Accounting and Finance: Traditional Costing vs Absorption Costing vs Activity Based Costing

This report compares traditional costing, absorption costing and activity based costing in accounting and finance. It explains their limitations and decision making capabilities. It provides examples and calculations. The report is useful for students studying accounting and finance in any college or university.

Running head: ACCOUNTING AND FINANCE
Accounting and finance
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Table of Contents
Introduction................................................................................................................................2
Traditional method of costing....................................................................................................2
Absorption costing.....................................................................................................................2
Example..................................................................................................................................3
Limitation of absorption costing............................................................................................4
Decision making.....................................................................................................................5
Activity based costing (ABC)....................................................................................................5
Example..................................................................................................................................5
Limitations.............................................................................................................................7
Decision making.....................................................................................................................7
Conclusion..................................................................................................................................8
Reference....................................................................................................................................9

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Introduction
The main objective of the report is to suggest other cost models as against the
traditional costing methods as the traditional method uses the labour hour rate or machine
hour rate for allocating the overheads. Therefore, the traditional costing method is regarded
as outdated systems and is receiving various criticisms in recent times. The report will focus
on other cost allocation system that is more systematic and use systematic approach to
allocate the costs. Other costing systems that can be used against the traditional method of
costing are absorption costing and activity based costing to calculate cost of individual
product, activity or service (Ruiz-de-Arbulo-Lopez, Fortuny-Santos and Cuatrecasas-Arbós
2013. Pp. 647-668).
Traditional method of costing
Under the traditional costing method, the manufacturing overheads are allocated on
the basis of cost driver volume that is requirement of direct labour hours for producing the
product. Cost diver is the factor that causes incurring of the costs like direct material, direct
labour and machine hours. However the traditional accounting fails to assign the non-
manufacturing costs associated with the product like the administrative costs (Subramaniam
and Watson 2016. Pp. 275-305). Traditional costing method is outdated systems and
receiving various criticisms in recent times. The reason behind this is that this system does
not assign the cost appropriately as direct labour hour is not the best and most appropriate
method. Further, it does not take into consideration other cost drivers associated with the
product. Therefore, it can lead to inefficient management decision as it fails to take into
consideration various non-manufacturing costs.
Absorption costing
The absorption costing or full product costing is the method of calculating the cost of
a product or service by taking into consideration all the indirect expenses and direct expenses.
It considers all the costs incurred by business for manufacturing the product (Fullerton,
Kennedy and Widener 2013. Pp 50-71). The accountant gathers all the costs like overhead,

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labour and materials costs throughout the company. Under absorption costing the overhead
must be allocated to each product that is being manufactured (Salah and Zaki 2013).
Example
XYZ Plc manufactures product “P”. Following are other information associated with
the production of “P” –
Selling price - £ 50.00 per unit
Direct materials - £ 8.00 per unit
Direct labour - £ 5.00 per unit
Variable production overheads - £ 3.00 per unit
Production for the month of January – 500 units
Sales for the month of January – 300 units
Fixed production overheads - £ 4,000 per month and absorbed on the basis of units. Normal
production level is 400 units
Other costs are as follows –
Fixed selling cost - £ 4,000 per month
Fixed administrative cost - £ 2,000 per month
Variable sales commission - 5% of revenue from sales
No opening inventory was there. (Hoare 2018).
Solution –
Computation of full production cost
Direct material £ 8.00
Direct labour £ 5.00
Variable manufacturing overhead £ 3.00
Fixed manufacturing overhead (£ 4000 / 400 units) £ 10.00
Full production cost £ 26.00

