Activity Based Costing vs Traditional/Absorption Costing

This report compares Activity Based Costing and Traditional/Absorption Costing. It discusses the allocation of indirect costs and the impact on product cost. It also explores the advantages and disadvantages of Absorption Costing and its use for inventory valuation. Additionally, it highlights the benefits of Activity Based Costing for decision making and budgeting.

REPORT ON ACTIVITY BASED COSTING VS
TRADITIONAL/ABSORPTION COSTING

Answer 1,2,3& 4
Resource drivers consumed by activity centres
Cost categories (resource drivers) Wages
Building
costs Depreciation
Consuma
bles Energy Other
Activity centres
(employe
es) (m2)
(machine
hours) (orders)
(kilowatt
hours)
(employe
es)
New Product Development 115541 55610 0 559 2752 1027
Sales and distribution 404392 111220 0 1118 3302 3595
Inspecting 115541 111220 0 559 3302 1027
Mixing 1097635 222439 304000 12294 41276 9757
Filling 1097635 222439 385067 8941 63290 9757
Baking and Packing 866554 222439 70933 12294 41276 7703
Administration 404392 111220 0 1118 2752 3595
Corporate management 173311 83415 0 1118 1651 1541
Total quantity of resource drivers across all
activity centres 4275000 1140000 760000 38000 159600 38000
Activities and resource drivers used - Inspecting
Activity
Percentage of labour
time
Percentage of floor
space
Percentage of order
placed
Energ
y
Othe
r
Inspect Meat 34662 55609.8 0.0 1651 0
Disposal of Substandard Meat 11554 11122.0 167.6 330 308
Move to Mincing Room 11554 11122.0 0.0 330 0
Inspect Finished Product 34662 11122.0 0.0 330 0
Disposal of Substandard
Product 11554 11122.0 167.6 330 308
Reports to Health Dept. 11554 11122.0 223.5 330 411
Total 115541 111220 559 3302 1027

Activity
Activit
y cost Activity driver
Annual quantity of
activity driver
Cost per unit of
Activity Driver
Corporate
management
17331
1
Assigned directly to
products
Process receivables
19783
3 No. of invoices 3800 invoices 52.0613
Process payables
12740
9 No. of purchase orders 1900
purchase
orders 67.0574
Production planning
19783
3
No. of production
schedules 760
production
schedules 260.3066
Reports to Health
Dept
23640.
6 No. of reports 76 reports 311.0599
Process sales order
33443
8 No. of sales orders 3040 sales orders 110.0125
Dispatch sales order
18588
6 No. of dispatches 1900 dispatches 97.8347
New Product
Development
11554
1
Assigned directly to
new products lines
Inspect Meat
91923.
0 No. of batches 760 batches 120.9513
Disposal of
substandard Meat
23482.
0 No. of batches 760 batches 30.8973
Move to mincing
room
23006.
2 No. of batches 760 batches 30.2713
Set up mincer
12186
1 No. of batches 760 batches 160.3434
Weigh and sort
ingredients
12186
1 No. of batches 760 batches 160.3434
Load mincer
95623
4 No. of kilograms 152000 kilograms 6.2910
Operate mincer
23260
0 No. of batches 760 batches 306.0526
Unload and Clean
mincer
12186
1 No. of batches 760 batches 160.3434
Move to mixing room
13298
3 No. of batches 760 batches 174.9776
Set up scales 66492 No. of batches 760 batches 87.4895
Weight Ingredients
12186
1 No. of batches 760 batches 160.3434
Load Mixer
24372
2 No. of batches 760 batches 320.6868
Operate Mixer
11444
57 No. of kilograms 152000 kilograms 7.5293
Clean Mixer
13298
3 No. of batches 760 batches 174.9776
Move Mixer to
Smoke house 77613 No. of kilograms 152000 kilograms 0.5106
Pack into skins
27417
4 No. of products 608000 products 0.4509
Setup Smokehouse 98548 No. of trays 12160 trays 8.1043
Move to
Smokehouse 54385 No. of trays 12160 trays 4.4725
Smoke products
67285
1 No. of trays 12160 trays 55.3331
Unload Smokehouse 54835 No. of trays 12160 trays 4.5095
Inspect finished
products
46114.
3 No. of trays 12160 trays 3.7923
Disposal of
substandard product
23482.
0 No. of trays 12160 trays 1.9311
Move to truck 65957 No. of trays 11550 Finished 5.7106

