Question

Critically discuss the idea that ABC is a more accurate costing approach than traditional full (absorption) costing. Present in detail the differences between ABC and traditional full (absorption) costing, and the main advantages and limitations of ABC implementation.

Answer 1

Traditional cost systems (single department rate) came to origin when manufacturing processes were labor intensive. A single company-wide overhead rate based on basis of volume such as the number of units produced, direct labor hours or the production machine hours may be used to allocate overhead to products in these labor intensive processes. A single department overhead rate based on direct labor hours, or the production machine hours may be used to allocate overhead to products in these labor intensive processes.

Traditionally, this approach have been reasonable or at least sufficient to understand the company's external financial statements, however, in recent decades manufacturer also wants to know the true cost to produce specific products for specific customers, wherein traditional method of cost accounting provides inadequate information. Activity based costing (ABC) was developed to overcome the shortcomings of the traditional method. Instead of just one cost driver such as machine hours, Activity based costing will use multiple cost drivers to allocate a manufacturer's indirect costs. A few of the cost drivers that is used by ABC include the cost of material purchased or used, the number of machine setups involved, counting the number of engineering change orders, and the number of machine hours

Advantages of ABC Costing:

--Helps in cutting costs by providing reliable information on the opportunities available for reducing costs

--Assists management in making quality decision by knowing the nature of each activity.

--Helps managers on focusing the forces on value adding activities and eliminating non-value adding activities

-- A proper cost allocation to various products leads to proper pricing policy

-- Assist managers to adopt productivity improvement approaches such as TQM, BPR etc

-- Identifies processes which are inefficient and target for improvements

-- Discovers the processes which have wasted and unnecessary costs

Disadvantages of ABC Costing:

-- Data collection and preparation take loads of time

-- High cost for accumulating and analyzing the information

-- ABC reports don't always conform to generally accepted accounting principles and thus not to be used for external reporting

-- Data produced by ABC can conflict with management performance standards previously established from traditional costing methods

-- May not be as useful for small firms where overhead is small in proportion to total operating costs