M.A

Management Accounting Activity Based Costing vs Absorption Costing

Table of Contents Budgeted Profit Statements 1 1.1 Absorption Costing 1 1.2 Activity Based Costing 3 1.3 Comments on the results 5 2.0 Discussion of the statement 6 References 9

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1.0 Budgeted Profit Statements

1.1 Absorption Costing

Traditional absorption costing involves the calculation of product cost, using direct and indirect variable costs and fixed and variable overheads, which are substituted over the complete production. Overhead cost substitution is based upon the process activity that drives the cost. Machine hours and assembly hours are two example activities that influence product development; overheads are allocated based upon the hours consumed in each department.

The following table summarises the activity levels involved in the production process:

Product	Units	Machine (Hours)	Assembly (Hours)	Setups	Orders	Suppliers
XYI	50,000	100,000	350,000	120	8,000	3,000
YZT	40,000	200,000	120,000	200	8,000	4,000
ABW	30,000	120,000	60,000	200	16,000	4,200
Total	120,000	420,000	530,000	520	32,000	11,200

When the cost is allocated to each product, finding each product’s contribution towards overhead provides a clearer picture. The following table summarises the total contributions of the three products.

	Total Contribution
Products	Selling Price (£) (1)	Cost Price (£) (2)	Contribution (£) (3)= (1)-(2)	Units (4)	Total Contribution (5)= (3)x(4)
XYI	45	32	13	50,000	650,000
YZT	95	84	11	40,000	440,000
ABW	73	65	8	30,000	240,000

The absorption rate on which the overhead cost is allocated to the products is also important in making the profit and loss statement. Since this involves two significant activities, the overhead is allocated over these two cost drivers.

· O/H Absorption rate (Machine Hours)

Overheads / machine hours = £504,000 / 420,000 = £1.20/hour

· O/H Absorption rate (Assembly Hours)

Overheads / assembly hours = £437,000 / 530,000 = £0.8245/hour

Based upon absorption rates, the following table summarises the division of overhead costs over the three products.

	Machine Hours	Assembly Hours
Products	Hours (1)	Rate (2)	Overheads (3)=(1)*(2)	Hours (4)	Rate (5)	Overheads (6)=(4)*(5)	Total O/H (7)=(3)+(6)
XYI	100,000	1.20	120,000	350,000	0.8245	288,575	408,575
YZT	200,000	1.20	240,000	120,000	0.8245	98,940	298,940
ABW	120,000	1.20	144,000	60,000	0.8245	49,470	169,470
			504,000			436,985	940,985

· Statement of Profit / (Loss)

Using Absorption Costing Method

Revenue	XYI	YZT	ABW
(1) Units	50,000 units	40,000 units	30,000 units
	(£)	(£)	(£)	(£)
(2) Sale Price	45	95	73
(3) Cost Price	32	84	65
(4) Contribution (2) – (3)	13	11	8
Total Contribution (4) * (1)	650,000	440,000	240,000	1,330,000
Overheads *	(408,575)	(298,940)	(169,470)	(940,985)
Net Profit	241,425	101,060	46,530	389,015

1.2 Activity Based Costing

The focus of activity based costing is upon departmentalizing overheads cost; this cost can be attributed to the cost driver, based upon the overhead rate. This method involves the identification of all activities, with a cost, that are involved in the process. For instance, apart from machinery hours and assembly hours exclusive to the manufacturing process, there is a setup cost each time a production schedule is initiated; receiving customer orders and generating purchase orders involve significant costs, which can be associated with the production of each of the three product quantities.

The following table summarises the absorption rates for the activities involved, based upon the cost pool (overall cost), and the cost drivers (activities that trigger cost).

Overheads Absorption Rates:

	Cost Pool (1)	Cost Driver (2)	Overhead Rate (3)=(1)/(2)
Machinery Hours (ABR1)	357,000	420,000	0.85
Assembly Hours (ABR2)	318,000	530,000	0.60
Setups (ABR3)	26,000	520	50
Customer Orders (ABR4)	156,000	32,000	4.875
Purchase Orders (ABR5)	84,000	11,200	7.50

All absorption rates were calculated. The overhead costs associated with each product category are summarized in the following table.

