Finance:Efficiency-based absorption costing
Efficiency-based absorption costing (EBAC) is the discipline of accounting, which is concerned with establishing methods or techniques to allocate fixed costs to each product or service an organization produces. EBAC (Samuel et al. 2009) is an alternative or even improved technique of absorption compared to previous established techniques as it takes into account the different level of overhead use efficiency of products. EBAC highlights the problem with use of the single standard absorption rate to allocate fixed costs to products. The single standard absorption rate was used for simplicity purposes (Steve R. and Ken 1994; Gunasekaran et al. 1999). However, it ignores the different level of efficiency of each product or service in incurring the fixed cost and as a result, a high degree of cross subsidization occurs between more efficient and less efficient products and services. In a nutshell, EBAC focuses on the efficiency aspect by identifying the products’ different level of overhead utilization efficiency.
The EBAC first coined by Samuel et al. (2009) uses efficiency as the main determinant to calculate the absorption rate. Efficiency is defined here as the ratio of input required to produce an output. An output or product or service is efficient if it requires lesser input to produce a given number of outputs. For example if Product A needs 200 set ups to produce 100 of its units and Product B needs 50 set ups to produce 100 of its units, Product B is more efficient. This is because Product B needs lesser input or drivers to produce a given number of outputs.
EBAC is a methodology that is both easy and convenient to apply. Firms using ABC could instantly explore the alternative and improved EBAC as no new data collection effort is required. The use of EBAC as compared to earlier established methods results in key changes in host of pertinent cost control and decision making scenario business face like to make or buy, to accept or reject a special order, to continue or shut down a cost/revenue centre, how much to price products and services and how much resources to allocate to different products and establish output volume levels.
Example
Given below is an illustrative example on the working of EBAC and its comparison with the traditional absorption costing system (TCS) and Activity-based costing (ABC).
Firm Samuel Plc produces two products, A and B. Details of the cost information of product A and B are as follow:
| Product A | Product B | |
|---|---|---|
| Direct material | 20 | 30 |
| Direct labour | 10 | 15 |
| Variable cost | 30 | 45 |
| Total labour hours | 10,000 | 20,000 |
| Total units produced | 5,000 | 10,000 |
| Cost pool | Cost driver | |||
|---|---|---|---|---|
| Fixed costs: | $ | A | B | |
| Rental | 20,000 | Square feet | 3,000 | 1,000 |
| Maintenance costs | 30,000 | Number of maintenance | 40 | 20 |
| Inspection costs | 10,000 | Number of maintenance | 5 | 20 |
| 60,000 |
a)The direct labour hour is used as the base to absorb fixed cost in the Traditional Absorption Costing System (TCS). b)The cost drivers and cost pools are used as the base to absorb fixed cost in the Activity Based Costing (ABC) method. c)The cost drivers, cost pools and the efficiency rate are used as the base to absorb fixed cost in the Efficiency Based Absorption Costing (EBAC) method. d)Samuel Plc applies a standard mark up of 10% for its products to arrive at the selling price.
Calculation of TCS overhead absorption rate – Samuel Plc
| Cost Pool | RM | Driver | Absorption rate (AR) |
|---|---|---|---|
| Total overhead costs | 60,000 | Direct labour hours | 60,000/ 30,000 = 2 per hour |
Calculation of ABC overhead absorption rate – Samuel Plc
| Cost Pool | RM | Driver | AR/Driver | A | Overhead/unit | B | Overhead/ unit |
|---|---|---|---|---|---|---|---|
| Rental | 20,000 | Square feet – 4,000 | 5.00 | (5 × 3,000) /5,000 | 3.00 | 5 × 1,000)/10,000 | 0.5 |
| Maintenance cost | 30,000 | No. of maintenance – 60 | 500.00 | (500 × 40) / 5,000 | 4.00 | (500 × 20) / 10,000 | 1.00 |
| Inspection cost | 10,000 | No. of inspections – 25 | 400.00 | 4.00 | 0.4 | (400 × 20) / 10,000 | 0.80 |
| 60,000 |
Calculation of EBAC overhead absorption rate – Samuel Plc
| Cost pool | RM | Driver | A | No of units | ER | Overhead/ unit | B | No of units | ER | Overhead/ unit | Total ER |
| Rental | 20,000 | Square feet | 3,000 | 5,000 | 0.60 | [(0.6/0.7) × 20,000] /5,000 = 3.4 | 1,000 | 10,000 | 0.10 | [(0.1/0.7) × 20,000]/ 10,000 = 0.3 | 0.70 |
| Maintenance cost | 30,000 | Number of maintenance | 40 | 5,000 | 0.008 | [(0.008/0.01) × 30,000] / 5,000 = 4.8 | 20 | 10,000 | 0.002 | [(0.002/0.01) × 30,000] / 10,000 = 0.6 | 0.01 |
| Inspection cost | 10,000 | Number of inspections | 5 | 5,000 | 0.001 | [(0.001/0.003) × 10,000] / 5,000 = 0.7 | 25 | 10,000 | 0.002 | [(0.002/0.003) × 10,000] / 10,000 = 0.7 | 0.003 |
| 60,000 |
Cost and profitability of A and B under different costing methods – Samuel Plc
| A | B | |||||
| $ | $ | $ | $ | $ | $ | |
| TCS | ABC | EBAC | TCS | ABC | EBAC | |
| Variable costs | 30 | 30 | 30 | 45 | 45 | 45 |
| Fixed Costs | 4 | 4 | ||||
| Rental | 3.00 | 3.4 | 3.4 | 0.5 | 0.30 | |
| Maintenance cost | 4.00 | 4.80 | 1.00 | 0.60 | ||
| Inspection cost | 0.4 | 0.70 | 0.8 | 0.70 | ||
| Total costs | 34 | 37.4 | 38.90 | 49 | 47.3 | 46.55 |
| 20% Mark Up | 6.80 | 7.48 | 7.78 | 9.80 | 9.46 | 9.31 |
| Price | 40.8 | 44.88 | 46.67 | 58.8 | 56.76 | 55.86 |
References
- ↑ Gunasekaran, A., Marri, H., & Yusuf, Y. (1999). Application of activity-based costing: some case experiences. Managerial Auditing Journal, 14(6), pp. 286–293.
- ↑ Samuel, J. B., Saravanan, M., & Srikamaladevi, M. (2009) “An improved methodology for absorption costing: Efficiency Based Absorption Costing (EBAC)”, Journal of Applied Business Research, Vol 25 (No 6), pp. 87–104.
- ↑ Steve R., L., & Ken, G. (1994). Should Activity-based Costing Be Considered as the Costing Method of Choice for Total Quality Organizations? The TQM Magazine, 6(5), pp.1–7.
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