Features Of Absorption And Activity Based Methods Accounting Essay

The allotment of operating expenses has ever been a affair of concern in fabrication concerns particularly in recent times. The method used in apportioning operating expenses plays a function in the finding of the comparison of the costs of making concern vis- & A ; agrave ; -vis the cost to rivals. In fact Geri and Ronen ( 2005 ) indicate that cost accounting systems do non usually command a high ranking in the hierarchy of most administrations, it is the information that they generate that plays a critical function in the public presentation of administrations and in the determination devising procedure. The scope of systems available and the claims made by the advocates of each have led to several arguments. However, some of the statements have some virtues in every bit much as they allow for a better apprehension of the methods that are being utilised. Some of the techniques and systems in usage are of traditional direction accounting sphere while others are of the more recent strategic direction accounting sphere. Some of the unfavorable judgments that have been put frontward in relation to traditional systems are that they fail to supply the necessary information that would better the strategic determination doing procedure ( Johnson and Kaplan, 1987 ; Bromwich and Bhimani, 1989 ; Roslender and Hart, 2003 ) . Suggestions like these are based on the sensed inability of the traditional systems to supply information that would do the administration more competitory and hence better long tally public presentation. In fact, Benjamin et Al ( 2009 ) indicates that the inefficiencies of traditional systems particularly in the country of soaking up costing in get bying with modern concern environments have been of great concern. The spreads that are thought to be every bit good as alterations in the fabrication industry including the move from being labour intensifier to being capital intensifier have provided the drift for invention in this really critical country of concern ( Benjamin 2009 ; Chenhall 2003 ; Lukka and Shields 1999 ) . Johnson and Kaplan ( 1987 ) indicate that this alteration can be found in the application of ABC to fabrication concerns.

Management comptrollers employed to fabricating concerns every bit good as service administrations are required to hold sound cognition of merchandise costing in order to be effectual at puting monetary values. The different full costing methods in usage have their advantages and disadvantages. Those advantages and disadvantages are factors that should be considered when doing the determination on which method is more appropriate. The method that is considered appropriate must be suited to the fortunes of the concern. Suffice it to state, surveies have shown that determination results which tend to change bears some degree of relationship to the method used to apportion costs to merchandises and services ( Bloom et al 1984 ; Barnes and Webb 1986 ) . This paper looks at two signifiers of full bing systems – traditional soaking up costing and the more recent activity based costing ( ABC ) . Both methods take a different attack in delegating cost to merchandises.

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Absorption bing

Absorption costing has it roots in the fabrication industry ( Benjamin et al 2009 ) . BPP ( 2011 ) indicates that the aim of this method of bing is to include an appropriate portion of an entity ‘s operating expenses in the cost of a merchandise. What is appropriate should be brooding of the clip and attempt that was used in the production of the merchandise. The method becomes complicated when an administration produces a mix of merchandises and activities or resources used do non bear any relationship with the volume of points produced. Geri and Ronen ( 2002 ) indicates that the usage of this method requires the allotment of a relative rate of the fixed cost of production to units produced but which has non yet been sold ( Geri and Ronen 2005 ) .

Activity Based Costing

Activity based costing ( ABC ) was developed as an option to soaking up costing. ( BPP 2011 ) . This method of bing identifies the cost drivers of the activities of an entity ‘s production procedure. Operating expenses are so charged to merchandises based on how they utilise a peculiar activity. BPP

2.0 Literature Review

This reappraisal while critically measuring the literature examines the characteristics of two bing methods looks at the justification for their usage. It besides examines the advantages and disadvantages of utilizing them.

2.1 Features of soaking up and activity based methods of bing

This attack to bing requires three stairss – allotment ; allotment ; and soaking up. However, one of the unfavorable judgment ‘s put frontward is that excessively much is operating expenses may be allocated to merchandises with high volumes and excessively small to those with low volumes. This is one of the issues that ABC seeks to turn to.

