Activity-Based Costing Vs Absorption Costing

Activity-based costing is a comprehensive cost allocation method. It helps the management identify cost activities and cost drivers.

ABC method serves several purposes including product costing, pricing, profitability, and customer profitability analysis.

On the other hand, absorption costing is the conventional costing approach. It adds fixed overhead costs to the variable costs of production.

Let us discuss Activity-Based Costing and Absorption costing methods in detail.

What is Activity-Based Costing?

Activity-based costing or ABC costing is an accounting method that allocates product costs based on activities that are used by cost objects.

ABC costing identifies production costs linked with each activity. Thus, it allocates production costs in further detail as compared to other costing approaches.

A key feature of ABC costing is the linking of overhead costs, manufacturing products, and overhead activities. Hence, it identifies activities and cost-drivers to allocate production costs.

Activity-based costing can be used for any manufacturing facility. However, as it is a complex process, it brings full benefits to a manufacturing facility with several products.

The management can use ABC costing for overhead cost analysis, target costing, customer profitability analysis, and product line analysis.

The main advantage of ABC costing is to get detailed information on product costs that are derived by activities rather than using a blanket approach of spreading costs equally.

Calculating the Cost per Unit with Activity-Based Costing

Activity-based costing needs a comprehensive and step-by-step approach to calculate the cost per unit.

Step 1: The first step is to identify all activities required to produce a product. These activities can then be divided into cost pools.

Step 2: The second step is to identify the cost driver for each activity. A cost driver is a process that causes the cost or “drives” the cost for a particular activity.

Step 3: Next step is to calculate the cost driver rate by dividing the total cost for an activity divided by the total cost drivers.

This step is similar to calculating the overhead absorption costing. The only difference is in the ABC method, the OAR is calculated for each activity separately.

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Step 4: In this step, driver cost rates are absorbed back into individual products.

Step 5: The last step is to calculate the total cost per unit by adding costs of all activity costs identified above.

Example of ABC Costing

Suppose a company Blue-Tech produces two products P1 and P2. The following data is available for production costs.

DetailsP1P2
Units10,0003,000
 $$
Direct Material4050
Direct Labor1015
Other Overheads510
Total Marginal Cost5575

Further, the following data is available regarding the cost pools and activities of production.

Details  
Production Batch Costs$ 90,000 
Warehouse Costs$ 80,000 
Other costs$ 50,000 
Cost DriversP1P2
Batch size1,000100
Items per Unit1530

To calculate the product costs using the ABC method, we need to apply the step-by-step approach as described above.

The cost pools and cost drivers are identified.

Batch Setups:    

  • P1 = 10,000/1,000 = 10             
  • P2= 3,000/100 = 30   
  • Total = 40

Warehouse costs are as follow:   

  • P1= 10,000 * 15 = 150,000 
  • P2= 3,000 * 30 = 90,000
  • Total = 240,000

Suppose, P1 requires 5 labor hours and P2 requires 10 labor hours at a rate of $ 2 per hour. Thus, P1 will require 50,000 and P2 30,000 labor hours.

Total Labor hours = 80,000

Other overheads = 50,000/80,000 = $ 0.625 per labor hour

Any other overheads can be absorbed on these labor hours.

Batch Costs = 90,000/40= $ 2,250 per batch

Warehousing Costs = 80,000/240,000 = $ 0.33 per item

Other overheads = 50,000/80,000 = $ 0.625 per labor hour

Now, we can calculate cost per unit based on these calculations.

Batch Costs:                

  • P1= $ 2,250/1,000 = $ 2.25 per unit         
  • P2= 2,250/100= $ 22.5

Warehousing Costs:  

  • P1 = $ 0.33 * 15 = $ 4.95                
  • P2= 0.33 * 30 = $ 9.9

Other overheads:     

  • P1 = 0.625 * 5 = $ 3.125                     
  • P2= $ 6.25

In the final step, we can calculate the total costs of production using the ABC method.

DetailsP1P2
Units10,0003,000
 $$
Total Marginal Cost5575
Batch set up costs2.2522.5
Warehouse Handling4.959.9
Other Overheads3.1256.25
Total Production Costs65.325113.65

Pros and Cons of Activity-Based Costing

Activity-based costing is a comprehensive costing approach. It calculates accurate costs per unit that include variable costs and fixed overheads.

