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The Advantages And Disadvantages Of Traditional Absorption Costing And Activity Based Costing

The major distinguishing features of ABC compared with traditional costing system are that ABC systems assign costs to activity cost centres rather than departments. (Drury, 2008) Although traditional absorption techniques may apparently seem to less complicated or tedious as opposed to ABC, the report will show why, ABC is the best most accurate technique. The traditional technique used to determine which technique is better of the two will be absorbing indirect costs on a labour hour basis.
Why does the company need either absorption costing or ABC? There are two main reasons why the company needs to employ either technique these include;
To identify product costs for pricing and/or cost control purposes
It’s necessary for manufacturers to ascertain the cost of closing stock in order to measure and report profits to the shareholders, plus in the UK SSAP 9 IN 1975 has requires all companies to include manufacturing overheads in the cost of closing stock. (Drury, 2008)
Differences between Traditional Absorption Costing and ABC There are three major differences between absorption costing and ABC:
In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.
Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.
Traditional cost accounting is structure-oriented whereas ABC is process-oriented. (Emblemsvag, 2008)
This is further illustrated in the figure below (Emblemsvag, 2008)
ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any ’cause and effect’ relations (Emblemsvag, 2008).
Further differences include; (James D. Tarr, 2004)
Traditional cost models apply resources to products in two ways. So called direct costs like material and direct labour are attributed directly to the product and other resources are arbitrarily allocated to the product, typically through the mechanism of direct labour hours, labour dollars or machine hours. Sales, marketing and administrative costs are not included in product costs.
Activity Based Costing (ABC) does not change the way material and direct labour are attributed to manufactured products with the exception that direct labour loses its special place as a surrogate application method for overhead resources. Direct labour is considered another cost pool to be assigned to processes and products in a meaningful manner, no different than any other resource.
The primary task of activity based costing is to break out indirect activities into meaningful pools which can then be assigned to processes in a manner which better reflects the way costs are actually incurred. The system must recognize that resources are consumed by processes or products in different proportions for each activity.
With ABC, all costs reside in resources, which are such things as material, labour, space, equipment and services. Resources are consumed by activities which have no inherent cost. The cost associated with activities represents the amount of resource they consume per unit of activity. Resources and activities are then applied to cost objects, that is, the purpose for which the resource is consumed and the activity is performed.
Each resource and activity has a unit of measure which defines the amount of the resource consumed or activity required by a unit of demand for it. Resources can be consumed by resources (e.g. office space resource is consumed by an employee resource), by activities (e.g. telephone resource is consumed by a customer service call activity) or by cost objects (e.g. material resource is consumed by a product cost object).
Activities can be performed in support of another activity (e.g. invoice printing activity supports the billing activity) or in response to a cost object (e.g. purchase orders are issued to support the material acquisition process). A cost object can be a process or product and either an interim cost object or an end user (customer) cost object. For example, hiring personnel may be a cost object of Human Resources Department utilizing space, utility, telephone, supply and labour resources and performing advertising, calling, interviewing and orientation activities. That cost object may be a resource used by other departments to secure labour resource for their department.
Building a network of resources, activities and cost objects defines the operational flow of the process or processes to be costed. Each resource and activity has a unit of measure which converts them at a unit of demand rate. If a cost model is to be useful and effective in determining process and product costs, it is imperative that the business process be identified and understood first. Only then can costs be attached to determine the cost of the defined process. (James D. Tarr, 2004)
Advantages and Disadvantages of Traditional absorption costing techniques Advantages: (College Accounting Coach, 2006)
It recognizes the importance of fixed costs in production.
This method is accepted by Inland Revenue as stock is not undervalued
This method is always used to prepare financial accounts;
When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit and
Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation.
Disadvantages:
Ignores the fact that different products make different demands on factory support services. (Drury, 2008)
As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control. (College Accounting Coach, 2006)
As the manager’s emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision. (College Accounting Coach, 2006)
Lucey, lists the following Advantages and Disadvantages of Activity Based Costing (ABC) (Lucey, 2002)
Advantages:
More realistic product costs are provided especially in, industries where support overheads are a significant proportion of total costs.
