Welcome to Absorption and Activity Based Costing!
Hello! This chapter is where management accounting gets really interesting—and crucial. We are moving beyond just calculating profit (like we did with Marginal Costing) and learning how to find the *true, full cost* of producing a product.
Why is this important? Because setting the wrong selling price, or thinking a product is profitable when it isn't, can destroy a business! We will look at two powerful methods for dealing with the trickiest part of cost accounting: how to accurately share out indirect costs (overheads).
Quick Review: The Problem with Overheads
Remember, a product's total cost includes:
- Direct Costs: Easy to trace (e.g., materials, direct labour).
- Indirect Costs (Overheads): Difficult to trace directly (e.g., factory rent, supervisor salaries, electricity).
The challenge, and the focus of this chapter, is how to handle Indirect Costs.
Part 1: Absorption Costing (AC) – The Traditional Method
Absorption Costing (also known as Full Costing) is the traditional method. The key idea is that products must absorb a fair share of all production overheads (fixed and variable) to determine the full cost.
Key Terminology in Absorption Costing
Understanding these terms is vital for AC calculations:
- Allocation: Assigning a whole indirect cost directly to a specific cost centre (e.g., the cost of a machine supervisor dedicated only to Department A is allocated entirely to Department A).
- Apportionment: Sharing out indirect costs among various cost centres or departments using an appropriate basis (e.g., rent is apportioned based on the square metres occupied by each department).
- Absorption: Charging the overheads that have been allocated and apportioned to cost centres, onto the individual product units using a calculated rate.
Step-by-Step Process for Absorption Costing
If you follow these three main steps, you will master AC calculations:
- Overhead Allocation and Apportionment: Gather all factory overheads and distribute them across the production departments (cost centres).
- Example: Rent is apportioned using floor area. Insurance of machinery is apportioned using the value of machinery.
- Calculate the Overhead Absorption Rate (OAR): Determine a rate that products must pay for using the department's resources. This is usually based on volume (like direct labour hours or machine hours).
- Overhead Absorption: Apply the calculated OAR to the specific products based on how many hours (or whatever base) they use.
The formula for OAR is:
\(\text{OAR} = \frac{\text{Total Budgeted Overheads for Department}}{\text{Total Budgeted Activity Level (Base)}}\)
Analogy: Think of the OAR as the price (per hour or per unit) you charge products for renting space in that department.
Overhead Absorbed \( = \text{OAR} \times \text{Actual activity used by product}\)
Under-absorption and Over-absorption
Absorption costing relies on budgeted figures (budgeted overheads and budgeted activity level) to calculate the OAR.
When the actual period ends, the Absorbed Overheads (what we charged the products) must be compared to the Actual Overheads Incurred (what we actually paid).
- Under-absorption: This happens when we absorbed less overhead than was actually spent. This means we under-costed our products. (Too little absorbed, need to increase Cost of Sales/decrease profit.)
- Over-absorption: This happens when we absorbed more overhead than was actually spent. This means we over-costed our products. (Too much absorbed, need to decrease Cost of Sales/increase profit.)
\(\text{Absorbed Overheads} < \text{Actual Overheads}\)
\(\text{Absorbed Overheads} > \text{Actual Overheads}\)
Key Takeaway for AC: Absorption Costing spreads overheads based primarily on volume (like hours worked), often using a single rate per department. It ensures all production costs are included in the inventory valuation.
Part 2: Activity Based Costing (ABC) – The Modern Approach
Activity Based Costing (ABC) is a more modern approach, designed for complex businesses where overheads are driven by many different factors, not just volume.
Did you know? ABC was developed because traditional AC systems often distort product costs, especially when a company produces a wide range of products with varying complexities (high-volume simple items vs. low-volume complex items).
The core idea of ABC is simple: Products consume activities, and activities consume resources (costs).
Key Terminology in Activity Based Costing
- Cost Pool: A grouping of related overhead costs that are caused by the same activity (e.g., all costs related to setting up machines—labour, spare parts, administration time—form the "Set-up Cost Pool").
- Cost Driver: The factor that causes or drives the costs in a Cost Pool. It is a measure of the activity level (e.g., the cost driver for the "Set-up Cost Pool" is the number of set-ups).
- Attribution: The process of charging the overhead costs in a Cost Pool to products based on their actual consumption of the Cost Driver (i.e., how many set-ups Product X required).
