Analyzing costs can help companies make strategic, financially sound decisions.
Activity-based costing and absorption costing are two popular accounting methods that companies employ when evaluating business activities.
What is activity-based costing?
Activity-based costing, also known as ABC, is an accounting method that identifies a company's activities and assigns costs to units produced by the company 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 company and then assigns a proportionate cost to every individual unit produced based on its consumption of those activities.
Let's say a company spends $20,000 per year on equipment setup. Under activity-based costing, it would then attempt to assign a proportion of that $20,000 to each unit it produces.
However, doing so is not just a simple matter of taking that $20,000 and dividing it by the number of units produced. Instead, the company would need to figure out which units or products utilize 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.
Furthermore, some indirect costs can be difficult to assign 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 can be tricky to assign that $100,000, or portions thereof, to individual products or units.
What is absorption costing?
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 absorption costing, the cost of an individual unit produced will include direct materials, labor, and both fixed and variable manufacturing overhead costs. These costs are not recognized as expenses in the month a company pays for 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 a company's cost of goods sold. Absorption costing is typically required for financial and income tax reporting purposes.
Let's say a company manufactures 10,000 units of a particular product with a cost per unit 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 absorption costing, the cost per unit can be calculated as follows: $10 (direct materials) + $8 (direct labor) + $2 (variable manufacturing costs) + $4 ($40,000 per year in fixed manufacturing overhead costs divided by 10,000 units) = $24 per unit.
Activity-based costing vs. absorption costing: What are differences in approach?
Absorption costing and activity-based costing differ in approach. Absorption costing assigns costs to individual units, whereas activity-based costing focuses on company activities as a central cost and then attempts to assign indirect costs to units.
One major advantage of activity-based costing is that it allows companies to understand the true cost and profitability of individual units produced or services rendered.
This increased accuracy is achieved by essentially converting indirect costs to direct costs. In fact, activity-based costing can be applied to all business costs, not just production-related overhead.
For instance, a company can assign its marketing costs directly to the individual units it produces. Because of this, activity-based costing can paint a more precise picture than absorption costing.
On the other hand, activity-based costing can be an expensive system to implement, and it may not be as useful to companies whose overhead costs are primarily volume-related, or to companies whose overhead represents a small proportion of their overall costs.
Absorption costing, meanwhile, is easier to implement yet recognized as perfectly compliant with generally accepted accounting principles and IRS reporting requirements. The downside, however, is that it may offer less insight to those charged with making strategic decisions regarding production practices and costs.