BPP ( 2011 ) besides identifies a four measure procedure in the operation of an ABC system. Step 1 identifies the major activities of an administration ; Step 2 identifies the cost drivers that determine the size of the costs of an activity ; Step 3 collects the costs of each activity and pools so into what is described as cost pools ; Step 4 charges the back uping operating expenses to a merchandise based on use of the activity. The usage of an activity by a merchandise is based on the figure of activity cost drivers it generates. BPP ( 2011 ) provides illustrations of how Steps 2 and 4 are applied. Using the activities provided earlier – telling stuffs, managing stuffs, scheduling production, and dispatching goods the cost drivers would be the figure of orders, the figure of times the production line is run, and the figure of orders despatched severally. Material handling and production programming relates to the same cost driver – the figure of times the production line is run. An illustration is besides provided for Step 4. If the cost pool for the ordination activity cost & A ; lb ; 200,000 and 20,000 orders were received so the activity would be & amp ; lb ; 10 per unit. This suggests that the higher the figure of orders received so the lower the cost per activity will be. This evidently gives rise to a similar state of affairs described in soaking up costing as under or over soaking up. If non so be per unit of a merchandise will change in relation to efficiency degrees. It goes without stating that the figure of order received may or may non associate to efficiency degrees. Neither does the figure of times the production line is run. To diminish the figure of times a production line is run may intend bring forthing more than is required of a peculiar merchandise. This may non be justified as some merchandises are capable to spoilage. Additionally, the cost of hive awaying points that are non needed anytime shortly gives rise to increased storage every bit good as managing costs each clip the points are moved in order to suit the storage of other points.

2.2 Justification for different costing methods

BPP ( 2011 ) indicates that soaking up costing can be justified theoretically and practically. The theoretical justification is that operating expenses incurred during production are portion of the entire costs of bring forthing the merchandises and therefore should be included. However, while this can non be disputed the method or attack to apportioning and allocating costs is considered by many to be haphazard. The practical grounds given include the undermentioned.

Evaluation of stock list – Inventory is included in the fiscal statements and for this statement to be considered true and just stock list should be valued at full mill cost. This demand complies with IAS 2 – Inventories. IAS 2 is an international accounting criterion and acceptance in assorted states through the procedure of harmonization allows for comparison of fiscal statements among entities runing in the same industry.

Pricing determinations – In doing pricing determinations most companies attach a mark-up on the full cost of the point. It is considered that if this method is non used so the full cost can non be ascertained.

Determination of profitableness – the greater the assortment of merchandises sold the greater the degree of trouble an entity will see in the finding of the profitableness of each merchandise unless operating expenses are included. BPP ( 2011 ) indicates that this is a combative issue.

BPP ( 2011 ) indicates that soaking up bing came into being when merely a few merchandises were produced by fabricating companies and when operating expenses represented a comparatively little proportion of entire costs. At that clip direct costs of chiefly stuff and labor were the chief constituents of cost. Therefore, the value of the over-absorbed or under-absorbed operating expenses was undistinguished. The usage of new and more advanced engineering has resulted in production being more capital intensive. This meant that overheads became much more of import and a really little proportion of labor was being utilised in the procedure. Additionally, progresss in information engineering has allowed for more efficient and effectual methods of apportioning operating expenses than antecedently encountered. Therefore, it was no longer allow in some cases to utilize direct stuff and direct labor as bases for the allotment of operating expenses. Although soaking up bing accurately allocates to merchandises the cost of resources used in proportion to the figure of units produced many resources are used in support activities that are non related to figure of units produced. Volume related resources include power and lubricators while resources that do non associate to volume but which has increased because of the now more capital intensive nature of production includes set-up costs, production programming, review of the first set of points and informations processing activities. BPP ( 2011 ) further provinces that these support activities allows for efficiencies to be gained in fabricating a scope of merchandises and are hence non affected by volume alterations. Alternatively they vary in conformity with how complex and broad runing the merchandises that are being produced truly are. A more complex fabrication procedure would necessitate more support services while a less complex procedure may merely necessitate the bare lower limit. The usage of ABC accounting was hence seen as a manner to decide the jobs encountered with the usage of soaking up costing. Absorption bing assumes that merchandises use resources in direct proportion to volume and so a big proportion of operating expenses were allocated to high volume merchandises and smaller proportions to low volume procedure. This method wholly disregarded any complexnesss in bring forthing low volume merchandises.

BPP ( 2011 ) provides information on thoughts behind ABC. First, activities cause costs to originate. Some of the activities include telling stuffs, managing stuffs, machine plants, piecing points, scheduling production and despatching points. Second, when goods are produced several activities are involved as the act in itself creates a demand for the activities that are required to acquire the occupation done. Finally, the cost of bring forthing a merchandise is assigned based on how much of the activities the merchandise consumes. In drumhead ABC requires the factors which consequences in costs of major activities in an entity to be identified. Support activities are so charged to a peculiar merchandise in conformity with the manner in which that merchandise utilises support activities activities. Whereas BPP ( 2011 ) assumes that low volume merchandises cause greater diverseness and so use more support service, it may be true to state that puting up the production line to bring forth a different merchandise may non be necessary in all fortunes and some fabrication entities plan their production in such a manner that different merchandises are produced on different yearss. In this instance the machine hr rates would use. Additionally, in order to forestall unneeded interruption downs and excessively much clip puting up, different machines are used for different merchandises or groups of merchandises. Therefore, despite the more capital intensive nature of modern production systems it could still let for the usage of traditional methods of bing – viz. soaking up bing. In fact, the people involved in puting up a production line and inspecting merchandises are normally paid an hourly rate and hence labour hr rates which is a method of allotment is in order. Where, the method interruptions down is when there is a high degree of under and over captive operating expenses. What would be required under soaking up costing is a regular reappraisal of soaking up rates. Additionally, efficiency degrees are capable to alter and this drama a function in whether are non there is under or over soaking up.