Activity
Activit
y cost Activity driver
Annual quantity of
activity driver
Cost per unit of
Activity Driver
trays
Mettwurst
Activities consumed Annual quantity of activity driver
Corporate management 52379 Assigned directly to products
Process receivables 20824.5 invoices
Process payables 13411.5 purchase orders
Production planning 41649.1 production schedules
Reports to Health Dept 4977.0 reports
Process sales order 41804.8 sales orders
Dispatch sales order 29350.4 dispatches
New Product Development Assigned directly to new products lines
Inspect Meat 19352.2 batches
Disposal of substandard Meat 4943.6 batches
Move to mincing room 4843.4 batches
Set up mincer 25654.9 batches
Weigh and sort ingredients 25654.9 batches
Load mincer 191875.9 kilograms
Operate mincer 48968.4 batches
Unload and Clean mincer 25654.9 batches
Move to mixing room 27996.4 batches
Set up scales 13998.3 batches
Weight Ingredients 25654.9 batches
Load Mixer 51309.9 batches
Operate Mixer 229644.3 kilograms
Clean Mixer 27996.4 batches
Move Mixer to Smoke house 15573.7 kilograms
Pack into skins 54834.8 products
Setup Smokehouse 9887.2 trays
Move to Smokehouse 5456.4 trays
Smoke products 67506.4 trays
Unload Smokehouse 5501.5 trays
Inspect finished products 0.0 trays
Disposal of substandard product 0.0 trays
Move to truck 6966.9 Finished trays
Direct Materials 2
per kilogram
Assigned directly to products
Current Market Selling Price 9.0 per unit of product
Batch size 800
Annual Volume 122000
* All Calculations to 4 decimal places
Total Indirect cost 1093671.79
Per unit Cost 9.0

Csabai
Activities consumed
Annual quantity of activity
driver
Corporate management 6440 Assigned directly to products
Process receivables 5206 invoices
Process payables 6706 purchase orders
Production planning 10412 production schedules
Reports to Health Dept 1555 reports
Process sales order 12101 sales orders
Dispatch sales order 9783 dispatches
New Product Development 57911
Assigned directly to new
products lines
Inspect filling ingredients 6048 batches
Disposal of substandard filling 1545 batches
Move to mixing room 1514 batches
Set up mincer 8017 batches
Weigh and sort ingredients 8017 batches
Load mincer 47183 kilograms
Operate mincer 15303 batches
Unload and Clean mincer 8017 batches
Move to filling room 8749 batches
Set up pastry cases 4374 batches
Stack cases on filling machine 8017 batches
Load hopper 16034 batches
Fill pastry cases 56470 kilograms
Clean hopper 8749 batches
Move to baking 3830 kilograms
Stack cases on baking trays 6854 products
Setup ovens 2512 trays
Move to ovens 1386 trays
Bake products 17153 trays
Unload oven 1398 trays
Inspect finished products 1176 trays
Disposal of substandard
product 599 trays
Move to truck 1713 Finished trays
Direct Materials 2
per kilogram
Assigned directly to products
Current Market Selling Price 12 per unit of product
Batch size 300
Annual Volume 15000
* All Calculations to 4 decimal
places
Total Indirect cost 344773.0326
Per unit Cost 23.0

Indirect Cost under conventional System
Sl No Particulars Briefs
1 Total indirect cost 6410600
2 Estimated Annual Number of Units 225000
3 Cost per unit 28.49155556
4 Indirect cost allocated to Mettwurst 3475969.778
5 Indirect cost allocated to Csabai 427373.3333

