The advantages and disadvantages of traditional Absorption costing techniques

The advantages and disadvantages of traditional soaking up damage techniquesIntroductionThrough the years when it comes to planning Managers has developed techniques and methods of forecasting future appeals. One of such methods is Absorption cost and operation found be (ABC)What is Absorption cost?Absorption cost is the traditional method of be and stock evaluation, having been developed roughly the 1870s to 1920s is widely used by the manufacturing companies. The idea behind concentration costing to spread alone hits of the manufacturing cost centers as well as the direct cost surrounded by the finished carrefours, and treat every(prenominal) 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, production overheads costs to cost units by means of one or more number of absorption rates.What is practise based costing?Is the new method of cost management having been developed in 1980s. it is the preferred method for the services industry. The CIMA definition for body process based costing is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final exam outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to sequestrate 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 order to achieve that they need to have a cost method of accounting formation such as absorption coting or activity based costing. Here are the advantages of having such systems and their disadvantagesThe advantages of Absorption CostingIt recognizes the importance of immovable costs in productionis method is accepted by Inland Revenue asstockis not undervaluedis method is al paths used to preparefiscalaccountsWhen production remains constant but sales fluctuate absorption costing will deliver less fluctuation in net profit andThe disadvantages of Absorption CostingAs absorption costing emphasized on total cost namely both variable and fixed, it is not so expedient 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 practise ground CostingMore accuratecosting of products/services, customers, SKUs, distribution channels.Better understandingoverhead.Easier tounderstandfor everyone.Utilizesunit costrather than just total cost.Integrates well withSix Sigmaand othercontinuous improvement progr ams.Makes visible go throughandnon-value added activities.Supportsperformance management and scorecardsEnables costing ofprocesses, supply chains, and value streamsActivity Based Costingmirrorsway make foris doneFacilitatesbenchmarkingThe disadvantages of activity based costingIt costs a drawing card 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 costing is the traditional cost accounting method that foc uses on the product or service when localisation 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 gets a more scientific approach. Price fixation in absorption costing depends on the inventory. The higher the inventory, the lower the product cost and lower the inventory or the higher per-product cost. Price fixation in activity based costing bases calculations to derive the a ctual overheads incurred on a unit, and does not vary with change 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 physical exertion 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 substantial 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.sound ValidityAbsorption costing complies with thegenerally accepted accounting principles(GAAP) whereas theFinancialAccounting Standards Board (FASB) and intimate Revenue Service (IRS) do not accept ABC for externally published financial statements. Firms that follow activity based costing, therefore, need to maintain two cost systems and accounting books, one for internal use, and other for external reports, filings, and statutory compliance.Difference in ScopeAbsorption costing helps ascertain the overall profitableness or efficiency of the manufacturing system but fails to provide the real cost of individual 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 similarly 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 operations where conventional overhead p arcelling 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 introduce activity based costing system as its more suitable for the public service industry.