Step-by-Step Process for Activity Based Costing
- Identify Major Activities and Cost Pools: Determine what activities cause costs (e.g., material handling, quality inspection, order processing) and group related costs into Cost Pools.
- Identify the Cost Driver for Each Pool: Select the driver that best explains why the costs are being incurred (e.g., Material handling is driven by the Number of Material Movements).
- Calculate the Cost Driver Rate: Determine the cost per unit of the driver.
- Attribution to Products: Trace the cost driver usage back to the products and multiply by the Cost Driver Rate.
Formula for Cost Driver Rate:
\(\text{Cost Driver Rate} = \frac{\text{Total Cost Pool Amount}}{\text{Total Activity Level (Cost Driver Volume)}}\)
Overhead Attributed \( = \text{Cost Driver Rate} \times \text{Usage of Driver per product}\)
Example: If the "Inspection Cost Pool" is $50,000 and the Cost Driver is 1,000 total inspection hours, the rate is $50 per hour. If Product Z uses 5 inspection hours, it absorbs $250 ($50 x 5).
Key Takeaway for ABC: ABC uses multiple cost drivers, reflecting the complexity of activities (like number of orders, or number of inspections) rather than relying only on production volume. This provides a much more accurate product cost, especially for high-mix, low-volume manufacturers.
Part 3: Applications and Evaluation
Calculating the Selling Price
Both AC and ABC are essential for setting long-term selling prices, especially in a cost-plus environment, because they calculate the *full* cost.
Formula for Selling Price:
\(\text{Selling Price} = \text{Total Product Cost (AC or ABC)} + \text{Mark-up (desired profit margin)}\)
Using a more accurate cost (like ABC provides) leads to a better-informed pricing decision, preventing managers from underpricing complex products or overpricing simple, high-volume products.
Comparison of Costing Methods
We now have three main methods for internal reporting: Marginal Costing (MC), Absorption Costing (AC), and Activity Based Costing (ABC). It is critical to know how they differ, especially regarding profit calculation and inventory valuation.
How Inventory and Profit Differ
The key difference lies in Fixed Production Overheads:
- Marginal Costing (MC): Treats fixed production overheads as period costs. They are expensed in full in the Income Statement in the period they occur. They are *never* included in inventory valuation.
- Absorption Costing (AC) & ABC: Treat fixed production overheads as product costs. They are absorbed into the cost of units produced and sit in inventory until the unit is sold.
Impact on Profit:
If production is higher than sales, AC/ABC profit will be higher than MC profit (because some fixed overheads are carried forward in unsold inventory).
If production is lower than sales (inventory is run down), AC/ABC profit will be lower than MC profit (because fixed overheads from a previous period are now released from opening inventory and charged to the Income Statement).
Benefits and Limitations
Absorption Costing (AC)
- Benefits:
- Complies with external financial reporting standards (IAS 2 requires full cost, including fixed overheads, for inventory valuation).
- It ensures the selling price covers all costs, fixed and variable, in the long run.
- Limitations:
- If based on volume (e.g., labour hours), it can distort costs for complex, low-volume products and simple, high-volume products.
- Provides poor information for short-term decision making (since it includes fixed costs which are irrelevant in many short-run decisions).
Activity Based Costing (ABC)
- Benefits:
- Provides highly accurate product costs, especially in modern, complex manufacturing environments with diverse product lines.
- Highlights inefficient activities and helps managers control costs better by focusing on the activities that drive them.
- Limitations:
- High implementation cost: Identifying all activities, cost pools, and drivers can be time-consuming and expensive.
- It can still involve some arbitrary decisions (e.g., choosing the 'best' cost driver).
Marginal Costing (MC)
- Benefits:
- Excellent for short-term decision making (e.g., make-or-buy, acceptance of special orders) because it focuses on contribution and relevant variable costs.
- Profit figures are not affected by changes in inventory levels (unlike AC/ABC).
- Limitations:
- It cannot be used for external reporting (as it ignores fixed production costs in inventory).
- In the long run, setting prices based only on marginal cost will lead to losses, as fixed costs are ignored.
Quick Review Box: Costing Purpose
MC: Decisions & Internal Management.
AC: External Reporting & Long-Term Pricing.
ABC: Accurate Cost Determination & Activity Management.
Don't worry if matching drivers to costs seems tricky at first—the key is logic! Always choose the cost driver that has the clearest cause-and-effect relationship with the cost pool.