Activity-Based Costing System vs. Absorption Costing System

activity based costing 150x150 Activity Based Costing System vs. Absorption Costing SystemActivity-based costing system is “a technique of cost attribution to cost units on the basis of benefits received from indirect activities e.g. ordering, setting up, assuring quality” (CIMA, in Rajasekaran and Lalitha, 2011, p.272). In simple terms, in activity-based costing system overheads are assigned to specific activities with individual cost centres and cost activities clearly identified.

The current costing system of Manac plc, absorption costing system can be explained as “a costing system wherein fixed manufacturing overhead is allocated to (or absorbed by) products being manufactured” (Accounting Coach, 2013, online). The main differences between the two costing systems relate to the role of overheads in accounting system, the types of cost drivers, and the allocations of costs.

Advantages of Activity-Based Costing System for Manac plc

There is a set of advantages to be obtained by Manac plc from replacing its current absorption costing system with activity-based costing system. First of all, by introducing activity-based costing system Manac plc management would be able to eliminate a range of activities that do not add value, consequently reducing the cost of product.

Introduction of activity-based costing also provides Manac plc financial management the possibility of tracing the costs overheads with an increased level of accuracy and reliability. The value of this advantage can be explained in a way that the management would be able to explore the possibilities of reducing overhead costs to increase the levels of profit margins. Furthermore, by adopting activity-based costing system Manac plc financial management would be able to monitor the total life-cycles of all costs and identify and utilise the possibilities of their reduction.

Activity-based costing system can also provide an effective linkage between Manac plc corporate strategy and decision making at an operational level. In other words, Manac plc managers would be able to analyse cost-life cycle and make decisions regarding the cost overheads focusing on strategic direction of the company.

It worth to be noted that activity-based costing system is associated with a high level of integration with Six Sigma, Total Quality Management and a wide range of other programs of continuous improvement. This advantage alone represents a weighty argument in support of introduction of activity-based costing system by Manac plc, due to the fact that the implementation of continuous improvement programs has become a necessary survival condition in the modern marketplace.

Additional advantages of activity-based costing system include encouragement of continuous improvement and control of the quality, effective facilitation of benchmarking, utilisation of unit cost instead of the total cost to achieve enhanced level of clarity, and a high level of support for performance management and a scorecard system.

Disadvantages of Activity-Based Costing System for Manac plc

It is important that Manac plc fully understand a range of disadvantages associated with the introduction of activity-based costing system. The major disadvantage relates to difficulties and high costs associated with identification and cost estimations associated with activity pools of Manac plc business practices.

Moreover, activity-based costing system involves more cost calculations compared to Manac plc current absorption costing system. This requires additional amount of clerical work and other related expenses such as using one of the most important types of resources – time.

In activity-based costing system mistakes may occur in the process cost identification in general, and finding appropriate cost pools in particular with negative implications on the level of accuracy of results.  Furthermore, scholars warn that “activity-based costing data can easily be misinterpreted and must be used with care when used in making decisions” (Garrison, 2009, p.338).

Manac plc is going to be the most vulnerable to these disadvantages during the initial period after the introduction of activity-based costing system due to the lack of previous experience in cost identification per activity and interpretation of relevant data.

Moreover, the definition of production process in an appropriate manner is going to represent another challenging task for Manac plc employees due to the lack of experience, yet appropriate definition of production process in a correct manner is one of the primary conditions for activity-based costing system.

Adaptability can be specified as another potential disadvantage associated with the introduction of activity-based costing system. To be more specific, the extension of product line and introduction of new technology is going to require adjustments in accounting procedures within activity-based costing system, and a wide range of difficulties may arise in the initial period of adaptation.

The negative implications of this particular disadvantage is further increased taking into account the fact that new product development and technological innovation has become a frequent necessity in consumer electrical goods sector that Manac plc operates in.

Conclusions and Recommendation

To summarise, as it has been discussed above, the introduction of activity-based costing by Manac plc is associated with a set of both, advantages, as well as, disadvantages. Nevertheless, a set of significant advantages to be obtained by adoption of activity-based costing such as eliminating a range of activities that do not add value and possibility of tracing the costs overheads with an increased level of accuracy and reliability oughtweight the disadvantages. Therefore, Manac plc management is recommended to replace its current absorption costing system with activity-based costing system.

At the same time it is critically important for Manac plc management to adopt a proactive approach in terms of addressing the disadvantages of activity-based costing system once the system is introduced. This can be achieved through providing training and development for finance and accounts departments employees to engage in cost identification and data interpretation in an appropriate manner.

 

References

  • Absorption Costing (2013) Accounting Coach, Available at: http://www.accountingcoach.com/terms/A/absorption-costing.html
  • Garrison, D. (2009) “Managerial Accounting” 11th edition, Tata McGraw-Hill Educational
  • Heisinger, K. (2009) “Essentials of Managerial Accounting” Cengage Learning
  • Kanyanat, R. & Phapruke, U. (2010) “Activity-based costing effectiveness: how does it influence competitive advantage and performance of Thai-listed firms?” International Journal of Business Strategy, Volume 10, Issue:2.
  • Rajasekaran, V. & Lalitha, R. (2011) “Cost Accounting” Pearson

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