Activity-based costing and cost absorption are two valid accounting methods. However, one is trickier. The Ascent guides you through the differences.
Cost analysis can help companies make strategic and financially sound decisions.
Activity costing and absorption costing are two popular accounting methods companies use when evaluating business activities.
What is cost per activity?
Activity-based costing, also known as ABC, is an accounting method that identifies the activities of a business and allocates costs to the units produced by the business based on the number of activities used by each unit.
Activity-based costing first determines the purpose and cost of each activity performed by a firm, and then assigns a proportional cost to each individual unit produced based on its consumption of those activities.
Let’s say a company spends $20,000 a year on equipment setup. As part of activity-based costing, he would then attempt to allocate a proportion of that $20,000 to each unit he produces.
However, it’s not just about taking that $20,000 and dividing it by the number of units produced. Instead, the business should determine which units or products use which equipment the most, and then assign each unit a cost based on its individual consumption of that usage.
Companies rely on activity-based costing to better understand the true costs of manufacturing or producing products. The downside of activity-based costing is that it can be a time-consuming system to follow.
In addition, some indirect costs may be difficult to attribute to an individual unit or product produced. For example, if a company pays $100,000 in administrative staff salaries and manufactures a number of different products, it may be difficult to allocate that $100,000, or portions thereof, to individual products or units. .
What is the cost of absorption?
Also known as full costing, absorption costing is an accounting method in which all manufacturing costs are absorbed by the units produced by a given company.
In calculating absorption costs, the cost of an individual unit produced will include direct materials, labor, and fixed and variable manufacturing overhead. These costs are not expensed in the month a company pays them.
Rather, they are recorded as assets in the form of inventory until the units produced are sold. Once this happens, they are charged against the company’s cost of goods sold. Absorption costing is generally required for financial and tax reporting purposes.
Let’s say a company manufactures 10,000 units of a particular product with a unit cost of $10 in direct materials, $8 in direct labor, and $2 in variable manufacturing costs. Let’s say the company also has fixed manufacturing overhead costs totaling $40,000 per year.
Under the absorption cost, the unit cost can be calculated as follows: $10 (direct materials) + $8 (direct labor) + $2 (variable manufacturing costs) + $4 ($40,000 per year in fixed manufacturing overhead divided by 10,000 units) = $24 per unit.
Cost per activity vs absorption cost: what are the differences in approach?
Absorption cost and cost per activity differ in their approach. Absorption costing allocates costs to individual units, while costing by activity focuses on business activities as the central cost and then attempts to allocate indirect costs to units.
One of the main benefits of activity-based costing is that it allows businesses to understand the true cost and profitability of individual units produced or services rendered.
This increased accuracy is achieved by essentially converting indirect costs into direct costs. In fact, activity-based costing can be applied to all business costs, not just production-related overhead.
For example, a company can allocate its marketing costs directly to the individual units it produces. For this reason, cost per activity can paint a more accurate picture than absorption cost.
On the other hand, activity-based costing can be an expensive system to implement and may not be as useful to businesses whose overhead is primarily volume-related or to businesses whose overhead is a small proportion of their overall costs.
Absorption costing, on the other hand, is easier to implement but recognized as fully compliant with generally accepted accounting principles and IRS reporting requirements. The downside, however, is that it may offer less information to those tasked with making strategic decisions about production practices and costs.