The advantages and disadvantages of traditional Absorption costing techniques

The advantages and disadvantages of traditional concentration approaching techniquesIntroductionThrough the years when it comes to planning Managers has highly-developed techniques and manners of forecasting future costs. angiotensin converting enzyme of such(prenominal)(prenominal) methods is Absorption be and activity base be (ABC)What is Absorption cost?Absorption costing is the traditional method of costing and strain evaluation, having been developed around the 1870s to 1920s is widely used by the manufacturing companies. The idea behind tightness costing to spread all overheads of the manufacturing cost centers as well as the direct cost between the finished yields, and treat all non-manufacturing overhead as period costs. CIMA defined Absorption Costing as a method of costing that, in addition to direct costs, assigns all, or a proportion of, point of intersectionion overheads costs to cost units by means of one or to a greater extent number of absorption rates.What is activity establish costing?Is the modern method of cost management having been developed in 1980s. it is the preferred method for the services industry. The CIMA commentary for activity found costing is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources ar assigned to activities, and activities to cost objects found on consumption estimates. The latter(prenominal) utilise cost drivers to attach activity costs to outputs.CIMA Official Terminology, 2005 (http//www.cimaglobal.com/Documents/ImportedDocuments/cid_tg_activity_based_costing_nov08.pdf.pdf)AnalysisWhy does the company need either absorption costing or ABC?Its very important for managers to have an idea of the actualcostof processes, departments, operations or product which is the foundation of their budget.and in fellowship to achieve that they need to have a cost accounting system system such as absorption coting or activity base d costing. Here are the advantages of having such systems and their disadvantagesThe advantages of Absorption CostingIt recognizes the importance of fixed costs in productionis method is accepted by Inland Revenue asstockis not undervaluedis method is always used to preparefinancialaccountsWhen production remains constant nevertheless sales fluctuate absorption costing willing show less fluctuation in net profit andThe disadvantages of Absorption CostingAs absorption costing emphasized on measure cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and controlas the managers emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision.The advantages of Activity Based CostingMore accuratecosting of products/services, customers, SKUs, distribution channels.Better understandingoverhead.Easier tounderstandfor everyone.Utilizesunit costrather than just total c ost.Integrates well withSix Sigmaand othercontinuous improvement programs.Makes discerniblewasteandnon-value added activities.Supportsperformance management and scorecardsEnables costing ofprocesses, supply chains, and value streamsActivity Based Costingmirrorswayworkis doneFacilitatesbenchmarkingThe disadvantages of activity based costingIt costs a lot to maintain it, it takes a lot of time and resources to collect, check and enter it into the system for the date needed to measure activity based costing.Is not accepted by GAAP (accepted accounting principles) therefor companies need to have a different system when preparing external reports.What are the differences between Absorption costing and ABC?There are many differences between absorption costing and activity based costing.Difference in ApproachOne of such differences is the way it approached. Absorption costing allocates costs to product units, whereas activity based costing traces the costs of product units.Absorption cost ing is the traditional cost accounting method that focuses on the product or service when fixing costs. It works under the simple approach of assigning resources to products or services directly.Activity based costing is a modern cost accounting approach that focuses on activities as the fundamental cost. ABC presumes that products or services consume activities, and activities consume resources. It thus, works to convert indirect costs into direct costs.Difference in MethodologyAbsorption costing divides equally the fixed overhead costs with the number of product units whereas activity based costing identifies the actual proportion of fixed overheads costs incurred by the product unit.Comparing absorption costing and activity based costing, the latter follows a more scientific approach. Price fixation in absorption costing depends on the instrument. The higher the inventory, the lower the product cost and lower the inventory or the higher per-product cost. Price fixation in activ ity based costing bases calculations to derive the actual overheads incurred on a unit, and does not vary with neuter in inventory levels.Activity based costing, however, faces serious challenges in practical application, for appropriating some of the fixed overheads such as the chief executives salary on a per-product usage basis, is next to impossible. Moreover, process of data collection, data entry, anddata analysis requiredto divide the fixed overhead costs among units based on usage, requires unquestionable resources and remains costly to maintain. Absorption costing that divides all fixed overhead costs with the number of units produced is a simple and easy approach and free from such complexities.Legal ValidityAbsorption costing complies with thegenerally accepted accounting principles(GAAP) whereas theFinancialAccounting Standards Board (FASB) and Internal Revenue Service (IRS) do not accept ABC for externally published financial statements. Firms that follow activity bas ed costing, therefore, need to maintain two cost systems and accounting books, one for ingrained use, and another for external reports, filings, and statutory compliance.Difference in ScopeAbsorption costing helps ascertain the overall profitability or efficiency of the manufacturing system but fails to provide the real cost of undivided product units.Activity based costing mirrors the functioning of theenterpriseand contributes to strategic decision-making processes. ABC provides the real cost of individual product units and, thereby, helps identify inefficient or non-profitable products that eat into 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 based costing improves the quality of management accounting information, especially in large and multi-product ope rations where conventional overhead allocation methods such as absorption costing may produce misleading results. Absorption costing, however, remains more suitable for small firms andenterpriseswith homogeneous products or services.Recommendation and implementationI recommend to claim activity based costing system as its more suitable for the public service industry.