More overheads can be traced to the product. ABC is concerned with all activities so takes product costing beyond the traditional factory floor basis.
It recognises activities which cause cost, not products and it is products which consume activities.
Focuses attention on the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product.
ABC recognises the complexity and diversity of modern production by the use of multiple cost drivers, many of which are transaction based rather than based solely on production volume.
ABC provides a reliable indication of long run variable product cost which is relevant to strategic making.
ABC is flexible enough to trace costs to processes, customers, areas of managerial responsibility, as well as product costs.
ABC provides useful financial measures (e.g. cost driver rates) and non-financial measures (e.g. transactions volume)
Disadvantages:
Even though ABC removes most the problems with traditional absorption techniques it’s faced with the following criticism
The choice of cost drivers. It is a simplistic assumption that a chosen cost driver is an adequate summary measure of complex activities
The assumption of a direct, linear relationship between the usage of a cost driver and the amount of overheads. Very few costs indeed are truly variable in this sense whether in the short or long term.
The problem of common costs. It is often difficult to attribute costs to single activities; some costs support several activities.
Tracing difficulties. It is not always apparent which product should carry the traced overhead.
Complexity. A full ABC system having numerous cost pools and cost drivers is more complex and consequently more expensive to operate. (Lucey, 2002)
Definitions: An allocation: where discrete items of cost can be allotted to cost centres
An apportionment: this is where the cost has to be spread or shared over several cost centres
Absorption rates: Is the rate determined in advance for all cost centres for allocating fixed costs and variable costs (together or separately) to the output, in an accounting period.
Recommendation: I suggest that the company consider adopting the ABC technique as this is much more suitable way to monitor costs especially in a company in where direct costs are a declining proportion of total cost and support overheads are a major proportion of costs in this company and is therefore of considerable importance that these support overheads are traced to product costs in a more realistic manner.

Just In Time Benefits For Mcdonalds Accounting Essay

McDonalds uses JIT system in which it doesn’t begin to cook (reheat and assemble) its orders until the order is being placed.Initially it used to preheat a batch of hamburgers and let them be under heat lamps for as long as possible.And eventually the burgers that were not sold were discarded.A special order had to be made to get a fresh burger during the old system.McDonalds has now developed new burger making technology which assists in making burgers faster.While having the finished product sitting in inventory for as short as possible, they also see to it that the customer gets the product as quickly as possible.
Benefits for McDonalds McDonalds has used JIT in such a way that allows them to improve quality and lower costs.
Improved Quality They have an advantage when it comes to freshness and taste of the product.The other advantages include firstly,McDonalds is that they don’t freak out when they have to make a special order,as they have an experience of making burgers as and when ordered.McDonalds ability to actually produce faster,helps them achieve customer satisfaction.Without this ability,McDonalds ordering costs would be very high as they would have to bare the loss of customers tired of waiting for long durations. Second,McDonalds can adapt to demands in a better and a faster way because of JIT systems.As they can produce burgers in a record time,They don’t need to worry about their pre-made burger inventories running out in the middle of a busy shift,as they can produce burgers in a record time.
Lower Costs Spoilage costs for burger parts are fairly high and lead to high holding costs.Thats the reason a burger has a short shelf life and needs to be sold within fifteen minutes or so.But now because of its ability to decrease the inventory and serve the customer faster has lead to significant decrease in the costs.
DELL: Dell has used JIT principles to make its manufacturing process a success.Dell has used a different approach in which it has leveraged its suppliers to achieve the JIT goal.Dell is able to provide their customers short lead times by forcing their suppliers to carry inventory instead of carrying it themselves. By this they can simply assemble the components so that the products can reach the customers quickly.
Effects of JIT on Dell’s performance First we need to see why low inventory would have such a great effect on Dell’s performance. The reason behind this is that computers depreciate at a very high rate.”The longer you keep it, the faster it deteriorates, you can literally see the stuff rot”, Kevin Rollins said it in an interview with Fast Company.Computer components depreciate anywhere between half to full point a week.Thats the reason cutting inventory is a financial imperative.The inventory turnover (COGS/Value Of Inventory) for Dell for 10 years.
