In todays ever changing world of business the role of the Management Accountant has become more prominent in many areas throughout the organisation which means that Management Accountants have to be more adaptable and efficient. In this article we will be putting the spotlight on two types of job costing; Absorption Costing and Activity Based Costing (ABC). We will be examining the limitations of traditional Absorption Costing and pitting it against its newer potentially more efficient counterpart which is ABC .
Traditional Absorption Costing… limitations ?
First of all lets take a look at traditional Absorption Costing; when was it introduced and by who?, what are the perceived limitations? and what does academia say about this method of job costing?.
As written in The Accounting Historians Journal Vol. 3, No. 1/4 (Winter – Fall 1976), pp. 1-9 Basil Yeamy has traced the first cost accounting beginnings to Robert Loders Farm Accounts 1610-1620. Efforts were made by many industrialists in Great Britain and the United States to install factory cost systems as early as 1805. However, the concentrated advancement only really began between 1890 and 1915, this was influenced by the growth of scientific management and a shift of emphasis from ascertainment to cost control.
Up until the 1980s Direct Labour was often the biggest cost of production and the overhead cost that the companies accrued were therefore smaller. This meant that the indications that the overhead was inappropriately allocated hadn’t appeared yet. Because of this Direct Labour was used as a nodal point to allocate absorption overheads to various products based off their direct labour hours. This therefore brings us onto one of the limitations of traditional absorption costing ; according to Colin Drury in Colin, C., Management Cost Accounting 10e. (s.n.), for businesses involved in the manufacture of large quantities of a small range of products, traditional costing can be capable of providing an accurate value of costs for the manufacturing process. However, in recent years diversity in output is becoming more common and absorption costing is becoming less relevant for users nowadays.
The idea that there are evident limitations to traditional absorption costing is indeed backed up by academia. A very interesting study was carried out by Martha J. Turner and Ronald W. Hilton in the Journal of Accounting Research Vol. 27, No. 2 (Autumn, 1989), pp. 297-312 (16 pages) where companies were divided up into 6 different groups based upon their attitude towards risk. They were surveyed on their choices of product costing systems (variable and absorption costing). The objective of the study was to analyse the ‘Use of Accounting Product-Costing Systems in Making Production Decisions’. Both deterministic and stochastic analysis of the results determined that 4 out of the six groups used variable costing as it was the product costing system which that yielded a production quantity closer to the optimal quantity for both risk neutral and risk averse companies. There was some other interesting results derived from that study but for the purpose of this article it shows us that in the world of business, decision makers along with academia understand limitations within traditional absorption costing ; Fixed Costs are Period Costs (they shouldn’t be included in the cost of the product and inventory which they are in a/c )and Its Not Useful in Decision Making (which I have previous highlighted) to name a few .
ABC Costing the way forward?
Abc (Activity based costing) really came to forefront of commercial job costing in the 1980s and this was due to factors such as increased global competition which made other job costing systems inadequate because of decision errors caused by inadequate cost information which was more probable and more costly which is again mentioned in Colin, C., Management Cost Accounting 10e. (s.n.). ABC was seen as a more sophisticated and adequate job costing system .There is a clear distinction between ABC and traditional job costing systems in that traditional systems allocate indirect expenses to products based upon characteristics of a single allocation factor. This however is not typically related to the type and level of work consumed.
In an article titled Cost-System Choice and Incentives-Traditional vs. Activity-Based Costing Birendra Mishra and Igor Vaysman published by Journal of Accounting Research Vol. 39, No. 3 (Dec., 2001), pp. 619-641 (23 pages) ABC costing is evaluated in relation to other costing systems in relation to profit maximisation for the firm . The results section of this report read that “the enhanced performance is due to better information under ABC however this does not unequivocally lead to higher expected profits of the firm “ however it is noted that when comparing ABC to Traditional methods exclusively ABC is better for profit maximisation and in this article as we are only comparing these two that is the result we will look at. The reasons why I believe that ABC is the super systems for larger firms is because it give more accurate product costs because It recognises that it is activities which cause costs, not products and it is the product which consume activities and Better Decision making because ABC helps the manager in providing more reliable product cost data in the decision making process and fixing selling prices of the products as the correct data of product cost is now available
Conclusion
So in this article I looked at the history, perceived pros and cons and what academia had to say of both Traditional Absorption Costing and Activity Based Costing. Both had their time of heavy usage throughout the past 200 years but for a large firm today the benefits of ABC far outweigh that of Traditional Absorption costing as I have discussed previously discussed.