Question

What costs are affected by an Activity Based Costing system? By a Traditional Absorption Costing system?

Answer 1

Absorption costing and activity-based costing differ in approach. Absorption costing assigns costs to individual units, whereas activity-based costing focuses on company activities as a central cost and then attempts to assign indirect costs to units.

One major advantage of activity-based costing is that it allows companies to understand the true cost and profitability of individual units produced or services rendered.

This increased accuracy is achieved by essentially converting indirect costs to direct costs. In fact, activity-based costing can be applied to all business costs, not just production-related overhead.

For instance, a company can assign its marketing costs directly to the individual units it produces. Because of this, activity-based costing can paint a more precise picture than absorption costing.

On the other hand, activity-based costing can be an expensive system to implement, and it may not be as useful to companies whose overhead costs are primarily volume-related, or to companies whose overhead represents a small proportion of their overall costs.

Absorption costing, meanwhile, is easier to implement yet recognized as perfectly compliant with generally accepted accounting principles and IRS reporting requirements. The downside, however, is that it may offer less insight to those charged with making strategic decisions regarding production practices and costs.

Activity-based costing is the most accurate, but it is also the most difficult and costly to implement. It is more suited to businesses with high overhead costs that manufacture products, rather than companies that offer services. Companies that manufacture a large number of different products prefer an activity-based system because it gives more accurate costs of each product. With activity-based allocation of overhead costs, it is easier to identify areas where expenses are being wasted on unprofitable products.

Deciding between traditional or activity-based costing is not easy. Your choice should depend on the purpose of the reporting and who will see the information. Managers need accurate product costs and prefer to use an activity-based accounting system. Even though this system is more costly, it provides better information that will enable managers to make more profitable decisions in the long-term.

For external reporting, companies still use the traditional costing system, but it is becoming obsolete as outsiders demand more accurate information about businesses.