ACCA PM Syllabus B. Specialist Cost And Management Accounting Techniques - Comparing ABC and Traditional Methods of Overhead Absorption - Notes ^{4 / 4}

Traditional absorption costing assumes that overhead expenditure is related to direct labour hours, machine hours or production units.

However, this assumption is no longer reliable in many companies.

Using ABC to allocate overhead costs to products will lead to very different values of overheads allocated per unit.

The Advantages of ABC

1. More accurate cost information is obtained. It identifies ways of reducing overhead costs in the longer-term. This will enable managers to make better decisions, particularly in respect of pricing and marketing activities.

2. In absorption costing, as the profitability of a product would be overstated, the company's marketing effort is likely to be directed towards maximising the sale of this product, with a lesser emphasis on the other products.

   In addition, as the resulting selling price will be less than is required to fully recover overheads and yield a satisfactory profit, the market will perceive the product to be particularly attractive.

3. It provides much better insights into what drives overhead costs. ABC recognises that overhead costs are not all related to volume. 

   It also identifies activities and costs that do not add value.

4. ABC can be applied to all overhead costs, not just production overheads.

Disadvantages of ABC

ABC may not be universally beneficial. There are four major issues to be considered:

1. Cost vs benefit

   The need to analyse costs on a radically different basis will require resources, which will lead to additional costs. Clearly the benefits which will be obtained must exceed these costs. 

   In general terms, an organisation which has little competition, a stable and standardised product range and for which overheads represent a small proportion of total cost, will not benefit from the introduction of ABC.

2. Need for informed application

   While ABC is likely to provide better information for decision makers, it must still be applied with care.  ABC is not fully understood by many managers and therefore is not fully accepted as a means of cost control.

3. Difficulty in identifying cost drivers

   ABC costs are based on assumptions and simplifications which affect the choice of both activities and cost drivers

4. Lack of appropriate accounting records

   ABC needs a new set of accounting records, this is often not immediately available and therefore resistance to change is common. The setting up of new cost pools is needed which is time-consuming.

Service organisations

Five key characteristics of service organisations are

• Simultaneity/spontaneity (production and consumption of the service coinciding)

• Perishability (the inability to store the service

• Heterogeneity (variability in the standard of performance of the provision of the service)

• Intangibility (of what is provided to and valued by individual customers)

• No transfer of ownership

ABC can be effectively applied to service organisations. Indeed, the fact that for most service organisations, indirect costs will represent the major proportion of total cost means that the technique is of particular relevance to service organisations.