Answer 5
On perusal of the above tables, there has been significant difference in
indirect cost allocation under the two methods.
Answer 6
It overstates the cost of both the products based on computation
presented above.
Answer 7
The changes that have occurred in cost majorly be due to the following:
(a) Wages on account of increased production, new employees would
have been recruited;
(b) Building Cost: Additional floor space must have been required to meet
with the increased demand and production capacity;
(c) Energy: Due to increased production increased electricity
consumption;
(d) Others: Must have increased;
(e) Direct cost.
Answer 8 & 9
Absorption Costing is a costing technique that is used for the valuation for
inventory. This technique includes all the cost of material and labour and
also consider the fixed and variable overhead inventory cost. This is also
known as full costing technique for computing the cost of product. The
components which are included in the absorption costing method are
direct material cost, direct labour cost, variable manufacturing overhead
and fixed manufacturing overhead of the product. Under this technique
the variable and fixed selling and administrative expenses are considered
to be the period cost and are included in the same period in which they
are incurred. (CFI Education Inc., 2019).This method is mainly used for the
purpose of external reporting and income tax filing purpose. For Example
if laptop company HP used full absorption costing method to value the
inventory of their HP, the stock valuation would consider the materials
used to manufacture the HP laptop, the wages which are paid to the
worker to manufacture the laptop, the manufacturing overhead as the
other fixed overhead which are to be included for the manufacture of
laptop. (MyAccountingCourse.com , 2019)
Few Advantages of Absorption Costing
1) Absorption Costing takes into account fixed overhead cost also in
the computation of product cost and form part of the unit cost of

production ,which shows the more realistic and accurate cost of the
product per unit.
2) This cost is the most suitable and accurate form of costing for the
preparation of accounts. This is generally accepted under the
principles of Generally Accepted Accounting Principles (GAAP).The
main advantage point in this under absorption costing is that the
stocks are not under valued under this particular costing system as
this the costing technique under which the stock amount also
include the fixed manufacturing overhead which are incurred during
the production process. ( Accounting For Management, 2019)
3) Under this costing technique it shows a decreased value of the cost
of sales and the increase revenue for the organization .As the
formula involved for the computation purpose is “Opening
Stock+Purchase-Closing Stock”, the stock which has been remained
at the end of the year generally has a higher value as generally
reported under the marginal costing system. ( Accounting For
Management, 2019)
4) For smaller companies it is very much beneficial .As it makes the
calculation very much easy for the small companies .It becomes
very easy for the small business to compute the value of product
easily by taking into account fixed overhead too as part of the
product value and sell their products in a more realistic price and
earn profit. ( Accounting For Management, 2019)
5) It is also very helpful for the business who have a stagnant demand
for the product throughout the year.
Few Dis advantages Of Absorption Costing
1) This costing technique cannot be used as an efficient tool to
compute the profitability of the company, because this costing
technique includes the fixed cost of the overhead irrespective of the
volume of production. ( Accounting For Management, 2019)
2) As this costing technique includes both fixed and overhead cost of
product, so the management of the company cannot consider this
technique for the purpose of decision making purpose or for
budgeting or forecasting purpose.
3) Absorption costing technique makes the outlook of the company
look more good as the fixed cost form part of the product cost so
this procedure can be easily used to manipulate the profit of the
company and increase the practice of ‘creative accounting’.
( Accounting For Management, 2019)