Dell’s Inventory Turnover Data Due to depreciation alone in 1993 Dell was losing roughly 10% per computer inventory,by 2001 it reduced to 1%.And from there onwards Dell has continued to lower its inventory
Advantages of JIT Low ordering cost for inventory.
Better output quality.
Reduction in handling cost of material.
Efficient space utilisation.
Less paperwork.
No bottlenecks.
Reduction in losses due to obsolescence of available material.
Quality becomes responsibility of the worker and not just the quality inspector.
Reduced rework.
Smoother production flow.
Easy to trace defects.
Higher worker participation.
Workforce becomes more skilled in the process.
Vendor development as he gets long and guaranteed contracts at a steady price.
Quality of material sent by vendor is improved.
Sales cost savings.
Limitations of JIT: Implementation JIT will be expensive initially.
It takes a lot of time to give results.
Chances of losses in the process.
It requires continuous effort and lapse in the intensity can harm the process of implementation.
Its implementation varies for every organisation. There is no fixed way of implementing it.
Its success is also varied from industry to industry.
Companies relying on safety stock can have a problem in implementing this methodology.
It adds pressure on workers.
Due to standardization of processes, workers are not able to find out of the box of solutions for a problem.
JIT implementation also depends on management-workers relations. The two parties being at loggerheads don’t help the cause.
JIT involves change. It has been found out that normally people are resistant to change.
Employees need to commit to this philosophy in order for it to be successful.
JIT is best suited to only medium and high volume of production.
JUST IN TIME (JIT) Just in time(JIT) is a an approach and set of activities designed to achieve high levels of efficiency and involving minimum inventories of raw material, finished goods and work in process. In other words, this philosophy aims at delivering the right product in the required quantity at the right time at minimum cost. needed. It is a pull production system.This approach aims at continual reduction of waste and variance.
HISTORY JIT is a management philosophy and it has been practiced since 1700’s. After the Second World War, Toyota needed to overtake total production of American counterparts in order to survive. American firms produced approximately nine times that of Japanese companies. Ohno, then the president of Toyota studied American system of manufacturing and found out that it could not be applied in Toyota as the demand for automobiles in local markets was low.C:UsersAdityaDesktoptaiichi-ohno.jpg
Accordingly he devised a new system of eliminating “waste” from production system. He identified several aspects, like transportation, overproduction, inventory, defects, etc where waste could be avoided. They also changed the layout of their plants for smoother flow during production.
Taiichi Ohno Ohno introduced Kanban system. It is essentially information about the work to be done. It was basically a rectangular card which had information about the work that was needed to be performed by a worker. All movement throughout the company was controlled by it. Kanban was completely instituted in the production system of the company ten years after it was introduced. This whole process involved many hiccups and mistakes, but they learnt from those mistakes. It took nearly 10 years, but due to Toyota’s high and more efficient production, the west started to take notice. The positive results were there for everyone to see.
Hence JIT is also referred as “Toyota Production System” and Taiichi Ohno is generally referred to as the father of JIT.
JIT and the world In today’s world of globalization, the competition in any sector is very high. So JIT initiatives help companies to gain that extra edge with respect to its competitors. JIT reviews and revamps every operation of the company which helps in the better working of a company . It involves planning from executives, workers, inventory etc. In other words it takes into account the operations of various departments o in a company.
Prerequisites of applying JIT in a company: Reason
Executive commitment
Strategic manufacturing plan
Goals of JIT Various goals targeted by JIT are as given below:
Help the company to have an edge over its competitors.
It aims at minimizing defects occurring during production.
Attainment of customer satisfaction is one of its prime objectives.
It views stock inventory as waste, hence it aims at reducing this aspect in a production system.
This philosophy aims at reducing material handling during production.
Minimum setup time.
Techniques to minimize lead time are brain stormed.
A JIT applied production system should be less vulnerable to breakdowns.
Paperwork involved in the whole process should be reduced to minimum.
Produce products when they are needed and rate at which they are needed.