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Computation of production and inventory value
Opening inventory Production Closing inventory
Nil 500 units * £ 26 = £ 13,000 200 units * £ 26 = £ 5,200
Over / under absorption of cost
Actual fixed manufacturing overhead £ 4,000
Fixed manufacturing overhead absorbed (500 units * £ 10) £ 5,000
Over absorption £ 1,000
Computation of profit
Sales (300 units *£ 50) £ 15,000
Less: cost of sales
Opening inventory Nil
Production £ 13,000
Closing inventory £ (5200) £ 7,800
Over absorption of fixed manufacturing overhead £ 1,000
Gross profit £ 8,200
Less: Expenses
Variable sales commission £ 750
Fixed administration expenses £ 2,000
Fixed selling expenses £ 4000 £ 6,750
Net profit £ 1,450
Therefore, it can be observed from the above example that the product manufacturing
costs were fully absorbed by the produced units. It includes both the fixed variable costs and
variable overhead costs. It is the accurate way for accounting the true cost of production.
Limitation of absorption costing
 Apportionment of the overhead cost – the validity for determining the absorption
costing is depended upon appropriateness of the allocation of overheads in correct
manner. However, some overhead costs are allocated on arbitrary method. Therefore,

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the resulting costs are doubtful that can lead to unreliable and inaccurate product cost
(Ahmed and Duellman 2013. Pp. 1-30)
 Fixed costs are periodic – as per the views of many accountants, the fixed
administration, selling and manufacturing costs are periodic that is not beneficial for
the future and hence, shall not be included in the inventory and product cost
(Parthiban, Zubar and Katakar 2013. Pp. 1535-1548)
Decision making
Absorption costing is not useful for decision making purpose of the management.
Various problems related to this are selection of the production volume, utilization of
optimum capacity, selection of the product mix, performance evaluation and choice of
various alternatives that can only be solved with the assistance of variable cost analysis
(Estampe et al. 2013. Pp. 247-258). Further, it leads to mispricing of product if product mixes
are not selected properly.
Activity based costing (ABC)
ABC costing technique identifies all the activities required for manufacturing the
product and then allocates the indirect costs to the product. It further recognizes the
relationship among products, costs and activities and based on that allocates indirect costs
systematically and less arbitrarily as compared to absorption costing and traditional costing
(Monroy, Nasiri and Peláez 2014. Pp 11-17).
Example
XYZ Plc manufactures product “P”. Following are other information associated with
the production of “P” –
Administration and selling overhead £ 300,000
Manufacturing overhead £ 500,000
Total overhead expenses £ 800,000
Activity cost pool Activity cost drivers
Processing orders No. of orders
Assembling units No. of units
Customer supports No. of customers

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Allocation of overhead expenses (Accounting for Overheads - Activity Based Costing
(ABC), 2016)
Assembling Order
processing
Customers
supporting
Total
Manufacturing 50% 35% 15% 100%
Administration and selling 30% 45% 25% 100%
Total activity 1000 units 250 orders 100 customers
Solution –
Cost allocation –
Assembling Order
processing
Customers
supporting
Total
Manufacturing £ 250,000 £ 175,000 £ 75,000 £ 500,000
Administration and selling £ 90,000 £ 135,000 £ 75,000 £ 300,000
Total activity £ 340,000 £ 310,000 £ 150,000 £ 800,000
Activity rate for activity driver –
Cost drivers Total cost Total activity Activity rate
Assembling £ 340,000 1000 units £ 340 per unit
Order processing £ 310,000 250 orders £ 1,240 per unit
Customer supporting £ 150,000 100 customers £ 1,500 per customer
Computation of profit
Sales (100 units * £ 1000) £ 100,000
Less: costs
Direct material (£ 100 * 100 units) £ 10,000
Direct labour (£ 20 per hour * 4 hr * 100 units) £ 8,000
Assembling cost (£ 340 * 100 units) £ 34,000
Order processing (£ 1240 * 10) £ 12,400

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Customer supporting (£ 1500 * 10) £ 15,000
Total cost £ 79,400
Total profit (Sales – Total cost) £ 20,600
Profit per unit £ 20.60
It has been observed from the above example that the overheads have been allocated
based on the cost drivers like assembling, customer supporting and order processing.
Therefore, it is focussed on nature of the cost behaviour and it attempts providing meaningful
costs for the product.
Limitations
 It is a costly method to implement
 Adaptability of this system is not appropriate for all organizations as small companies
have too many activities with very less transactions (Monroy, Nasiri and Peláez 2014.
Pp. 11-17).
 It does not comply with the GAAP and the management has to prepare the reports
through using the traditional as well as AVC both systems for external and internal
purpose (Öker and Adıgüzel 2016. Pp. 39-56).
 Data produced from this system can easily be misinterpreted that can lead to
mispricing of product (Monroy, Nasiri and Peláez 2014. Pp. 11-17)
Decision making
ABC system can be used by the management as decision making tool as it delivers
structured data for financial support that is different from the accounting data delivered by the
general ledger (Govindan, Khodaverdi and Jafarian 2013. Pp. 345-354) Further, through
association of costs to activities the clear relationship can be formed among the activity cost
driver to related activity. Further, it is beneficial for the management to determine where the
costs are incurred and where it can be minimized with appropriate efforts (Estampe, Lamouri,
Paris and Brahim-Djelloul 2013. Pp. 247-248).

