Business decisions involve an essential need in management for constant alertness, simultaneously implementing control, making choices, updating plans and generally adapting as optimally as possible in the current environment while moving towards agreed business goals considering both short term and long term implications. All this involves making decisions. Furthermore, company managers rely on cost accounting to provide actual expenses of operations, processes, departments or product which is the fundamental element of their budget, allowing them to critically analyze fluctuation and the way funds are used socially for the purpose of maximizing profit. Therefore, the need for a cost accumulation system is essential in accommodating relevant cost information for internal and external decision making. Many indirect costs are relevant in decision making although they are not clearly observable compared to direct costs that are uniquely attributed to individual products. For companies with high long term indirect costs, managers have to determine the role of joint sources which are indirect but fluctuate on demand and make relatively important decisions regardless of the transparency of the costs. An attention-directing information system is required that consistently identifies those potentially unprofitable products that require more detailed special studies. The importance of such system is that decisions can be made in whether research or development is necessary to determine the sustainability of the products deemed to be unprofitable and strategies to promote the profitability in the future. Cost accumulation system is important as product decisions are not always independent. If individual products are being focused without considering the effect of joint resources as mentioned, decisions will be taken in isolation of decisions made on other products.
Operational differences between ABC and absorption costing:
Absorption costing as the term suggested is a cost accumulation system where all of the manufacturing overhead costs are absorbed by the units produced. The cost of a finished product includes direct labor, direct materials, and both variable and fixed manufacturing overhead. The main idea behind absorption costing is to spread and allocate all manufacturing cost centers as well as the direct cost between the finished products, and then apportion all production overheads to which of the main production indicators such as labor hours, operating hours or materials used. Although Activity Based Costing (ABC) system does not continuously identify and record all necessary cost information in production, ABC costing system provides a more decision-relevant way for managers in identifying problems and ascertaining useful information for decision making. The aim of ABC is to establish a relationship between cost generating activities and common expenses by introducing cost drivers. The difference is that absorption costing uses overhead absorption rate defined as total overhead divided by total of absorption basis; ABC system uses cost drivers instead of absorption rate. Introducing ABC system is not a simple task, it is by no means as easy as ABC because under the ABC approach, there are various stages including:
Identifying the major production activities.
Determining the cost driver for each activity.
Setting up cost centre to collect the costs of the activity.
Using the cost-driver of each activity as indicators for the volume of each activity consumed on behalf of each individual product and allocates them to the cost of the products.
ABC provides a greater amount efficiency and accuracy in terms of the stage allocation process. ABC and absorption costing both use a two-stage allocation. In ABC, overhead costs are allocated into each major activity cost centers known as activity pools rather than departments in absorption costing. Activity pools and departments in the two different costing systems might be identical such as repairing for instance. Generally, ABC will have a larger amount of cost centers. The second stage of the two stage allocation process allocates costs from cost centers to products or the cost output. Due to the large number of cost centers and great variety of volume and non-volume based drivers in second stage allocation, this makes ABC a relatively more precise costing system.
ABC First and Second Stage Allocation:
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Source: Science Direct, http://www.sciencedirect.com/science/article/pii/S0167923611001199
ABC emphasize on the cause and effect relationship that is easily traceable and thus more 'cost sensitive' compared to absorption rate that averages the indirect costs. ABC focuses on this relationship between overhead costs and product costs; by using cost drivers to estimate the actual cost behavior in order to determine the critical cost factors. This is because cost drivers are related to the actual costs processes occurring at different levels:
Unit level activities: The cost drivers are triggered each time when a unit of product is produced. For example, when a unit is produced by a worker or machine equipment, the related direct labor hours will be the unit level cost driver. Absorption costing is related to unit level cost driver where only volume based activities are considered.
Batch level activities: When each batch of product is produced, the cost drivers are triggered. A good example is the planning and shipping costs of each batch regardless of the size of each batch when they are being shipped or transported out.
Product sustaining activities: Cost drivers are triggered when these activities occur to support different products within a product line. Cost drivers take no account into units or batches of product involved. The number of engineering hours per product is a good example of cost driver as the more the products trigger the engineering hours, the more product engineering costs should be allocated to the costs of the products.
Facility level activities: In this level, the cost drivers are not related to the products at all. Costs are traced and then being allocated on products. The difference between allocation and tracing is that allocation is quite subjective and arbitrary whereas tracing is based on the cause and effect relationship of the costs and the products.
Absorption costing might report misleading information as it has a higher tendency to charge a high proportion of overheads to high volume.