JIT aims at exposing hidden causes of inventory keeping. According to this philosophy, inventory is considered as waste and it incurs loss instead of adding value, as opposed to the notion that of traditional accounting concepts.
Elements of Just-In-Time Systems People involvement: Applying JIT in a production system requires combined and committed efforts from each and every person who is directly or indirectly involved with the company. A successful institution of JIT is characterized by degree of people involvement.
Plant layout: A layout of a factory is one of the biggest factors affecting the efficiency of JIT, when applied to an industry.
Standardisation: There has to be standardisation in the components to be able to group activities .
Minimum volatility: There has to minimum volatility in the cost of inputs and outputs.Also the quality of the inputs are not expected to deteriote over time.If there is cost increase and quality deteriotion , it might more than compensate for the reduction in expenditure on inventory management
Waste: Waste is defined as anything other than minimum amount of equipment, material, part and workers which are absolutely essential for production. According to JIT, there are 7 types of waste.
Transportation waste
Process waste
Inventory waste
Waste of motion
Waste from defects
Wastage of time
Overproduction
Some of the causes of this wastage are identified as layout, incapable processes, methods, lack of training, maintenance, etc. JIT aims at minimizing these and similar wastages taking place in various operations while a company manufactures its final product.
Principles of JIT: One piece flow: It is also known as Single piece flow or continuous flow. In short it aims at moving the parts from step to step such that there is no wastage in between. It is best suited for a cellular layout where all necessary machines are located in a U-shaped cell in required sequence. This system is mainly used for low mix, high volume manufacturing environments.
Machines in order of process: Machines should be located in such a way that it minimizes material handling. Also the machines should be placed sequentially with respect to the processes the input undergoes.
Small and inexpensive equipments: The whole point of JIT is to maximize productivity and thus reduce overall cost.
Multi process handling workers: This principles aims at combining various processes so that it minimizes material handling.
Easy moving operations: Simple techniques can be used like slides so that it decreases on overall cost of the operations.
Definition of standard operations: This principle helps in attaining high quality as it predefines standard way of performing operations. This results in decrease in probability of defect during processing.
Rate at which customer buys a product: Inventory is ordered, dispatched and handled as and when it is required. This results in minimum stock in the cycle.
Use of KANBAN system: This technique was invented by Toyota motor company. It aims at controlling all the operations that are performed by use of signalling cards( Kanban).It helps in quick notification and reduces delay and ambiguity in the production line.
Tactics: Single minute exchange of dies
Statistical process control
Use of standard containers
Doable schedule with adequate visibility
TAKT time
5-s program
Kaizen event
Visual control
Flexible workers
Tools where they are needed.
Product redesign
Group technology
Total productive maintenance
Following diagrams shows how to go about implementing JIT in a company
C:UsersAdityaDesktopjit.jpgC:UsersAdityaDesktopChart JIT.jpg
Misconceptions of JIT JIT is a Japanese technique.
Inventory is a major part while applying this philosophy, but it is not the only aspect in JIT. If JIT in applied as inventory control alone, chances are that it might fail.
Using JIT technique doesn’t push the inventory to the supplier, leaving him with heavy inventory load. JIT implementation results in no excess inventory anywhere.
JIT systems are not just quality control programs. It is more of an operating philosophy.
Advantages of JIT
Low ordering cost for inventory.
Better output quality.
Reduction in handling cost of material.
Efficient space utilisation.
Less paperwork.
No bottlenecks.
Reduction in losses due to obsolescence of available material.
Quality becomes responsibility of the worker and not just the quality inspector.
Reduced rework.
Smoother production flow.
Easy to trace defects.
Higher worker participation.
Workforce becomes more skilled in the process.
Vendor development as he gets long and guaranteed contracts at a steady price.
Quality of material sent by vendor is improved.
Sales cost savings.
Limitations of JIT: Implementation JIT will be expensive initially.
It takes a lot of time to give results.
Chances of losses in the process.
It requires continuous effort and lapse in the intensity can harm the process of implementation.
Its implementation varies for every organisation. There is no fixed way of implementing it.
Its success is also varied from industry to industry.
