⏱️Managerial Accounting Unit 6 – Activity-Based and Absorption Costing Methods

Key Concepts and Definitions

• Managerial accounting involves providing financial information to managers for decision-making purposes
• Cost accounting is a subset of managerial accounting that focuses on measuring and analyzing costs
• Absorption costing, also known as full costing, assigns all manufacturing costs (direct materials, direct labor, and overhead) to products
  • Includes both variable and fixed manufacturing costs in the product cost
• Activity-based costing (ABC) assigns overhead costs to products based on the activities that drive those costs
  • Aims to more accurately allocate overhead costs to products or services
• Cost drivers are factors that cause changes in the costs of business activities (machine hours, labor hours, number of setups)
• Cost pools are groups of individual costs that are allocated to cost objects using a single cost driver
• Overhead allocation is the process of assigning indirect costs to products or services

Traditional Absorption Costing Explained

• Traditional absorption costing is a method of inventory costing that includes all manufacturing costs in the cost of a product
• Direct materials and direct labor costs are easily traced to specific products
• Manufacturing overhead costs are allocated to products using a predetermined overhead rate
  • The predetermined overhead rate is calculated by dividing estimated overhead costs by an allocation base (direct labor hours, machine hours)
• The overhead costs are applied to products based on the actual quantity of the allocation base used
• Absorption costing follows GAAP (Generally Accepted Accounting Principles) for external reporting
• Can lead to overproduction to absorb more fixed manufacturing overhead costs
• May not provide accurate product cost information for decision-making purposes

Activity-Based Costing (ABC) Breakdown

• ABC is a costing method that assigns overhead costs to products based on the activities that drive those costs
• Identifies activities that consume resources and assigns costs to those activities
• Cost pools are created for each activity, and overhead costs are allocated to products based on their consumption of these activities
• Cost drivers are used to measure the consumption of activities by products (number of setups, inspection hours, machine hours)
• ABC is more complex and costly to implement than traditional absorption costing
  • Requires a thorough analysis of activities and cost drivers
• Provides more accurate product cost information, especially when products consume overhead resources in different proportions
• Helps identify non-value-added activities and opportunities for cost reduction

Comparing ABC and Absorption Costing

• Absorption costing allocates overhead costs based on volume-related measures (direct labor hours, machine hours)
  • May not accurately reflect the true cost of products that consume overhead resources disproportionately
• ABC allocates overhead costs based on the activities that drive those costs
  • Provides a more accurate representation of product costs
• Absorption costing is simpler and less costly to implement than ABC
• ABC is more complex but provides better information for decision-making purposes
• Absorption costing is required for external financial reporting (GAAP), while ABC is used for internal decision-making
• ABC is particularly useful in companies with diverse products and high overhead costs

Cost Allocation Processes

• Cost allocation is the process of assigning indirect costs to cost objects (products, services, departments)
• In absorption costing, overhead costs are allocated using a predetermined overhead rate based on volume-related measures
  • The predetermined overhead rate is calculated by dividing estimated overhead costs by an estimated volume of the allocation base
• In ABC, overhead costs are allocated to activities using resource drivers, and then to products using activity drivers
  • Resource drivers measure the consumption of resources by activities (square footage, number of employees)
  • Activity drivers measure the consumption of activities by products (number of setups, inspection hours)
• Direct costs (direct materials and direct labor) are traced directly to products
• Indirect costs (manufacturing overhead) are allocated to products using the chosen costing method

Practical Applications in Business

• Managerial accountants use costing methods to provide information for decision-making purposes
  • Pricing decisions, product mix decisions, cost reduction initiatives
• Absorption costing is used for external financial reporting and inventory valuation
  • Required by GAAP for external stakeholders (investors, creditors)
• ABC is used for internal decision-making and cost management
  • Helps identify non-value-added activities and opportunities for process improvement
• Companies may use a combination of costing methods for different purposes
  • Absorption costing for external reporting and ABC for internal decision-making
• Accurate product cost information is crucial for making informed business decisions
  • Pricing, product mix, outsourcing, cost reduction

Advantages and Limitations

• Absorption costing advantages:
  • Simple and less costly to implement than ABC
  • Required for external financial reporting (GAAP)
  • Provides a consistent method for inventory valuation
• Absorption costing limitations:
  • May not accurately reflect the true cost of products with disproportionate overhead consumption
  • Can lead to overproduction to absorb fixed manufacturing overhead costs
• ABC advantages:
  • Provides more accurate product cost information, especially for diverse product mixes
  • Helps identify non-value-added activities and cost reduction opportunities
  • Supports better decision-making for pricing, product mix, and process improvement
• ABC limitations:
  • More complex and costly to implement than absorption costing
  • Requires extensive data collection and analysis
  • May not be suitable for companies with homogeneous products and low overhead costs

Calculation Examples and Practice

• Absorption costing predetermined overhead rate:
  • Estimated overhead costs ÷ Estimated allocation base (direct labor hours, machine hours)
  • Example: $500,000 estimated overhead costs ÷ 10,000 estimated machine hours =$50 per machine hour
• Applying overhead costs to products:
  • Predetermined overhead rate × Actual quantity of allocation base used
  • Example: $50 per machine hour × 100 machine hours used =$5,000 overhead applied
• ABC cost allocation:
  • Identify activities, cost pools, and cost drivers
  • Assign overhead costs to cost pools
  • Calculate activity rates: Cost pool ÷ Cost driver quantity
  • Assign activity costs to products based on their consumption of cost drivers
• Example:
  • Setup cost pool: $100,000, Cost driver: Number of setups (1,000)
  • Activity rate: $100,000 ÷ 1,000 setups =$100 per setup
  • Product A consumes 200 setups: 200 × $100 =$20,000 setup cost allocated