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Business Management and Accounting
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Activity Based Costing and the Theory of Constraints are, respectively, Overhead Absorption Costing and Marginal Costing in a different guise
In this assignment I will be investigating the assertion that Activity Based Costing and the Theory of Constraints are, respectively, Overhead Absorption Costing and Marginal Costing in a different guise. To analyse this statement I will compare ABC with Overhead Absorption Costing and Theory of Constraints with Marginal Costing. All of these methods are well know and generally used in organisations, however Activity Based Costing and Theory of Constraints are relatively new methods, as both were developed in around 1970s whereas the other two are more than seventy years old. This is why it will be interesting to see how those methods compare, whether older methods will be still relevant and can they really be replaced by more contemporary techniques if those methods are alternative to each other. The results should show similarities and differences between each method used in cost and management accounting, primarily whether each method is an alternative to each other, assuming it is used depending on required outcome, suitability to given information or size of the organisation.
Activity Based Costing vs. Overhead Absorption Costing
Overhead Absorption costing is a two stage process of allocating organisation’s overhead costs to particular cost objects. In allocation process, all variable and fixed overhead costs are charged to cost units produced. It was developed during 1920s, when most organisations were labour intensive. Although this method is probably the oldest method developed in cost allocation, still this day is most widely used by most organisations. Absorption Costing is recognised by Ireland Revenue, as stock is not undervalued, moreover all companies must use this method in preparing financial accounts. Absorption process has two stages: allocation and apportionment of costs into departments called cost centres where they are reapportioned and finally absorbed to specific cost object which is the cost for specific unit. “Received wisdom has it that absorption costing should not be used for decision making, i.e. non-volume related costs should not be allocated to the product unit level.” (Absorption costing for decision making by Mike Lucas, Management Accounting; London: Oct 1997) This is because some of the cost incurred by the company will be self-determining of the number of units produced. Major flaw to overhead absorption costing is that its absorption bases (cost drivers) are mainly volume related, such as machine hours or labour hours and in present times indirect overheads become larger proportion of total costs. Therefore allocating these overheads using this cost drives causes under or over absorption. The consequence of this is variance between budgeted costs and actual cost. That is why this method is not appropriate for cost control. This is the main difference from ABC method, where there are more of costs centres know as...