Introduction
Public sector enterprises with an increased attachment to the bureaucratization of internal processes and accountability need a transparent and predictable determination of costs incurred. Public organizations can employ various methods to calculate and record costs, depending on the preferences of decision-makers, the attitudes of the political and accounting systems, and the ultimate goals of this accounting. Among these, two methods, namely absorption and activity-based costing (ABC), are the most important to highlight (UL, 2021). This essay proposes a comprehensive critical comparison and contrast of the two costing methods, with a preference for the one that offers the most significant benefits and advantages for government organizations.
Importance of Cost Accounting
The need for public sector organizations to understand and calculate costs stems from the desire to operate more efficiently and optimize internal processes. The key prerequisites for using either of the two methods of calculation are budgeting and planning for future financial projects, monitoring the execution of these plans, the duty of financial accountability to audit enterprises and the general public, and making decisions about future activities based on financial resources (Mauro et al., 2021). These prerequisites can be used in different ways to justify the choice of a particular computation method, be it absorption or ABC.
There is a need to clearly define both terms to form an understanding of the essence of both costing methods. First, the absorption method should be regarded as a classical costing method that considers all costs of production or operating activities (UL, 2021). In this calculation method, the final cost of a product or service comprises not only the direct costs of production but also the indirect costs resulting from the production process that led to the finished product or service. For a more precise understanding, giving a theoretical example of a public company producing stationery is acceptable.
Table 1 provides information on all costs used in the production of the finished product. Assuming that this organization produces 1000 units of writing instruments, 500 packages of paper, and 200 brochures each month, and considering the total monthly costs, it becomes possible to determine the cost of the product using this method. Specifically, the cost per unit of writing instruments is $17.10 ($17,100 ÷ 1,000); the cost per package of paper is $34.20 ($17,100 ÷ 500); and the cost per brochure is also $34.20 ($17,100 ÷ 500).
Table 1. Example expense list for a hypothetical public company
Second, the ABC method is a modern method of cost accounting which, as the name implies, takes into account the specific operations and activities involved in producing a good or service. Thus, the entire list of costs is initially allocated to activities and only then recalculated per production unit (UL, 2021). This method helps businesses estimate actual production costs more accurately, which enables them to set more precise pricing.
For example, one can refer to a public company that produces office supplies for enterprises. In this case, however, the actual costs incurred in creating each product category must be taken into account (Table 2). As the calculations shown in the table below indicate, the costs of each product category depend not only on their quantity but also on the actual costs incurred by the production company in creating them.
Table 2. Sample list of expenses for a hypothetical example of a public company
Comparative Analysis
Similarities
There are a few similarities between the two types of cost calculations. Firstly, both can be used to determine production costs and thus contribute to an enterprise’s budgeting and building financial plans (UL, 2021). Secondly, both methods can be used to generate accounting statements, thereby increasing transparency in managing an organization’s financial flows. Thirdly, both methods form the foundation for making management decisions based on actual data and real costs.
Differences
However, both methods have many more differences between them than similarities. First, the essence differs, whether unit cost determinations are based solely on quantity or on quantity and actual spend. Second, the ABC method helps determine the most accurate costs and gives better accuracy than the absorption method (UL, 2021).
Third, the absorption method is more applicable to smaller businesses or start-up business models, whereas organizations with complex structures are most likely to choose the ABC method (UL, 2021). Fourth, managerial decision-making is more effective when the ABC method is used, illustrating the inefficient expenditure of finance in production. Meanwhile, the implementation of the absorption method is more straightforward and less resource-intensive than the ABC method (UL, 2021). It also follows that preparing reports using the absorption method is simpler and less time-consuming.
Choice of Method and Conclusion
The ABC method is the most valid approach for a public enterprise with a complex bureaucratic structure and a need for accurate and transparent accountability. Such organizations typically offer a range of diverse goods and services, and the ABC method helps to estimate the near-true costs of their production. The decision-makers can then make informed management decisions to reduce a particular type of cost or restructure the production category to optimize the enterprise’s administration. Thus, both cost calculation methods have been analyzed and compared in this paper, and it has been shown that public sector organizations prefer the ABC method over the more straightforward and less accurate absorption method.
References
Mauro, S. G., Cinquini, L., & Pianezzi, D. (2021). New public management between reality and illusion: Analyzing the validity of performance-based budgeting. The British Accounting Review, 53(6), 1-23.
UL. (2021). Public financial management: Planning and performance. Unit 3: Costs. University of London.