Consumption of activities versus consumption of resources:
ABC and absorption costing have different approaches in arriving at a different costing outcome. However, ABC is deemed to be more efficient because the process of costing assumed that cost of individual products or output consumes the production activities. ABC acknowledges that costs or input are not being managed but being regarded as the consequences of the products or the output. Absorption costing on the other hand, assumes that cost output consumes the input of the manufacturing resources. It is believed that costs can be managed but this is not the case when many company managers had found this system relatively difficult and almost unachievable. For instance, inventory is considered as an asset in companies' balance sheet and in absorption costing, cost outputs are being consumed or allocated into product costs. The expenses will not appear only after it is being sold in future. This is not the case in ABC as cost drivers determine the amount of output consumptions by the products.
Absorption Costing:
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Source: Managerial Accounting, http://www.principlesofaccounting.com/chapter20/chapter20.html
ABC:
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Source: Managerial Accounting, http://www.principlesofaccounting.com/chapter20/chapter20.html
Process-orientated versus structure-orientated:
ABC is more preferable and more superior to absorption accounting in the sense that it is more subjected for a diversify array of measures when it comes to improving productivity. ABC provides a clear advantage when the company is using common production facilities to make similar products and functions on widely differing quantities. The difference for this is that ABC is more process orientated and it gathers useful information from the processes that can be used to determine 'what needs to be done' and to allocate resources efficiently. Hence, when inspection is being performed on the activities of production system based on ABC, managers will not only be able to determine surplus capacity if occurs, but also the lack of capacity and misallocation of capacity. Managers can then decide on reallocation of capacity to where it is more on demand in order to yield higher production in a more effective way, compared to absorption costing. The reason behind this is that absorption costing is more concerned on the structural orientation of the organization rather than the actual process. Unlike in ABC, it is rather hard to determine 'what needs to be done' because the process is unknown. Absorption costing tends to provide an answer to the measures of disposals in order to carry out the job. Furthermore, absorption costing is less sensitive on related capacity because it tends to assemble all overheads and averaged them out across individual products.
Volume based versus non volume based cost drivers:
The variety of cost drivers in ABC accommodates the system when it comes to volume and non volume based cost drivers. The underlying assumption of volume based cost drivers suggest that there is a linear relationship between the overhead costs and the numbers of individual output produced. These volume based cost drivers are essential in measuring the overhead costs such as machine hours employed in production centre relating to production; when the consumption of machine hours increases, the cost of individual products increases. Volume based drivers are appropriate as the activities are being performed continuously each time a unit of product or service is produced. It is more precise towards the objective when direct costs are allocated on the cost of products. However, when overhead costs increases and new technology starts to take over companies' operating system, it goes without saying that volume based cost drivers are risky in assigning costs to products. Hence, non volume based cost drivers are critical in determining non volume related activities that has no direct relationship with the products. Financing charges, salaries and benefits of sales and administrative personnel and re-engineering products are activities that have no direct relationship with the cost of products. It is relatively hard to determine the rate of apportion for the costs as these activities are not volume based related and depend on a rather unique manufacturing characteristics in different operations: re-engineering products depends on the number of set ups rather than the number of products. There is a complication when volume based cost drivers are used to allocate non-volume based overhead costs. As a result, the product costs can be distorted and deemed to be not accurate when large proportion of overhead costs is not volume based. In contrast, the distortion of product costs will not be that much of a difference when non volume based costs are only a small proportion of total overhead costs. Absorption costing faces a great deal of complication and obstacles in dealing with non volume based overheads or activities as it is more consistent in providing a volume based cost in terms of product costs. Furthermore, distortion of overhead costs might occur when the products are diversified in the sense of having different volumes, set up times, complexity and sizes in terms of batches. If products consume overhead resources in the same proportions, products are less diversified and products will consume non volume based activities in aligned with that of volume based activities. This will severely affect the cost of the products where large overhead costs are a key indicator in decision making and thus affecting the accuracy and the efficiency of the overall costing system.
Conclusion:
Last but not least, ABC is a superior and accurate system compared to absorption costing because it can direct attention towards the critical success factors or the causes of overheads related to both cost objects, cost processes and the costs quality. ABC is a better system for management costing as it allows managers to design and construct improvements between the products and its processes concerning eliminating products, redesigning products and substituting products. The strong relationship between the cost information and the products allows managers to determine a much wider array of improvement strategies than absorption costing. Besides that, ABC is critical in the benefit of planning and budgeting as it can be made on the basis of activities in the forms of variance analysis. However, implementation of costs may be prohibitive in ABC and it is not necessarily more accurate compared to absorption costing on which it is promoted. In reality, indirect costs can be still subjective during cost allocation in ABC as it can still be very arbitrary.
