Absorption costing for decision making

1. Absorption Costing for decision making by Mike Lucas
REASONS FOR COST ALLOCATIONS
Cost allocation is an inescapable problem in nearly every organisation and every facet of
accounting. It is the process of assigning costs when a direct measure does not exist for the
quantity of resources consumed by a particular cost object.
1. To provide information for economic decisions, e.g., to decide whether to add more menus
in the canteen or to set new prices for customised product or service
2. To motivate managers and other employees – Zimmerman mentioned that cost allocations
are sometimes made to influence management behaviour and thus promote goal
congruence and managerial effort, e.g., cost allocation helps to motivate and control
managers.
3. To justify cost or compute disbursement – Sometimes prices are based directly on costs, or
it may be necessary to justify an accepted bid, e.g., government contracts often specify a
price that includes reimbursement for costs plus some profit margin. In these instances,
cost allocations become substitutes for the usual working of the market place in setting
prices.
4. To measure income and assets for reporting to external parties, e.g., to cost inventories for
financial reporting to stockholders, bondholders etc. Under GAAP (Generally Accepted
Accounting Principles), inventoriable costs include manufacturing costs but exclude R&D,
marketing, distribution and customer-service costs. These allocations frequently service
financial accounting purposes and the resulting costs are used by managers in planning and
performance evaluation.
However, the allocation of a particular cost may not necessarily satisfy the above four
purposes, e.g., the third and fourth reasons demonstrates how cost allocations may differ for
inventory costing and for setting prices. Ideally, all four purposes would be served
simultaneously by a single cost allocation.
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2. Absorption Costing for decision making by Mike Lucas
ZIMMERMAN APPROACH
Zimmerman strongly agreed with Kaplan and Cooper approach that cost allocations play a vital
role in motivating and controlling managers. ABC is a relatively new and widely-used approach
in full AC as it allocates overhead costs ‘more fairly’.
Zimmerman pointed out that some service/support costs are fixed in the short-run and this
may give rise to opportunity costs in form of delays/degradation of service which may add to
business costs but may change with the level of primary inputs (e.g. labour) in long term. Such
costs are categorised under general overhead (e.g. works canteen) as shown in Figure 1. He also
argued that these opportunity costs and consequent long-term incremental actual costs should
be taken into account by individual managers when deploying labour resources. Such costs are
hard to observe/measure, but allocating current average cost can serve to proxy them.
The following diagram will help the managers to take into account the additional costs of using
labour to recover the burden of overhead costs.
Figure 2: Selection of the optimal mix of input factors
Isocost line 1 represents relative prices if the
demands placed by labour on service
departments (e.g. canteen) are neglected and
only the actual cost of labour itself is
considered. If the ‘true’ cost of using labour
resource is understated, more labour hours
will be used. As a result, managers will make
decisions based on false price information.
If labour is charged with the burden of service
cost recovery, the least cost combination
shifts to Point 2. Hence, the hidden costs of
using labour are recognised at this point as it
is nearer to real optimum. Overhead is
included in unit product cost by charging
labour hours with fixed overhead burden. At
Point 2, capital-intensive method (C2) is
adopted rather than labour one (L2).
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3. Absorption Costing for decision making by Mike Lucas
Zimmerman argued that actual cost of the service resource will rise with the number of labour
hours worked and the allocated fixed cost is a proxy for these additional costs, i.e. one labour
hour gives rise to £x canteen costs.
DOES RENT MAKE A GOOD CASE FOR COST ALLOCATION?
Usually long-run volume-related costs are allocated to product unit level. Zimmerman
mentioned that additional consumption results to a rise of primary input (e.g. labour) which
leads to opportunity costs in form of delays/degradation of service that may raise actual costs in
the long-run. Therefore, it is not appropriate to allocate rent unless a huge increase in labour
force was being considered-necessitating a new factory. Works canteen, payroll and personnel
costs are considered to be a realistic possibility of good case for cost allocation.
PRODUCT COSTING PROCEDURES IN ORGANISATIONS BY ZIMMERMAN
TWO MAJOR TYPES OF ABSORPTION COSTING
Job Order Costing Process Costing
Definition: It estimates the Definition: It assesses the average
average unit costs for each job unit cost for each service provided
delivered. The costs are in a given time period. The costs
accumulated separately by job. cannot be directly traced to each
unit of product.
Examples include:
Building construction Examples include:
Law suit Petrochemical refinery
Processing a loan application Paint manufacturer
Paper mill
It is noted that AC allocates historical costs, and therefore the unit costs estimated by this
system may or may not be reasonably good estimates of opportunity costs.
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4. Absorption Costing for decision making by Mike Lucas
Economic costs/opportunity costs/true costs reflect the value of the alternative use of
resources. Moreover, the measurement of opportunity costs could be difficult and resource-
intensive because special studies are required to identify all the relevant alternatives of
possible use of resources and estimate the costs and benefits of each alternative. As a result, a
new decision problem may require a new costing study (Byford 2003, Zimmerman 2003).
The AC system can produce inaccurate unit cost estimates partly due to the biases embodied in
the overhead allocation methods applied. If the overhead allocation method does not
represent the cause-and-effect relationship between the final product (service or job) and the
overheads, the unit cost estimates could be more or less inaccurate especially in multi-product
plants, e.g. hospital. ABC was introduced to improve the accuracy of unit cost estimates, but it
has its limitations.
Both the product cost and the period cost include fixed, semi-variable and variable costs, and
both are historical costs. Moreover, the unit cost of a product could exclude period costs.
Therefore, it is important to report both product and period costs for decision makers.
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5. Absorption Costing for decision making by Mike Lucas
REFERENCES
1. Absorption costing for decision-making by Mike Lucas, University of Buckingham
2. Management and cost accounting, Sixth edition, Colin Drury
3. Journal: - The main methodological issues in costing health care services - Zsolt Mogyorosy,
Peter Smith – University of York
4. A Dissertation entitled The Impact of Time-Based Accounting on Manufacturing
Performance by Robert Hutchinson
5. Marginal and absorption costing by Khalid Aziz
6. Management Accounting – www.financedoctors.net – Saima Iqbal
7.
Absorption costing is widely used for cost control purpose whereas marginal costing is used for
managerial decision-making and control.
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