2.3 Comparison of ABC and Absorption Costing

In comparing ABC and soaking up bing BPP ( 2011 ) points out that in the same mode in which there are no regulations that can be used as the footing for the soaking up of operating expenses in soaking up costing there are troubles associated taking cost drivers. However, BPP ( 2011 ) points out that in ABC costs that varies with the volume makes usage cost drivers associated with volume while those related to minutess use activity related cost drivers. Therefore, Hundal ( 1997 ) indicates that a comparing of ABC bing with conventional methods such as soaking up costing shows that ABC provides a more acceptable method of apportioning operating expenses. However, there are disadvantages and advantages of utilizing both methods.

Advantages and disadvantages

Writers and research workers have focused the advantages and disadvantages associated with the usage of ABC. While the advantages are associated with the benefits that can be derived from its usage, the disadvantages are chiefly associated with execution – the costs versus benefits to be derived. Some of the advantages are included in the undermentioned list. It should be noted the advantage of one method represents the disadvantage of the other method and frailty versa.

The execution of ABC is comparatively easy every bit long as the information associating to cost drivers is available ( BPP 2011 ) .

It is focused on the proviso of merchandise costs that meaningful ( BPP 2011 ) .

It is the merely bing system that recognises that a figure of operating expenses are a consequence of the diverse and complex nature of fabrication and service operations ( BPP 2011 ) .

ABC recognises that fabrication is more complex now than antecedently due to an addition in the scope of merchandises, decreases in the life rhythm of merchandises, the increased demand for quality and other complexnesss in the production procedure and has responded with the usage of multiple cost drivers ( BPP 2011 ) .

It provides a more realistic manner of measuring the profitableness of merchandises by easing a better apprehension of the drivers for operating expense costs. This is necessary in a competitory environment ( BPP 2011 ) .

It takes direction accounting beyond the mill floor in consideration of all overhead costs including merchandise design, quality control, client service, production planning and gross revenues order planning ( BPP 2011 ) .

BPP ( 2011 ) and others have levelled a figure of unfavorable judgments against the usage of ABC systems. In fact, BPP ( 2011 ) has noted that there are a figure of serious defects including:

In pooling costs it may go necessary to arbitrarily apportion certain costs such as rent and depreciation. The sum of allotment by and large varies with the figure of cost pools. Therefore the greater the figure of cost pools the greater the figure of allotments.

Questions have been raised about the ability of a cost driver to supply a full account of how the cost of all points behaves in the cost pool to which it is associated.

A useable cost driver requires costs that are the consequences of activities and that can be both measured quantitatively and can be associated with production end product ( BPP 2011 ) . However, non all costs can be treated in this manner ( BPP 2011 ) .

Administrations may present ABC because of it is in manner and non because it is utile in supplying merchandise costs that are meaningful or more information. In this case soaking up bing would be more good because of the simpleness with which it can be operated

Although there are many cases in which the usage of ABC is suited there are some cases in which it is non. The cases that are suited for its usage include cases when:

the proportion of operating expenses are high compared to direct costs ;

the scope of merchandises is broad and diverse ;

there are fluctuations in the sum of overhead resources ;

the chief driver of the resources consumed is non volume.

Based on the aforesaid points it is suited in modern administrations where high degrees of operating expense costs, peculiarly those associating to back up services. It is considered to be more logical in how it assigns overhead costs. It besides provides a agency of both mensurating and bettering the efficiency and effectivity of back uping sections. It improves merchandise bing as many of the costs that are randomly allocated in soaking up costing can be traced to the relevant merchandises. It helps in replying a figure of inquiries associating to whether a peculiar activity adds value which is an of import inquiry in cost and direction accounting. If an activity does non add value so it is considered a waste of resources and should be eliminated ( Horngren et al 2000 ) . This consequences in increased efficiency and effectivity in the operation of the entity concerned.

3.0 Analysis and treatment

4.0 Decision

Although the disadvantages of soaking up costing in relation to its more modern opposite number – ABC have been touted about, it is clear that there besides advantages that are associated with its continued usage in many administrations.

Consequences of study carried out

Innes and Mitchell ( 1995 ) indicates In a … Results off s


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