Absorption Costing Approach

Introduction

The article under analysis discusses the benefits of the efficiency based absorption costing (EBAC) approach. Thus, Benjamin, Muthaiyah, and Marathamuthu point out the advantages of this approach opposite to such models as Activity Based Costing (ABC) and Traditional Costing System (TCS).

First and foremost, the authors elucidate the background of the model’s appearance. Hence, they note that the trigger for implementing an accounting innovation was the fact that the TCS could not eliminate the accuracy gap. The alternative solution, ABC, was aimed at addressing this problem. One of the key benefits of this new model was its complex structure that allowed evaluating the scope of resources essential for the production of a particular product. In the meantime, authors note that the new method, ABC, was still unable to ensure the relevant level of accuracy; as a result, an improved approach, EBAC was introduced.

The authors also provide a detailed description of each method. They explain that the TCS is based on the absorption of the overheads that do not comprise those that refer to selling and administration. This approach considers both the total labour costs and the blanket overhead recovery cost. In the meantime, the implementation of the new technologies and machinery that have replaced human labour significantly made this accounting strategy less reliable.

ABC model, in its turn, represents an improved accounting method that is aimed at elevating the accuracy of costing. According to this approach, a particular emphasis is put on considering indirect overheads or those units that compose the total overhead cost. The final cost is calculated in several stages. Meanwhile, the authors point out that this model turned out to be incapable of resolving the key problem of the TCS – otherwise stated, it still relies on the single standard absorption rate. Employing such a method results in a high cross subsidization; hence, the authors suggest using an improved approach, EBAC, which considers the differences in the products’ efficiency. Benjamin, Muthaiyah, and Marathamuthu (2009, p. 90) interpret efficiency as “the ratio of input required to produce an output.” It is rational that a small input, combined with a large output, signifies the high efficiency. In order to show the advantage of EBAC opposite to ABC and the TCS, the authors consider a series of scenarios in the framework of the three approaches.

Lastly, the authors elucidate other two accounting models that have been created as alternatives for the TCS. The first method is Transaction Costing (TC) that suggests that the main costing element is not the product itself but the element that has an impact on the transaction. The authors point out that this method has a series of weaknesses and is problematic to apply to such businesses as parcel delivery and retail banking, to name but a few. The second method under analysis is Kaplan and Anderson’s approach called Time-Driven Activity Base Costing (TDABC). This method is mainly based on considering only two variables: the supplying capacity cost and the transaction time. Benjamin, Muthaiyah, and Marathamuthu (2009, p. 99) point out that this method has the same disadvantage as TC – it directs the overhead costs to transactions but not to the products directly.

As a consequence, the authors come to the conclusion that the proposed accounting model, EBAC, has numerous advantages opposite to other alternative methods. They believe that the implementation of this model ensures a consistent cost control and effective decision making in the framework of the current economic environment.

Legislative Aspect

While entering a new emerging market, a company has to consider the accounting system to implement from different perspectives. It is critical to ensure that the implemented method will not only be efficient but also compatible with the local legislative system. The main problem resides in the fact that apart from managing the in-house accounting operations, multinational companies have to submit a series of official reports that need to be compliant with the local requirements. From this perspective, choosing the absorption system is particularly beneficial as it is compliant with the Generally Accepted Accounting Principles (GAAP). GAAP is recognized in almost all the countries with emerging markets: Russia, India, China, to name but a few. Moreover, the Internal Revenue Service (IRS) requires submitting reports in the absorption system format. Therefore, from the legislative perspective, absorption system is most appropriate to implement.

Comparative Analysis

Related Academic Research

The method under analysis has been widely discussed by the accounting community throughout the past decades. It should be noted that there is no consensus regarding the efficiency of the absorption costing system. Hence, for instance, the absorption costing method is severely criticized by the Expert Lean Coach, Brian Maskell. Maskell (2013, para. 1) notes that absorption costing results in inefficient decision making. The expert refers to the examples of the automobile industry where the necessity to absorb overhead costs leads to the critical overproduction of cars. In addition, he believes that absorption costing strategy makes managers focus on the short-term benefits overlooking the long-term perspectives. The expert assumes that the costing methodology needs to be reviewed complexly in order to make it more client-focused.

