Question

Comparison of absortion costing and activity based costing systems Through an optimization problem.

Answer 1

The answer to the following question with an example:

Absorption Costing

1.Absorption Costing allocates all the costs to the individual production units .

2.It incurs cost in the form of material ,labor and overheads to produce units.

3.The unit cost is arrived at by dividing the number of units to the unit cost of production.

4.It takes into account all the costs involved like the variable and the fixed cost also.

Consider the following example of a Company XYZ

Direct Material Cost per unit $10

Direct Labour Cost per unit $30

Variable Overhead cost per unit $50

Total Variable Cost per unit $90

Fixed Overhead $100000

Units of Production 10000

Fixed OH per unit $10

Total Cost Per Unit $100

This is a straight forward method and there are concerns about whether this method can give accurate results.

The drawbacks of traditional or the absorption costing is that how can it handle the allocation of the fixed overheads Since the overhead costs are not directly traceable to production as there can be increase and decrease of production levels.So there is concern about the fixed overheads which can allocated based on the labour or the machine hrs as there can be under or overabsorption of overheads

Activity Based Costing.

It is costing method which can overcome the problems of the traditional costing and there can be bases based on which the overhead costs can be allocated to different activities in the production process.which are called the drivers.Following are the steps

Step a. To determine the activities which are identified as key

Step b To determine the driver for each key activity

Step c To calculate the cost of every key activities

Step d To Calculate the allocation rate for each activity by dividing the activity cost by the allocation proprtions.

Step e To allocate the cost to the cost via this allocation proportions.

Example X is a manufacuturer and incurs the following activties and costs

Activity                   $               Cost Driver                     $                          Cost per Cost Driver

Assembly        76000          Number of labour

                                                  hrs                               15750                     4.8 /labor hrs

Cutting and

Sewing             85000         No of Machine

                                                hrs                                  18630                   4.56/machine hrs

Finishing         11600          No of Units                      6500                     1.78 /unit

It receives an order to produce and ship 1500 units .The overhead cost for this order is calculated as below:

Activity              Activity usuage               Cost per Cost Driver                         Total Overhead Cost

Assembly        2250                                   4.8 /labour hr                                    10800

Cutting and

Sewing            3084                                    4.6 /machine hr                               14186

Finishing         1500                                   1.8 /unit                                               2700

                                                                                                                                 27686

using the multiple allocation rates makes more accuracy in the calculation and it results in better cost control and decision making.Suppose if the shipping costs are allocated on the basis of number of labor units it will not be justifiable since it is not labor intensive and shipping charges can be allocated on the number of units shipped.