Companies relying on safety stock can have a problem in implementing this methodology.
It adds pressure on workers.
Due to standardization of processes, workers are not able to find out of the box of solutions for a problem.
JIT implementation also depends on management-workers relations. The two parties being at loggerheads don’t help the cause.
JIT involves change. It has been found out that normally people are resistant to change.
Employees need to commit to this philosophy in order for it to be successful.
JIT is best suited to only medium and high volume of production.
Application of JIT in Industry 1.Hospital Industry: With the application of JIT, hospitals are reducing the invenrory stock and are placing orders at a more regular interval.Nurses were scheduled in permanent shifts to improve the nursing quality.
2.Retail Industry: With the help of Information Technology,sales information is relayed to the vendors instantly.This helps in better monitoring of the stock level and reordering at the threshold time.It helps in reducing the inventory stock pile up and also at the same time respond quickly to a change in demand.Wal-Mart has shown good profits after the implementation of JIT.
3.Information Technology Industry: The IT industry has started following the Just In Time to improve the human resource utilisation.The traditional practise used to be to hire resources in advance in the anticipation of future projects.Now the trend is to hire resources as and when the projects are in hand.
4. Manufacturing Industry: The objective is to maximise the manufacturing capacity and at the same time maintain high quality.This is done by maintaining limited number of high quality suppliers but ensuring the relationship is very reliable between the customer and supplier.The next step is to optimise each step in production line and to make parts with no defects.Also the production should be in line with the demands of the consumers.
Just In Time in Indian Context: The lifestyle, values and beliefs that are influenced by traditions in societies have a direct impact on the work culture along with technological forces. The JIT methodology imposes requisites that are not necessarily aligned with this work culture. Managerial styles and practices vary from country to country depending on their cultural norms. Thus, JIT implementation and its success depend greatly on work culture. Taking this thought forward, the implementation of JIT in India would be different from its implementation in its western counterparts. Hence, using a generic implementation strategy might lead to issues not faced in other parts of the world.
JIT in Indian Companies: The last decade has witnessed a great deal of growth in the Indian automobile sector. The Indian Automobile industry is the seventh largest in the world, the fourth largest exporter in Asia and produced over 2.6 million units in 2009.
JIT methodology has been widely implemented in the Indian enterprises, especially in Indian automobile and manufacturing companies.
Some of the Indian companies which are using JIT techniques include Lukas TVS, Gontermann-Peipers Ind Ltd, Volkswagen India, Tata Motors, IFB etc.
Lucas-TVS: Lucas-TVS is a major player in Auto Electricals in India today with with almost fifty years experience in design and manufacturing. 80% ofvehicles rolled out daily are fitted with Lucas-TVS products. In order to deliver products at low cost and high quality, Lucas-TVS employed techniques like Total Quality Management (TQM) and Quality Assurance methods like Advanced Product Quality Planning, Statistical Process Control Techniques, Effective Tool Management System, Process Capability Improvements.
Stage I (1963-85):
Traditional (Batch mode, Functionally organized) manufacturing methods.
Stage II (1985-95):
Introduction of cellular (Lean) manufacturing – Formation of cells and product units.
ISO 9001
Stage III (1995-99):
Introduction of single piece flow manufacturing.
TQM Initiatives QS 9000
Stage IV (1999-2004):
TQM Initiatives
Advanced JIT – Chaku Chaku. Large Cells
ISO 14001
TS 16949
Challenging Deming Application Prize by 2004.
Stage V (2005 onwards):
Advanced TQM
TPM Initiatives
Advanced JIT, Mixed Model Line, Jidoka.
Challenging Japanese Quality medal by 2009.
In its pursuit of technological as well as methodological excellence, Lucas-TVS has adopted the Cellular Manufacturing System and Just In Time and also helped suppliers to adopt the same. With the implementation of this system, components from suppliers are delivered to it on a pull basis using FIFO concept and assisted by simple visual controls and using KANBAN system, supplied to the line on an hourly basis.
Following are the JIT related International awards won by the company:
• JIT Innovation Award by JIT Management Lab, Tokyo (2001

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