Absorption Rate with Respect to Each Product:

	XYI	YZT	ABW	TOTAL
Machinery	ABR1 x No. of hours x No. of units	ABR1 x No. of hours x No. of units	ABR1 x No. of hours x No. of units
	0.85 x 2 x 50000	0.85 x 5 x 40000	0.85 x 4 x 30000
	85,000	170,000	102,000	(357,000)
Assembly	ABR2 x No. of hours x No. of units	ABR2 x No. of hours x No. of units	ABR2 x No. of hours x No. of units
	0.60 x 7 x 50000	0.60 x 3 x 400000	0.60 x 2 x 30000
	210,000	72,000	36,000	(318,000)
Setups	ABR3 x No. of setups for product	ABR3 x No. of setups for product	ABR3 x No. of setups for product
	50 x 120	50 x 200	50 x 200
	6,000	10,000	10,000	(26,000)
Cust. Orders	ABR4 x No. of cust. orders for product	ABR4 x No. of cust. orders for product	ABR4 x No. of cust. orders for product
	4.875 x 8000	4.875 x 8000	4.875 x 16000
	39,000	39,000	78,000	(156,000)
Supp. Orders	ABR5 x No. of Supp. orders for product	ABR5 x No. of Supp. orders for product	ABR5 x No. of Supp. orders for product
	7.50 x 3000	7.50 x 4000	7.50 x 4200
TOTAL	22,500	30,000	31,500	(84,000)

· Statement of Profit / (Loss)

Using Activity Based Costing

	XYI - £	YZT - £	ABW - £
(1) Revenue	50000 x 45	40000 x 95	30000 x 73
	2,250,000	3,800,000	2,190,000	8,240,000
(2) Direct Cost	50000 x 32	40000 x 84	30000 x 65
	1,600,000	3,360,000	1,950,000	(6,910,000)
(3) Gross Profit (1) – (2)	650,000	440,000	240,000	1,330,000
Machinery	85,000	170,000	102,000	(357,000)
Assembly	210,000	72,000	36,000	(318,000)
Setups	6,000	10,000	10,000	(26,000)
Cust. Orders	39,000	39,000	78,000	(156,000)
Supp. Orders	22,500	30,000	31,500	(84,000)
(4) Total O/Hs	362,500	321,000	257,500	(941,000)
Net Profit (3) – (4)	287,500	119,000	(17,500)	389,000

1.3 Comment on the results

The two techniques of allocating the overheads cost produced different results even though both had the same overall profit ( Absorption being rounded at 389,015 and ABC 389,000). Absorption costing revealed that all of the products were generating profits, and contributing positively to the growth of the overall net profit. However, careful analysis of cost pools, using activity based costing, revealed different results. When each cost centre was allocated to the product appropriately, product ABW was actually operating at a loss of £17,500. Specifically, under the current profit margin, ABW is operating under the breakeven quantity for which either the volume or the price of the product needs to be increased (17500/30000) by £0.58/unit at this level (30,000 units). It also revealed that product XYI is making far more profit than estimated; therefore, focusing upon increasing the sale of this product could likely boost the company’s overall profitability.

This form of costing is critical to understanding the real performance of the products/departments, so management can pinpoint areas needing consideration. As ABC highlighted, one of the products was actually operating at a loss, and another was making more profit than anticipated. Such findings are critical to the allocation of resources on products that have higher contribution margins, and will maximize overall profitability.

2.0 Discussion of the statement

“It has been said that modern developments, such as ABC, are sometimes implemented because they are fashionable and not because they provide extra information to management.”

The primary purpose of clothing is to cover the body; fashion and style are choices we make. Some choices are due to an influence from our surroundings; some are necessary, others are not. For instance, although holding an umbrella seems natural when it is raining, it is also a choice to not let oneself be impacted by harsh environmental conditions.

Similarly, in cost accounting, we make choices based upon need. Every investor wants to know where his money is being invested, how much the return has galloped, and whether there is a potential for more. Although traditional absorption costing provides us an overall image of what is happening, paying attention to the details can help better understand what the cost centres are, and how the cost pools are being allocated to revenue generation activity.

Absorption costing allocates overheads to all the units produced equally, such that each unit produced gets its share of overheads absorbed. Based on absorption rate, all fixed and variable overheads are applied to each unit; therefore, the overall product cost includes both direct and indirect costs. This type of costing can be misleading, since a significant amount of cost is involved in the retained inventory. Moreover, since the cost is additionally determined through the allocation of fixed overheads, the information can lead management to rejecting an offer that should have been accepted to cover the fixed cost. Since the cost continuously changes depending upon the activity level, this kind of costing is especially confusing when production levels vary. Although quick, this method could be deceptive for outside parties. Nonetheless, the high costs of inventory balance can ratify the damages of a poor quarter (Cokins, 2001).