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A key advantage of the ABC method is that identifies activities that drive costs. Thus, the management can use the ABC method for detailed product costing, pricing, and other analysis.

Once the management identifies cost drivers and activities, it can control these cost drivers to reduce overhead costs. Also, this method tells us that overhead costs can be an indirect but significant part of the total product cost.

Another key advantage of the ABC method is to calculate overheads other than production overhead costs. The management can apply the same method across cost pools and activities to identify cost drivers.

The drawback of this method is its complexity. Although it is useful in a production environment with several products, the process is fairly complicated, costly, and time-consuming.

ABC method is not favorable for facilities where overheads are a small proportion of the total production cost. Also, identifying all types of overheads against cost drivers is not possible.

What is Absorption Costing Method?

Absorption costing is one of the costing methods that includes variable costs as well as fixed overheads costs in the total production cost of a product or service.

Although absorption costing considers fixed overhead manufacturing costs, it excludes some fixed costs such as admin, selling, and marketing costs.

The absorption cost method is the conventional costing method that lumps all fixed overhead costs. It then identifies fixed overhead costs per unit.

Absorption costing is a simple and comprehensive approach for a production facility with a small number of products. It is also beneficial for companies that produce large volumes of similar products with little differentiation.

Calculating the Cost per Unit with Absorption Costing Method

The absorption costing approach requires adding fixed overhead costs to the variable costs of production.

A general format of the approach can be listed as below:

ItemAmount
SalesX
Cost of Goods Sold: 
Beginning Inventoryx
Variable Overheadsx
Fixed Overheadsx
Closing Inventory(x)
Gross ProfitX/(X)
Under/Over Absorption (If any)X/(X)
Non-Production Costs(X)
Net ProfitX/(X)

Example of Absorption Costing

Continuing with our example above, we take the same data and calculate the cost using absorption costing.

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DetailsP1P2
Units10,0003,000
 $$
Direct Material4050
Direct Labor1015
Other Overheads510
Total Marginal Cost5575

Suppose the fixed overhead for this production facility is the labor cost that comes at a rate of $ 2 and total fixed overheads of $ 160,000. P1 requires 5 hours and P2 requires 10 hours to complete.

Labor Hours:

  • P1 = 10,000 * 5 = 50,000
  • P2 = 3,000 * 10 = 30,000   
  • Total = 80,000

Therefore, fixed overhead absorption = 160,000/80,000 = $ 2 per labor hour

Thus, FOH absorption for:  

  • P1 = 2 * 5 = $10 / unit 
  • P2= 2 * 10 = $ 20/ unit

Thus, total cost for:  P1 = $ 65  and  P2 = $ 95

Activity-Based Costing vs Absorption Costing – Key Differences

Absorption costing is the conventional and full costing method. However, it has some limitations as compared to the comprehensive ABC method.

Here are some key differences between activity-based costing and absorption costing.

Definitions

Activity-based costing is a costing approach that assigns overhead costs based on activities and cost drivers.

Absorption costing includes variable costs and fixed overhead costs in the total production costs.

Cost Calculation Approach

Absorption costing calculates the direct product costs such as direct labor, direct material, and other direct costs first. It then adds the fixed overhead costs to the marginal cost of the product.

The ABC method requires a comprehensive approach. It identifies cost pools, activities, and assigns cost drivers. It then allocates costs based on these cost drivers. Finally, it determines the cost per unit through the activity cost rates.

Suitable For

The absorption costing method can be suitable for production facilities with little customization needs. It is ideal for production facilities where a large volume of products is manufactured for similar products.

ABC method is costly, complex, and time-consuming. Thus, it is only suitable for large production facilities with a lot of customization needs.

Help in Decision-Making

Absorption costing takes conventional costing approaches such as marginal costs one step further. However, it does not help the management in the decision-making.

ABC approach is a comprehensive method of cost allocation. The management can identify cost drivers and activities that are not direct to product manufacturing. Thus, it can help the management in product pricing, costing, and product profitability analysis.

Reporting and Compliance

The absorption cost method is a widely used and accepted method. It is in compliance with the accounting standards such as US GAAP rules.

The ABC method is also a widely used method. However, it is not required under accounting standards such as the US GAAP rules.

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