3 Absorption costing and ABC Flashcards
Absorption costing
Assigns direct costs, and all or part of overhead to cost units using one or more overhead absorption rates
absorption costing was useful in „old” manufacturing, where O/H were small (direct materials and labour dominated) and production portfolio was narrow (few products). Precise O/H allocation was not so significant.
Steps in absorption costing
allocation. Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre.
overhead apportionment. This involves apportioning general overheads to cost centres and then reapportioning the costs of service cost centres to production departments
overhead absorption. An absorption rate is calculated for each production department.
level of activity
amount of work done or number of events that have occured etc.
cost behaviour vs level of activity
fixed, stepped fixed, semivariable (note that fixed/variable elements don’t have to start from 0), variable
Relevant range
Range within which cost behaviour predictions can be used.
Predictions of costs for activity levels which are outside the relevant range are unreliable.
High-low method
(a) Records of costs in previous periods are reviewed and the two periods with the highest and lowest volumes of activity selected
(b) The difference between the total cost of these two periods will be the variable cost of the difference in activity levels (since the same fixed cost is included in each total cost).
(c) The variable cost per unit may be calculated from this (difference in total costs ÷ difference in activity levels), and the fixed cost may then be determined by substitution.
Scattergraph method
A line of best fit, which is a line drawn by judgement to pass through the middle of the points, thereby having as many points above the line as below it, can then be drawn and the fixed and variable costs determined.
principles of absorption costing
(a) Fixed production costs are an integral part of the production cost of an item and so should be absorbed into product costs.
(b) Inventories are valued at their full production cost including absorbed fixed production costs.
Remember that total cost = production costs (direct and indirect costs) + non-production costs (for example, selling and distribution costs). When we use absorption costing to determine the cost per unit, we focus on the production costs only.
Activity Based Costing rationale
The rise of AMT with higher share of O/H in total costs, longer processes and wider scope of products in one factory brought need for more precise O/H allocation. Labour or materials may have a small share in total costs, so they cannot be used as reliable basis for absorption anymore. A lot of big O/H are not directly linked to production (scheduling, set-up, maintenance) and they vary in the long run based on complexity, not level of activity. As a result, in traditional absorption, too much cost is absorbed into high-volume products (lots of direct hours but little diversity = longer runs, fewer supporting activities) and too little absorbed into low volume products (less direct hours but lots of supporting activities = more set-ups etc.) ABC aims to overcome this.
ABC should be introduced when there is benefit to the organisation (better costing, pricing, increased profitability) and results from traditional absorption costing differ significantly. Most likely when:
- large share of production O/H,
- O/H consumption not driven by level of activity,
- variety in product range,
- O/H consumption differs significantly among products.
ABC definition
approach to costing. Tracing resource consumption and costing final outputs. Resources attached to activities, activities to cost objects, cost objects to outputs via cost drivers.
- Activities cause costs (ordering, materials handling, machining, assembly, scheduling, despatching)
- Producing products creates demand for activities,
- Costs are assigned to products based on their consumption of activities.
Operating ABC
- Identify organisation’s main activities,
- Identify activities’ cost drivers,
- Collect the costs associated with cost drivers into cost pools,
- Charge the costs in cost pool to products based on their usage of activity using a cost driver rate.
Allocation: separate cost pools instead of allocation to production departments. ABC avoids re-apportionment of service department costs (every O/H gets its own driver).
Absorption: many cost drivers allow for more precise absorption into particular products.
Cost driver
factor influencing the level of cost. Three types:
* Transaction drivers - cost affected by number of times an activity is undertaken: logistical, balancing, quality, change transactions,
* Duration drivers - cost affected by length of time it takes to perform the activity,
* Intensity (direct charging) - specific cases where cost is charged directly to product.
For costs that vary with level of activity in the short term, ABC uses volume-related cost drivers (labour or machine hours, like in absorption).
Cost pool
grouping of costs relating to particular activity.
Cost driver rate
= total costs in cost pool / number of units of cost driver
ABC vs absorption costing
ABC establishes separate cost pools for support activities such as despatching. As the costs of these activities are assigned directly to products through cost driver rates, reapportionment of service department costs is avoided.
The principal difference between the two systems is the way in which overheads are absorbed into products.
(a) Absorption costing most commonly uses two absorption bases (labour hours and/or machine hours) to charge overheads to products.
(b) ABC uses many cost drivers as absorption bases (number of orders, number of despatches and so on).
Absorption rates under ABC should therefore be more closely linked to the causes of overhead costs.