Activity based costing is a managerial based accounting that allocate all
the overhead cost incurred to the activities .In a simple definition it is a
way to allocate all the indirect cost to the products .
( MyAccountingCourse.com, 2019)
Few Advantages of Activity Based Costing (ABC)
The advantages of ABC are discussed here in below:
1) Accurate Product Cost: This ABC costing provides more accurate
and reliable method to determine the product cost .In the
manufacturing process where overhead constitute a large portion of
the total product cost, than this technique provides a more realistic
and more accurate product cost. In this costing technique the
product cost arrived at is more reliable and efficient as compare to
the traditional costing approach which brings more error in the
computation of the product cost per unit. (Agarwal, 2018)
2) Information about Cost Behaviour: ABC identifies the real
nature of the cost and particularly identify the cost which is not
adding any value to the product. Through this technique manager
will control the excess cost involved in any product. (Agarwal, 2018)
3) Tracing of Overhead Cost: ABC discover cost were it is assigned
in the areas of managerial responsibility, processes, customers and
various departments involved. (Agarwal, 2018)
4) Better decision making: Through this costing technique the
mangers can make more reliable and accurate decision. It is also
helpful in fixing the cost of the product more accurately and
properly as more proper and correct data is readily available.
5) Cost Management: Through the absorption costing technique cost
driver rates can be easily accessible which is very much useful for
the management for designing a new product or the existing
product. (Agarwal, 2018)
6) Benefits to Service industry: Many service organizations like
banking sector, hospital sector, government department sector
have totally different characteristics as compared to manufacturing
firm of the organization. In the service organization no, direct cost is
involved. All the cost which is incurred is generally indirect in nature
and the costs are overhead cost and any stock of service is also not
kept, as it is consumed immediately. This traditional costing
approach iOS considered to be inappropriate for these types of
organizations whereas the ABC costing approach offers varied types
of benefits and helpful for the management in the decision-making
purpose.

Few Dis advantages Of Activity Based Costing
1) Expensive and Complex type of Costing Approach: This
costing technique has many cost pools and multiple cost driver and
is also more complex type of costing compared to other type of
costing. (Agarwal, 2018)
2) Drivers Selection: Sometimes difficulties also arise in the selection
of cost drivers, common cost assignment.
3) Disadvantage to smaller firms: ABC has a level of difficulty as
the larger manufacturing firm can use it more usefully compared to
the smaller firm. Activity Based Costing also has different level of
benefits for the different types of organizations such as benefit of
ABC is more useful for the larger organizations as compared to the
smaller firm .The smaller firm cannot go ABC approach as it is very
much complex process to get into and the cost involved is also very
huge ,making it costly for the smaller firm to sustain with ABC
costing approach. While the bigger manufacturing companies can
easily opt for it due to involvement of large manufacturing overhead
cost and large scale of operations which make it easier for the them
to use and allocate the indirect cost on the basis of various cost
driver.
4) Difficulties in Measurement: The main issue in the ABC system
are the necessary measurement which is useful in order to
implement it. (Agarwal, 2018).ABC costing system is very costly as
the management of the company need to determine a particular
cost of goods and services by going through many complicated
calculations .It is also very costly because the drivers cost need to
be updated regularly on a permanent basis.
References
Accounting For Management, 2019. Advantages and disadvantages of absorption costing. [Online]
Available at: https://www.accountingformanagement.org/advantages-and-disadvantages-of-absorpt
[Accessed 19 May 2019].
MyAccountingCourse.com, 2019. What is Activity Based Costing (ABC)?. [Online]
Available at: https://www.myaccountingcourse.com/accounting-dictionary/activity-based-costing
[Accessed 19 May 2019].
Agarwal, R., 2018. Advantages and Demerits of Activity Based Costing (ABC). [Online]
Available at: http://www.yourarticlelibrary.com/accounting/costing/advantages-and-demerits-of-
activity-based-co
[Accessed 19 May 2019].

CFI Education Inc., 2019. Absorption Costing. [Online]
Available at: https://corporatefinanceinstitute.com/resources/knowledge/accounting/absorption-
costing-guide/
[Accessed 18 May 2019].
MyAccountingCourse.com , 2019. What is Absorption Costing?. [Online]
Available at: https://www.myaccountingcourse.com/accounting-dictionary/absorption-costing
[Accessed 19 May 2019].