Terence Lucey, in his turn, has a different vision of the absorption costing efficiency. The author assumes that the method can be applied effectively to costing management as long as no alternative has been suggested so far. In the meantime, the author points out that absorption costing methods vary significantly, and it is critical to choose the most effective approach. In his book, he presents a comparative analysis of the TCS and ABC methods. Lucey (2002, p. 121) claims that despite the simplicity of the former, it still fails to consider some critical characteristics; as a consequence, its application results in a considerable cost distortion.

Another accounting expert, Colin Drury, compares the method of absorption costing to that of variable costing. The author notes that the final profit statement depends largely on the selected approach. Thus, while the total profit will be the same in both systems, the absorption costing method will show higher profits in the case when the production exceeds the sales. Moreover, Drury (2008, p. 153) points out such advantages of the former method as the due consideration of the fixed cost variables and fixed manufacturing overheads, as well as the avoidance of the possibility of reporting “fictions losses.”

It should be noted that the advantages of the absorption approach were already recognized at the end of the twentieth century. Thence, Alan Pizzey likewise agrees upon the competitive advantage of the absorption costing approach. The author compares this method to the marginal costing systems, pointing out the disadvantages of the latter. Hence, according to Pizzey (1989, p. 378), this system includes the stocks evaluation and can serve as a “guide to long-term costs and therefore to performance.”

Kaplan and Anderson’s Methodology

In their article, Kaplan and Anderson c, reveal the main weaknesses of the ABC system as well as the reason why many companies find it problematic to adopt this model. According to them, the approach is practically inapplicable to those companies that perform a wide range of operation as the scope of the data required for a consistent analysis is too large to handle. In addition, the validity of the data is rather doubtful as the information is retrieved from the employees’ surveys that are likely to be highly subjective. In the meantime, Kaplan and Anderson (2004, p. 2) do not suggest abandoning the model completely – instead, they propose to use a revised version of the method, the so-called “time-driven ABC” that implies considering two variables: “the cost per time unit of supplying resource capacity and the unit times of consumption of resource capacity by products, services, and customers.”

The method suggests abandoning the surveys and relying on a rough estimation of the practical capacity that can be carried out basing on the previous statistics. The unit time of activity, according to this method, is likewise calculated roughly either through interviews or direct observations. The key idea is that the obtained cost rates will be lower than in the traditional ABC model due to the fact that some part of the reported practical capacity is normally wasted. Otherwise stated, while being surveyed, the employees tend to indicate the exceeding time of the practical work, neglecting intentionally the time spent on breaks and the activities non-related to work. The authors provide an overview of the application of the two models and point out the prevailing advantage of the time-driven approach. They likewise refer to the case study of Kemps LLC as the evidence of the method’s efficacy. According to Kaplan and Anderson (2004, p. 4), the main benefit of the proposed system resides in the fact that it considers “both the costs of a business’s activities as well as the time spent on them.”

Conclusion and Personal Opinion

The analysis of the article has revealed that the efficacy of the selected accounting system depends mainly on the cost-drivers that it considers to be critical. Hence, in the framework of the TCS, the main cost-drivers are the labour hours. In the meantime, it seems to be irrational to exclude the administration and the selling overheads in the modern economic environment. The ABC approach offers to considers the operation costs most critical; however, it is evident that such an approach is unfavorable from the breakeven standpoint.in other words, measuring the operation costs seems to be highly problematic in giant companies where the number of operations performed prevails a hundred. As to the improved ABC system suggested by Kaplan and Anderson, its efficacy appears to be grounded. Hence, the method suggests focusing on the real practical capacity that is a more likely way of ensuring the breakeven. Broadly speaking this model resembles largely the EBAC that also suggests regarding efficacy as the principal cost-driver.

