It is vital to have a proper costing system in place to offer services at competitive prices. This is all the more important in the current economic environment as the UK government is likely to curtail public expenditure in the future to rein in the fiscal deficit and this will increase the competition for public sector contracts. There are two important costing systems - absorption costing and activity based costing (ABC). This report analyses the usefulness of a costing system by highlighting the benefits that accrue to a company by using either of them.

The report compares the advantages and disadvantages of both costing systems. The company currently uses absorption costing. As the ABC is based upon a number of cost drivers and collection of data associated with them, a section of this report analyses the major steps that will be required if the company was to introduce an ABC system. There would be costs and resources associated with the implementation of an ABC system and a preference of one costing method over another will take those into account along with their benefits. Some of the key terms/concepts used in this report are also explained for better understanding.

Benefits of a costing system

A good costing system gives the management of company correct information required for pricing of a product. Management makes strategic pricing decisions based on the nature of various costs. This is important for success of the company to win orders in today's competitive world where lower economic growth has reduced the avenues for increasing sales.

The UK government has borrowed a large amount of money to prop up the balance sheets of the commercial banks. In order to rebalance its financial books, the government will have to reduce expenditure in the future. The government is unlikely to cut expenditure on health or education. But other services will be hit hard. Lesser number of contracts will result in higher competition and companies with relevant and proper costing systems will have competitive advantage to win more orders in a low profit margin environment.

Absorption costing and Activity based costing

Absorption Costing

Absorption costing is a technique that calculates unit cost of a product or service by including both fixed and variable costs. Variable costs are easy to identify and allocate but fixed costs are associated with more than one service or cost centre and have to be allocated on the basis of different assumptions.

With absorption costing, the company does not have to use separate internal and external financial reporting systems. Absorption costing includes all costs in a product thereby meeting the external financial reporting systems requirement of matching costs with the sales in a period. The company saves significant costs and resources by using one financial reporting system only.

As absorption costing includes all fixed costs, it is a better judgement of a firm's profitability in the longer run. A company has to recover all fixed costs in the medium to long-run and exclusion of them in pricing decision may lead to business failure over the long run.

But absorption costing has its drawbacks also. The fact that the fixed costs are allocated on the basis of various assumptions may lead to different costing standards within a company and prevent benchmarking of processes.

Activity Based Costing

ABC is a system that assigns the overhead costs for each activity of an organisation to the products, services or other cost objects that caused that activity (Horngren et. al, 1999: pg. 136).

ABC can be used for benchmarking and improving processes. The use of standard activities and data collection processes can enable a company to benchmark activities across plants and drive improvements. (Kaplan and Cooper, 1998, pg. 143).

The major drawback of ABC is that the costs of implementing and operating it are significantly more than that of an absorption costing system (Drury, 2004, pg. 389). As data collection about different costs has to be done in various departments, the costs associated with training of personnel and software installation makes an ABC system prohibitive especially for smaller organisations. Smaller organisations also normally do not have enough manpower to assign for ABC system.