Activity based costing is based upon activities associated with manufacturing/producing and selling/delivering of any product or service. Some terms pertain specifically to activity based costing: cost objects, activities, cost pool, cost drivers, and cost hierarchies (Michael et al., 2012).

Cost objects are the entities that trigger the activities for which costs can be attributed, individually, in most cases, for instance, products, services, customers, etc.

Activities are the associated tasks or routines involved in supporting the manufacturing process. Supporting activities include such things as checking the machine before operation. Assembled output, in comparison, is a process activity.

Cost pools are somewhat similar to cost objects; however, they are typically groups of similar activities, regardless of the departments involved (Cokins, 2001). For instance, in any automobile manufacturing environment, the cost pool of painting the vehicles will include the inspection and the painting cost. To understand how much cost can be allocated to the particular activity (for instance, painting one type of car, as compared to another), this can be allocated to each segment of the product line.

In this case, since the amount of surface to be painted, and the amount of paint used, will vary based upon type of car, it casually drives the cost associated to the cost of the car. Therefore, painting a car is a cost object. Finally, these costs can be categorized based upon their necessity of use, the level of activity in which they are involved, or the costs versus effects relationship (Michael et al., 2012).

In reality, ABC application is subjective. It is about understanding the concept, as these essential terms need to be defined to make a sound judgement regarding the allocation of costs to each unit. This takes a significant amount of time, effort, and close collaboration within the departments. Likewise, the definition of cost drivers takes a closer look at how activities flow; not all of the activities are directly related to products, and not all of the activities can be directly attributable to cost objects. Likewise, the fixed overheads are allocated to the products, which can be misleading. The fixed costs do not typically change until a certain activity level is achieved. Ultimately, it may not be sufficiently beneficial to outweigh the investment in it. Moreover, resistance is likely from managers if consensus is not reached about defining cost centres. Whereas one product may be better off under absorption costing, activity based costing may limit the performance based bonus value.

In reality, for a company, where there are many different products, and activities are relatively straightforward, ABC is the way to go. It provides better understanding of cost structure, and assists in decisions pertaining to continuing or shutting down part of the business. Moreover, more information leads to better decisions for the company. For instance, a product having a lesser cost through ABC compared to absorption costing may be re-priced to attract more customers (Rajasekaran & Lalitha, 2011). Likewise, while developing new products, management will have a better understanding of the actual cost of a product, and whether it may be viably sold at a price that the market will be willing to pay (Cokins, 2001).

Determining costs through ABC involves more than just finding the cost. The study of process provides a better understanding of how activities are running, and if their efficiency is being compromised. Moreover, the assessment of costs involved allows management to determine the value chain of each activity, so activities that are not adding any value for the business can be eliminated (Heisinger, 2010). Once management has a comprehensive outlook of the processes involved, it will be easier to implement performance evaluation techniques and monitor continuous improvement (Cokins, 2001).

After weighing the advantages and disadvantages of activity based costing, the statement claiming that ABC is fashion oriented is only contextual in nature. If a small company with very few product lines and relatively simplified activities implements activity based costing, it will not make a notable difference to them. However, if a large company with various product lines across different brands are considering such a move, it will provide them better control over the operations involved, the result will be beneficial for the company, and will eventually help the consumer as well (Michael et al., 2012). Shifting the cost mechanism to ABC is much like an investment for the company; for it, they will get more precise knowledge of what is happening and how is it costing them. This information will allow them to better control the proceedings. However, although cost benefit analysis is essential, fashion is not for everyone. It is only for those who can afford it.

1.0 References:

Cokins, G. 2001. Activity-based cost management: An executive’s guide. NY: John Wiley & Sons.

Heisinger, K. 2010. Essential of managerial accounting. USA: South Western Congage Learning.

Maher, M., Stickney, C., & Weil, R. 2012. Managerial accounting: An introduction to concepts, methods and uses. 11th Ed. Canada: Nelson Publishing Ltd.

Rajasekaran, V. & Lalitha, R. 2011. Cost accounting. India: Pearson Education.

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