The justification of ABC

The limitations of the margin contribution model, concerning the fact that it only distributes the volume dependent costs, have with been criticized through the years. Increasing automation has resulted in fewer costs that vary directly with production volume, and an ever larger part of the company costs become capacity costs, applying the margin contribution terminology. As the capacity costs are considered irrelevant for decision making, the financial controlling rests on increasingly inadequate and short-term foundations in the contribution margin model.

Also, the fact that outsourcing (where the supplier insist on having his ATC covered as a minimum) is becoming increasingly popular, results in the variable costs are changing fundamentally with the choices of whether to outsource or not. Moreover, the margin contribution model does not consider that MC can be either progressive or digressive with economies or diseconomies of scale as a result, and thereby differ substantially from AVC.

Opposite the contribution margin model, the full cost model seeks to distribute all the company's costs onto the company's products. However, this only happens through the use of distribution keys, and so the full cost model often moves far away from an economic theory where the distribution keys can be explained objectively. Thus, when the costs are attributed to products in conjunction with which they do not vary, the profitability of the products are presented in a true and fair way.

As we see, there are such essential issues at hand in the case of both the margin contribution model and the full cost model, that serious alternatives are more than welcome. ABC (activity based costing) seeks to counter some of the challenges faced by the two other models, in the process of which new problems arise. No wonder cost is a difficult issue.

Criticism of ABC

One could easily get the impression that ABC places itself between the margin contribution model and the full cost model, effectively incorporating the best from both worlds. Critics, on the other hand, point to the fact that ABC more likely places itself in a void, and fails when it comes to financial stringency.

Essential critique:

o It is problematic to continue ABC calculations in optimization situations, because ABC includes different levels of cost objects. It is too restraining that ABC can only be used as a source of inspiration for cost minimizing etc.

o ABC is a comprehensive solution, making it quite difficult to do ad hoc analyses on single products without setting up a relatively considerable system.

o The ABC model does not incorporate considerations of measurement, variability, and reversibility, which are regarded as fundamental for financial control.21 These factors are, for instance, central to the margin contribution model.

No universal recipe

For some people, the choice of calculation method is more a question of religion or politics than a rational choice. One can hardly wonder why, when considering all the choices and limitations that are tied to the particular methods. When all essential factors are to be considered in a calculation, the problem at hand becomes so immense that at this point there are no complete solutions in model form. When choosing the calculation model, the choice also falls upon advantages and disadvantages, opportunities and limitations.

When confronting the problem, it is crucial to weigh both advantages and disadvantages of the different methods and relate them to the situation at hand. Different methods are suitable means for different ends, and a model that seem appropriate in one occasion may be useless in another. The best choice is achieved by knowing the different methods well, and at the same time, be conscious of the aims and conditions of each calculation. The choice is hard, and only few have a good understanding of all methods.

Case 4.1: DK Bodywork Parts Ltd.

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