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Conclusion
It is concluded from the above discussion that the absorption costing are used for
reporting the product costs under the financial records. The product costs are recorded under
closing balance of inventory in balance sheet and are COGS in income statement. The
creditors, government agencies and investors use financial statement of the company for
taking various decisions. Further, the investors take decisions for purchasing the stocks from
the company and the creditors take decisions for extending the credit to the company.
Further, the government agencies take decision for analysing whether the company comply
the government programs. On the other hand, the ABC costing takes into consideration the
associated costs with different activities. It is used for analysing the internal process costs that
are involved with the production process. These 2 methods differ with respect to the cost data
and the application of cost. While the absorption costing is focussed on the requirement of the
outside users of financial statement, the ABC costing is focussed on the inside users of the
financial statement. Further, the absorption costing bases all the manufacturing costs for
production and ABC costing takes into consideration the cost associated with the product
process.

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Reference
Accounting for Overheads - Activity Based Costing (ABC). (2016). [ebook] Cenit Online,
pp.5-6. Available at: http://studyonline.ie/wp-content/uploads/2016/08/ABC.pdf [Accessed
23 Feb. 2018].
Ahmed, A.S. and Duellman, S., 2013. Managerial overconfidence and accounting
conservatism. Journal of Accounting Research, 51(1), pp.1-30.
Estampe, D., Lamouri, S., Paris, J.L. and Brahim-Djelloul, S., 2013. A framework for
analysing supply chain performance evaluation models. International Journal of Production
Economics, 142(2), pp.247-258.
Fullerton, R.R., Kennedy, F.A. and Widener, S.K., 2013. Management accounting and
control practices in a lean manufacturing environment. Accounting, Organizations and
Society, 38(1), pp.50-71.
Govindan, K., Khodaverdi, R. and Jafarian, A., 2013. A fuzzy multi criteria approach for
measuring sustainability performance of a supplier based on triple bottom line
approach. Journal of Cleaner Production, 47, pp.345-354.
Hoare, R. (2018). Absorption Costing V’s Marginal Costing. [ebook] Certified Public
Accountants, pp.1-2. Available at: http://www.cpaireland.ie/docs/default-source/Students/F2-
Mgmt-Accounting/absorption-costing-v-marginal-costing.pdf?sfvrsn=0 [Accessed 23 Feb.
2018].
Monroy, C.R., Nasiri, A. and Peláez, M.Á., 2014. Activity Based Costing, Time-Driven
Activity Based Costing and Lean Accounting: Differences among three accounting systems’

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approach to manufacturing. In Annals of Industrial Engineering 2012 (pp. 11-17). Springer,
London.
Öker, F. and Adıgüzel, H., 2016. Time‐driven activity‐based costing: An implementation in a
manufacturing company. Journal of Corporate Accounting & Finance, 27(3), pp.39-56.
Parthiban, P., Zubar, H.A. and Katakar, P., 2013. Vendor selection problem: a multi-criteria
approach based on strategic decisions. International Journal of Production Research, 51(5),
pp.1535-1548.
Ruiz-de-Arbulo-Lopez, P., Fortuny-Santos, J. and Cuatrecasas-Arbós, L., 2013. Lean
manufacturing: costing the value stream. Industrial Management & Data Systems, 113(5),
pp.647-668.
Salah, W. and Zaki, H., 2013. Product Costing in Lean Manufacturing
Organization. Research Journal of Finance and Accounting, 4(6), pp.86-98.
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costs. In Advances in Management Accounting (pp. 275-305). Emerald Group Publishing
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