extra costs can do the procedure painful ( Weil & A ; Maher, 2005: pg. 233 ) .

Identify the cost aims and activities.

The aim of implementing an ABC system is to set up costs of services being delivered by the company to assorted authorities organic structures. To run into this objective the company needs to place activities involved in finishing those services. A procedure flow chart is a good tool for placing chief activities ( Rozrocki et. Al, 2004, pg. 20 ) .

Identify cost drivers.

The company should choose cost drivers on the footing of the undermentioned standards:

A sensible cause-effect relationship between the cost-driver unit and ingestion of resources.

Handiness of quantifiable and mensurable informations on the cost drivers.

Collection of relevant informations refering costs.

The company should roll up all costs associated with the above identified activities and split them by the cost driver units to get at cost per cost-driver unit.

Calculate service costs.

The cost per cost-driver unit should be multiplied with figure of cost driver units required for finishing each activity used in a service. Summarizing the above costs for each activity in a service will give the cost of each service provided by the company.

Allotment, allotment and soaking up rates

Allotment of an disbursal takes topographic point when it can be specifically charged to a cost Centre. Apportionment of an disbursal happens when it can non be identified to a specific cost Centre. The chief difference between allotment and allotment of costs is that the allotment trades with the full costs but apportionment trades with proportion of points of costs. This means that allotment is a direct method whereas allotment is an indirect method as it uses some indirect footing to apportion costs. As an illustration, the wage of a worker in a care section will be allocated to the full to the care section. But as the care section services are used by other sections, the wage of a care worker will be apportioned to those sections.

The soaking up rate is a rate used in an accounting period to bear down operating expenses to the production in that period. Absorption rates are calculated by spliting the overhead disbursal by the entire production of goods or services.

Costing most suited for the company

The pick of a costing system by the company should be based on cost versus benefit considerations. There could be a figure of cost drivers because of the nature of activities performed in supplying assorted services to authorities organic structures. Adding all unallocated costs in to a cost pool and so absorbing them on the footing of some method will non ensue in true representation of costs. Alternatively the service house should utilize ABC to analyze different causes of the extra costs incurred and allocate costs on the footing of these cost drivers. An ABC system will bring forth more accurate informations for pricing of company ‘s services in an progressively competitory environment. Establishing cost drivers will non merely assist in proper costing of different services but besides cut downing costs through benchmarking of standard activities.

As the company is a medium sized concern, the costs of implementing an ABC system are non prohibitory in relation to this size. It besides has the manpower resources as employees working in different sections have procedure cognition and can be trained and assigned to enter cost informations without doing a important concern break. Hence in visible radiation of escalating competition, the company should implement an ABC system to keep or increase its competitory border.

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Absorption Costing and Activity Based Costing: Advantages and Disadvantages. (2016, Nov 24). Retrieved from https://graduateway.com/absorption-costing-and-activity-based-costing-advantages-and-disadvantages/