Accounting Terminology

• Absorption costing
• Absorption rate
• Activity Based Costing (ABC)
• Activity center
• Annual output
• Budget slack
• Budgeted capacity
• Budgeted full cost
• Cost accumulation
• Cost drivers
• Cost pool
• Costing element
• Cross subsidization
• Denominator level
• Distorted product costs
• Duration cost drivers
• Economic sector
• Efficiency based absorption costing method (EBAC)
• Efficiency rate
• Estimated capacity
• Fixed cost
• Full costing
• General overheads
• Global financial crisis
• Heterogeneous products
• High volume products
• Inaccurate cost planning
• Indirect and support resources
• Individual cost data
• Just-in-Time (JIT)
• Labour costs
• Low volume products
• Lubricants costs
• Maintenance costs
• Management accounting practice
• Marginal costing
• Mark up
• Normal capacity
• Optimum output level
• Practical capacity
• Product efficiency
• Production lot
• Profit oriented
• Profitability
• Pull-based system
• Recovery costs
• Reduced profit
• Selling and administration overheads
• Single standard absorption rate
• Staff costs
• Supplying capacity
• Theoretical maximum capacity
• To allocate operating costs
• To allocate overheads
• Total Quality Management (TQM)
• Traditional costing system (TCS)
• Transaction costing (TC)
• Transactional cost drivers
• Ultimate output
• Unused capacity

Analysis Report

In order to compare the income statements composed in absorption system and the TCS, let us consider company X that manufactures tables and chairs. The financial data for the past year is represented below.

Calculations for the absorption costing

• Fixed overhead cost per unit: total fixed overhead cost/units produced

Fixed overhead cost per unit ($): 30,000/20,000=1.5

• Total unit cost: raw materials per unit + labour per unit + variable overhead per unit + fixed overhead per unit

Total unit cost ($): 7+14+2+1.5=24.5

Calculations for the variable costing

• Total unit cost: raw materials per unit + labour per unit + variable overhead per unit
• Total unit cost ($): 7+14+2=23

Essential Calculations

Cost of Goods Sold

Units sold: Beginning inventory + Units produced – Ending inventory

Units sold: 0+20,000-2=18,000

Cost of goods (absorption approach): 24.5 x 18,000 = 441,000$

Cost of goods (variable approach): 23 x 18,000 = 414,000$

Ending inventory

Ending inventory (absorption approach) = 24.5 x 2,000 = $49,000

Ending inventory (variable approach) = 23 x 2,000 = $46,000

The key variables retrieved under the two methods can be viewed in the relevant income statements. As it might be seen above, the variable accounting does not consider the fixed costs while calculating the total product costs. As a result, the unit cost variable in the context of variable costing is insignificantly lower than that in the absorption costing method.

The selection of either the absorption costing or variable costing will essentially impact the variables reported in financial statements in the following manner:

1. As long as the unit cost varies in the two systems, the variables for the cost of goods sold reported in the income statement will vary as well.
2. The fixed overhead costs are included in the expense in the variable costing system. In the framework of the absorption costing model, only the fixed cost of the sold goods will be included in the expense, whereas the rest of the fixed costs will be included in ending inventory.
3. As long as the unit cost variables are different in these two methods, the variables reported in the balance sheet ending inventory section will be different as well.

Reference List

Benjamin, SJ, Muthaiyah, S & Marathamuthu, MS 2009, ‘An Improved Methodology For Absorption Costing: Efficiency Based Absorption Costing (EBAC)’, The Journal of Applied Business Research, vol. 25, no.6, pp. 87-104.

Drury, C 2008, Management and Cost Accounting, Cengage Learning EMEA, London.

Kaplan, K & Anderson, SR 2004, Time-driven activity – based costing, Web.

Lucey, T 2002, Costing, Cengage Learning EMEA, London.

Maskell, B 2013, Absorption costing is the enemy of lean. Chrysler and GM proved it in 2008, Web.

Pizzey, AV 1989, Cost and management accounting: an introduction for students, SAGE, London.