Difference Between Absorption Costing and Activity Based Costing

Cost accounting can utilise a variety of approaches to assign costs to goods, each of which has advantages and disadvantages. Costing is an important factor in determining selling prices; hence, costs should be calculated properly. Absorption costing and activity-based costing are two often utilised costing methodologies. The primary distinction between absorption costing and activity-based costing is that, whereas absorption costing allocates all costs to particular production units, activity-based costing uses several cost drivers to distribute expenses.

What is Absorption Costing?

Absorption costing is a conventional costing method that allocates expenses to specific units of production. It will incur expenditures for material, labour, and other overheads while producing a number of units. The total cost incurred may be divided by the number of units produced to determine the unit cost of production. Absorption costing is sometimes known as 'full costing' since it considers both fixed and variable expenses.

This differs from the other frequently used costing approach known as 'variable costing', which exclusively allocates direct expenses such as direct material, direct labour, and direct overheads to each units produced. In variable costing, fixed costs are treated as period costs and are examined as a whole, rather than being allocated to specific units.

Overhead expenses are those that cannot be directly attributed to the units of production. In other words, they should be incurred regardless of whether output levels grow or decrease. Absorption costing allocates overhead expenses on a single basis, such as the number of units produced or the total number of labour or machine hours.

What is Activity Based Costing?

Activity Based Costing, sometimes known as the 'ABC' approach, was created to solve the constraints of classic costing systems like as absorption costing and is a relatively new costing system. This is a shift away from utilising a single base to assign overhead expenses and towards identifying diverse activities in the manufacturing process and what 'drives' the costs; consequently, it focuses on determining 'cost drivers'. The overhead cost will then be estimated using the activity use and cost driver. The procedures below should be followed when determining overhead expenses using ABC:

Step-1: Identify the important actions.

Step-2: Identify a cost driver for every critical task.

Step-3: Determine the cost for each important activity category.

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

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

What is the difference between Absorption Costing and Activity Based Costing

Difference Between Absorption Costing and Activity Based Costing
Absorption CostingActivity Based Costing
Absorption costing is a method of distributing total costs to specific manufacturing units.Activity-based costing allocates expenses using several cost drivers.
In absorption costing, all expenses are allocated using a single basis.Activity-based costing allocates costs across several cost bases.
Absorption costing is a less time-consuming and less precise technique of cost allocation.Activity-based pricing takes more time but produces more accurate results.
Absorption costing is a conventional costing approach, and most managers believe it is a less effective cost allocation method.Activity-based costing is a contemporary form of cost accounting that is quickly gaining favour.

Summary - Absorption Costing vs Activity Based Costing

Absorption costing and activity-based costing take different approaches. Absorption costing allocates costs to individual units, whereas activity-based costing treats firm operations as a single cost and then seeks to assign indirect costs to units.

One significant benefit of activity-based costing is that it enables businesses to determine the exact cost and profitability of individual units produced or services supplied.

This improved precision is obtained by transforming indirect expenses into direct costs. In truth, activity-based costing is applicable to all company expenditures, not simply production-related overhead.

For example, a corporation can directly allocate its marketing spending to the particular units it produces. As a result, activity-based pricing can provide a more accurate picture than absorption costing.

However, activity-based costing can be a costly method to adopt, and it may not be as valuable to organisations whose overhead expenses are mostly volume-related, or to companies whose overhead costs account for a tiny part of their overall costs. Meanwhile, absorption costing is easy to apply while being fully consistent with generally accepted accounting standards and IRS reporting requirements. The disadvantage, however, is that it may provide less knowledge to those entrusted with making strategic decisions about production processes and costs.

The primary distinction between absorption costing and activity-based costing is how indirect expenses (overheads) are assigned. The allocation of direct costs is the same between the two techniques. Many managers favour activity-based costing because of the nature and usefulness of the information supplied; yet this technique is time-consuming and expensive to implement. Furthermore, both techniques are less relevant to service organisations because it may be difficult to identify individual cost drivers.






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