Absorption decide how to change the overhead cost
Absorption costing system has been created by Kaplan in 1980’s. It is a system of allocation manufacturing overheads using diver costs to products. The main advantages of this method are high accuracy allowing for better decision making within the company. However, this method is difficult to apply and expensive.The most common method of assigning cost – traditional costing used in the 2Sisters is highly simplistic, what makes this method less valuable than ABC. The major issue with traditional costing is used only for one measurement when calculating overhead absorption rate which divides the costs. Therefore, decisions based on this information are mostly inaccurate.In the 2Sisters Ltd company, which operates in food industry analysing the data provided ABC is highly appropriate. The company produce three different products, with unique features. This means that each product probably follows various processes in which they are using a different amount of materials or need longer time in some steps in production e.g. longer use of the machine, therefore more electricity usage.ABC can also be used as a tool to make various decisions. It can be used to decide how to change the overhead cost to maintain the lowest level of them as well as to determine the final price. Moreover, this information may be helpful in the future decision about the production line. This action can maintain a price reduction or increase the profit.Considering all these factors the 2Sisters Ltd should decide to change their method of cost allocation to the ABC.Contents PageIntroduction History of Activity Based CostingBenefit and Limitations of Activity Based Costing Drawbacks of tradition costingAppropriateness of Activity Based Costing in the businessUses of Activity Based CostingConclusion Introduction The aim of this report is to evaluate the use of Activity Based Costing (ABC) within the food sector. Showcasing the advantages and disadvantages of the ABC costing systems whilst looking at the drawbacks of the current historical costing system. Also the report will aim to look at the use of ABC within the food industry and how it will alter the business 2Sisters Ltd if they alter their costing system.History of ABCIn the 1980’s the concept of activity based costing (ABC) was defined by Robert Kaplan and William Burns and became popular to be used alongside traditional costing systems. (semanticsscholar) ABC initially concentrated on manufacturing industries to help rectify problems that were discovered with traditional cost price calculations. It concentrated on the manufacturing industry due to the productivity improvements and technological developments reducing the direct labour and material costs. This led to a huge increase indirect and overhead costs. (CIMA) Due to this ABC was the best costing method to use as it allocates costs to products / services in an accurate way. Traditional costing methods have been stated in the Jonsson & Kaplan’s 1987 publication as not being improved within companies in accordance to changes that have happened within a business environment since the early 1900 century. (semanticsscholar). In contrast ABC identifies activities/ costs in an appropriate way.Benefits and limitations of ABC costingThe ABC method can more accurately assign overhead costs (e.g. machine related, quality testing) to the products that use these overheads. One of the main reasons it is used is to try and reduce overhead costs in targeted areas. Activity based costing recognises that not all overhead costs are due to their sales volume and production of their ready-made vegetarian meals. Overheads make up a large proportion of the overall costs, and the management at 2Sisters Ltd need to be able to understand the cost drivers of the overhead costs which enables them to organise the business accuratelySP1 .The best place for ABC to work is in an environment which is complex and involves the use of numerous machines and several products and any entwined processes. It is not often seen in businesses when production processes are short or uncomplicated. ABC helps to identify the weaker or non-profitable products in which they produce and can help evaluate if 2Sisters Ltd should continue to make certain meals or remove them and focus more on highly profitable ready meals, therefore increasing the profitability of their company.Setting up the ABC system into 2Sisters Ltd could be expensive and time consuming. When the manufacturing activities of the ready meals are investigated they are split into smaller components to accurately determine each activity’s individual components. The process of ABC costing can use up limited resources as new information is collected, measured, and entered into the system. 2Sisters Ltd will have to hire a specialist in the ABC system to set up and train their staff on absorption based costing. Using software is a further expense to the process but it could be used by them to automate many of the labour-intensive processes involved in using ABCSP2 .Drawbacks of traditional systemThe traditional costing system (absorption costing) is a method of the full cost allocation (direct and indirect costs) to products by calculating the overhead absorption rate based on a single measure e.g. labour hours or machine hours. Therefore, it is considered as a simplistic tool for assigning costs and not advanced enough to use in the modern, changing environment. Traditional costing is easy to understand and for that reason inexpensive to apply due to treating fixed costs as a whole and applying them using only one OAR. This could be one of the reasons why 2Sisters Ltd have implemented it, as they are a newly established company that may have limited capital available.However, the main disadvantage is the high inaccuracy of the cost of units calculation, which afterwards is being used within the company in decision making. Decisions based on incorrect data can lead to many problems and are not useful, as they do not bring any value to the company e.g. production costs can be used to pricing the items, if the price implied basing on production cost provided is too high this might have an impact on sales and competition against other companies. The possibility to make the wrong decision by the managers using this method is much higher than when using ABC, which can cause a lot of harm and result in the destruction of