Difference Between Absorption Costing and Activity Based Costing

Key Difference – Absorption Costing vs Activity Based Costing
 

Cost accounting can use a number of methods to allocate costs to products where each consist of their own merits and demerits. Costing is a vital contributor in deciding the selling prices; thus costs should be determined accurately. Absorption costing and activity based costing are two widely used costing systems. The key difference between absorption costing and activity based costing is that while absorption costing is a way of allocating all costs to individual production units, activity based costing is a way of using multiple cost drivers to allocate costs.

CONTENTS
1. Overview and Key Difference
2. What is Absorption Costing
3. What is Activity Based Costing
4. Side by Side Comparison – Absorption Costing vs Activity Based Costing
5. Summary

What is Absorption Costing?

Absorption costing is a traditional costing system that assigns costs to individual units of production. It will incur costs in the form of material, labor and other overheads and produce a number of units. The total cost incurred can be divided by the number of units produced to arrive at the unit cost of production. Absorption costing takes into account both fixed and variable costs; thus, this approach is also referred to as ‘full costing’.

This is different to the other widely used costing method known as ‘variable costing’ which only allocates direct costs such as direct material, direct labor, and direct overheads into individual units produced. In variable costing, fixed cost is considered as a period cost and will be considered in whole without allocating to individual units.

E.g. Consider the following costs for ABC Company.

According to the above, total cost per unit is $60 ($50+$10)

This is a straightforward and simple method of cost allocation but, some accounting and business practitioners question whether such an approach can produce accurate financial results. One of the main drawbacks in traditional costing systems such as absorption costing or variable costing occurs with the method of allocating fixed and variable overheads.

Overhead costs are the costs that are not directly traceable to the units of production. In other words, these should be incurred irrespective of the increase or decrease in production levels. In absorption costing these overhead costs will be allocated using a single basis such as the number of units produced or the total number of labor or machine hours.

What is Activity Based Costing?

Activity Based Costing, commonly referred to as ‘ABC’ method, is developed in order to overcome the limitations of traditional costing systems such as absorption costing and is a relatively modern costing system. This is a move away from using a single base to allocate overhead costs and attempts to identify different activities in the production process and what ‘drives’ the costs; thus, it is focused on deriving ‘cost drivers’. Then the overhead cost will be calculated based on the activity usage and the cost driver. Following steps should be followed in calculating overhead costs using ABC.

Step-1: Determine the key activities

Step-2: Determine a cost driver for each key activity

Step-3: Calculate the cost of each key activity group

Step-4: Calculate cost driver/allocation rate for each activity by dividing activity cost into allocation base

Step-5: Allocate costs to each cost object via allocation rates

E.g. Z is a clothing manufacturer and incur the following activities and costs (Steps 1, 2 and 3 in ABC process)

Z obtains an order to produce and ship 1,500 garments. The overhead cost for this particular order can be calculated as below. (Steps 4 and 5 in ABS process)

Assume the following direct costs for the order; thus, the total cost (including overhead cost of $47,036)

Direct material        $55,653

Direct labor              $39,745

Overheads                $47,036

Total                          $142,434

Using multiple bases to assign costs facilitates more accurate cost allocation that ultimately results in better cost control and better decision making. Using the same cost base for all activities is less accurate and not justifiable.

E.g. In the above example, if shipping costs are allocated based on the number of labor units, it is not justifiable since it is not labor intensive and shipping charges are based on the number of units shipped.

What is the difference between Absorption Costing and Activity Based Costing?

Summary – Absorption Costing vs Activity Based Costing

The main difference between absorption costing and activity based costing lies with the manner indirect costs (overheads) are allocated. The allocation of direct cost remains the same across the two methods. Activity based costing is preferred by many managers due the nature and relevance of information provided; however, it is time-consuming and costly to use this method. Furthermore, both these systems are less applicable to service organizations where it may be difficult to identify specific cost drivers.

Reference:
1. “Absorption Costing.” Investopedia. N.p., 13 Mar. 2015. Web. 14 Mar. 2017.
2. “The Traditional (Absorption Costing) Income Statement.” Accounting In Focus. N.p., n.d. Web. 14 Mar. 2017.
3. Obaidullah Jan, ACA, CFAhire me at. “Activity-Based Costing.” Activity-Based Costing | Steps | Example. N.p., n.d. Web. 14 Mar. 2017.
4. Saygili1 Arikan Tarik, Cevdet Alptekin Kayali. “A comparison of absorption costing and activity based costing systems through an optimization problem.” International Journal of Research In Social Sciences (2015): 19-26. Web. 14 Mar. 2017.

Image Courtesy:
1. “Activity-based Costing”By User:Andrew pmk – Original author and conversion by User: Andrew pmk see File:Activity-based_Costing.png (Public Domain) via Commons Wikimedia