Financial Management Report on Costing Methods: Adiva Beauty

This financial management report provides a comprehensive overview of two key costing methods: absorption costing and activity-based costing. The report begins with an introduction to the importance of costing in determining product prices and achieving profitability. It then delves into a literature review, detailing the principles, advantages, and disadvantages of both absorption costing, also known as full costing, and activity-based costing (ABC). The report highlights that absorption costing allocates costs, including fixed costs, to products, while ABC assigns indirect costs based on activities and cost drivers. A case study of Adiva Halal Beauty is used to interpret computations and demonstrate the practical application of both methods. The analysis reveals that ABC often provides a more accurate allocation of overhead costs compared to traditional absorption costing. The conclusion summarizes the benefits of ABC, such as improved managerial decision-making and better pricing strategies, while acknowledging the complexity and cost associated with its implementation. The report references several key financial accounting and management texts to support its findings.

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TABLE OF CONTENTS
1. Introduction.........................................................................................................................1
2. Literature Review...............................................................................................................1
2.1 Absorption Costing...........................................................................................................1
2.2 Activity Based Costing.....................................................................................................2
3. Interpretation of Computation............................................................................................3
4. Conclusion..........................................................................................................................3
5. References...........................................................................................................................4

1. Introduction
The objective of various firms is to make profit which is essentially fulfilled by selling goods
or services at a price higher than the underlying cost. As a result, the price is typically
determined taking into consideration the input costs. The process of accumulating the various
costs to determine the unit costs is known as costing. There are two main approaches to
costing namely the traditional approach (where absorption costing is used) and activity based
costing approach. The objective of this report is to conduct a literature review on these two
techniques and demonstrate the working using Adiva Halal Beauty case.
2. Literature Review
2.1 Absorption Costing
Absorption costing is a costing method whereby production process related costs are
accumulated and apportioned into individual products. This costing method is also known as
full costing since with regards to a finished inventory unit, this considers all costs such as
direct material, direct labour along with manufacturing overhead (both fixed and variable)
(Heisinger, 2009).
One of the key advantages of absorption costing is that all the costs including fixed costs are
taken into consideration. Also, since both fixed and variable costs are taken into
consideration, hence there is no need to divide costs into fixed and variable which can
sometimes be difficult. Considering allocation of costs across departments, this helps in
fixing accountability on the requisite line managers. Another advantage is that this system is
compatible with accrual and matching concepts (Drury, 2016).
A key disadvantage of absorption costing is that cost control and comparison would be
difficult. This is primarily because the cost would be dependent on the number of units since
fixed cost is also considered. Another drawback of absorption costing is the limited use in
managerial decision making particularly related to buying or outsourcing (Petty et. al., 2015).
Considering that a portion of fixed cost is forwarded to the future through inventory, hence it
potentially misrepresents the current period financial statements. The biggest criticism with

the usage of absorption costing is the incorrect allocation of overhead costs based on a single
overhead rate (Weyganth, Kimmel and Kieso, 2014).
2.2 Activity Based Costing
In this costing method, the indirect costs or overhead costs are assigned to different products
based on the underlying activities involved in the manufacturing process and the incidence of
these identified activities (called as cost drivers) in the manufacturing of different products.
As a result, cost drivers need to be identified for various activities involved in the
manufacturing overhead (Northington, 2011).
One of the main advantages of activity based costing is that the overhead cost allocation is
highly accurate which leads to better costing of the different products. As a result, the
managerial decision making is improved since the cost over-allocation and under-allocation
is prevented. As the product costing is improved, hence there is a drastic improvement in the
pricing decisions along with decisions related to outsourcing of manufacturing of particular
products. It is also helpful in identifying wasteful activities and hence can enhance the overall
efficiency of manufacturing (Emmauel and Otley, 2010).
A key disadvantage of activity based costing is that it could be quite expensive and complex
to perform. This is because, this method requires breaking down the manufacturing overhead
process into smaller activities, identify the respective cost drivers for each activity and
determining the activity level for the different products (Parrino and Kidwell, 2011). Another
disadvantage is that even after producing the results, there could be misinterpretation and
wrong decisions taken. In order to avoid the same, specialised training needs to be extended
to the various managers who use the outcome from ABC system (Kinney and Rainborn ,
2012).
3. Interpretation of Computation
For Adiva Halal Beauty, it is apparent that the overhead costs in case of absorption costing
have been computed on the basis of direct labour costs. On the contrary, in the activity based

costing, the overhead costs are based on the respective activity drivers that have been
identified for the different products. This is also apparent from the Adiva Halal Beauty case
where the cost drivers for various activities (such as material purchase, machine setup,
packaging & testing) have been computed and used for overheads cost allocation. The results
clearly highlight that the traditional costing does not lead to proper allocation of overhead
costs to different products and hence ABC is preferable over absorption costing.
4. Conclusion
Based on the above literature review, it is apparent that activity based costing is superior to
the traditional costing (absorption costing) primarily due to accurate allocation of costs across
products. This has been highlighted in the Adiya Halal Beauty case. However, activity based
costing is complex, expensive and time consuming due to which smaller firms may prefer to
continue with traditional costing methods. But going forward, as the competition further
stiffens, activity based costing would emerge as a key competitive advantage tool.

5. References
Drury, C. (2016) Cost and Management Accounting: An Introduction. 6th ed. New York:
Cengage Learning.
Emmauel, R.C. and Otley, T.D. (2010) Accounting for Management Control. 8th ed. London:
Cengage Learning.
Heisinger, K. (2009) Essentials of Managerial Accounting. 4th ed. London: Cengage
Learning.
Kinney, R. M. and Rainborn , A. C. (2012) Cost Accounting: Foundations and Evolutions.
9th ed. New York: Cengage Learning.
Northington, S. (2011) Finance, 4th ed. New York: Ferguson
Parrino, R. and Kidwell, D. (2011) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications
Petty, JW, Titman, S, Keown, AJ, Martin, P, Martin JD and Burrow, M. (2015), Financial
Management: Principles and Applications, 6th ed. Sydney: Pearson Australia,
Weyganth, J.J., Kimmel, D. P. and Kieso, E. D. (2014) Managerial Accounting: Tools for
Business Decision Making. 5th ed. Sydney: John Wiley & Sons.