the company and their reputation. Because of the fact that environment was changing, one cost driver not necessarily shows the true apportionment and allocation of overheads, as well as most of the modern manufactured, are not based their production on ability and availability of use of labour or machine (on which the OAR calculations are based in traditional costing). Moreover, as well as ABC this method is using historical data, which in such a quickly changing environment is not valuable. In decision making, 2Sisters Ltd is focusing on the future and therefore the past data in which they have collected may not necessarily be needed to reflect future company behaviour. The decisions made based on this information by the managers at 2Sisters is highly unreliable and can lead to losing the possible opportunities that are present within the food industry. Appropriateness of ABC in the businessThe introduction of ABC within 2Sisters Ltd could be challenging, problematic and expensive. However, it can be beneficial in the situation in which 2Sisters Ltd is currently in. Firstly, this company has a relatively high level of fixed overheads in comparison to the direct cost (the overheads total for the whole production is equal to £206,470, whereas direct costs £377,200). Fixed costs make up the majority and have a substantial impact on the production therefore it is vital to appropriately apportion these costs to show the true value of their vegetarian meals . The second thing to consider is the variety of products which the company is selling. The products that 2 Sisters Ltd are producing and selling (Moroccan Beanfeast, Italian Vegetarian Pizza and French Surprise) are completely different due to the features they are holding and the different process of production they need to go through. Therefore, there can be a different use of indirect costs e.g. different machine time needed, the material or labour hours used. In this situation, one driving costs certainly does not express the true situation. Due to change in the environment and globalisation competition has increased. To stay competitive in the market it is important that the pricing policy is accurate so that 2Sisters know exactly their whole production cost for each meal to avoid overpricing the products. ABC is the method which gives the best answer for the changing world. Comparing the price of … using both technics: traditional costing it is …. and ABC it is …., we can see how different the sales price can be maintained.Uses of ABC CostingSP3 The main benefit of using ABC system is to precisely find how overhead is distributed. Once ABC system has been performed information can be gathered and used to further benefit 2Sisters.Activity costs are found from performing ABC costing, and they can be used to compare the company’s costs with industry standards. If they don’t measure up to the industry standards, then ABC can be used as a feedback tool and measures the cost of specific services to aid managements goal of reducing cost.When making a product most of the price charged to the customer is the product cost but here is also an additional cost added which is the overhead charged for services such as customer service levels, product returns and marketing agreement. By using this method, it helps to determine which customers are the most profitable as 2Sisters will want to keep the higher profit customers and turn away unprofitable customers to increase the company’s overall profit.2Sisters will use a variety of distribution and advertising methods to sell its meals such as the internet and shops. The majority of the cost of advertising and selling is overhead, therefore 2Sisters can use ABC to make decisions to change how the channels are used and to find out which are the most profitable and which can guarantee them the highest revenue from their meals.ABC provides a comprehensive overview of costs created by making products and can then look to see if it is financially better for the company to make the products themselves or outsource to an external company.Once overheads have been apportioned, ABC costing can be used to find the margins of products, manufacturing lines and subsidiaries. Finding the margin will help assist 2Sisters as they can decide which departments require more resources which helps to provide the largest margins possible.The ABC method will help determine the minimum cost a meal can be sold at before it loses 2Sisters money. It looks at which overhead costs should be included in the minimum cost, depending on how the products are being sold.Can compare the cost of production between different facilitiesABC can be a useful tool for many businesses but deteriorates in usefulness to the company over time. It is more useful to design a more specialised ABC system that provides information that the company needs, once this system is in place it should only be expanded once it has been established there will be a future benefit in doing so. It is ill-advisable to use a large and detailed ABC system as it is very costly and it most like to fail on a long-term basis ConclusionActivity-based costing is relatively a new model of assigning overhead costs to the products. It has been created in response to the changing in the environment, due to a significant increase in the total manufacturing costs the indirect costs. This generated need for innovative solutions, which will more accurately allocate these costs. However, ABC is not a perfect method, which removes all the disadvantages of the traditional system. Moreover, in according to recent studies carried by CIMA, ABC is not widely used by the food and drinks industry, what can be explained by many factors e.g. cost of implication, complexity. Consequently, traditional costing is still in use in many organisations proving that one model of assigning costs is not appropriate in every situation for the different companies. The decision made in regard to which method the company should use, should consider the gains and outcomes of each method against the costs, which are much higher for the ABC.Therefore, the 2Sisters Ltd should consider switching to ABC method, due to the possible advantages. The industry in which the company is operating is highly competitive, so this will allow them to gain a better position in the market as a result of appropriate sales price management and increase the reliability of decisions based on this data.