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Free Accounting Dissertations - All Manufacturing Costs Were Considered As Product Cost Regardless Of Whether

All manufacturing costs were considered as product cost regardless of whether they were variable or fixed cost. Thus, the main objective is to ensure all production overheads are absorbed into the total annual production costs.
Such accounting principles had technical flaws in the sense that it is largely inconceivable to fairly and justifiably divide the fixed costs between each of departments. Under absorption method price estimation looks deceptively simple. It just needs the company to compute its unit product costs, and then determine how much profit it wants and then set its selling price. It relies too much on forecast sales and management’s estimation of consumer perception on forecasted unit sales and the assumption that they are willing to pay whatever price the company decides.

Absorption costing was not designed for the modern automated technological environment. The traditional system accommodates all production overheads to be absorbed by all the production. In the past, overheads were only a small part of the total costs therefore it did not matter how mathematically accurate it is. But today, as suggested by Proctor, overheads often account for more than 50 % of the total costs. It is essential to estimate each cost contributing factor and look what activity gives rise to such costs.
In the days when traditional accounting practices were being formed and internationalised, the dominant industries were in the manufacturing sector. In a typical large manufacturing company, there would be large numbers of employees concerned with direct manufacturing and a much smaller number in the overhead departments In a situation where the direct labour costs could be as high as 90 per cent and overheads 10 per cent of total costs it was important to get some accuracy in terms of the hours, and therefore costs, of actually making components and assemblies. These discrepancies in cost estimation using traditional method are effectively corrected by another method called the Activity Based Costing (ABC).
2.1 Activity Based Management and Cost Estimation.
2.1.1 Activity Based Costing (ABC).

ABC system is based on activities linking organisational spending on resources to the products and services produced and delivered to customers. It uses activities for accumulating costs. Instead of assessing by how much each of these departments contribute to costs, ABC system starts by asking what activities are being performed by the service department sector. It focuses on Cost Drivers.
The process of estimating cost using the activity based costing method begins by first identifying the activities performed by the business. Once we can ascertain the activities, we then move on to calculate the total costs of each such activity over the financial period. As stated earlier, the activity method relies on cost drivers for each activity.