Management Accounting Activity Based Costing vs Absorption Costing Table of Contents Budgeted Profit Statements 1 1.1 Absorption Costing 1 1.2 Activity Based Costing 3 1.3 Comments on the results 5 2.0 Discussion of the statement 6 References 9 0 2 1.0 Budgeted Profit Statements 1.1 Absorption Costing Traditional absorption costing involves the calculation of product cost, using direct and indirect variable costs and fixed and variable overheads, which are substituted over the complete production. Overhead cost substitution is based upon the process activity that drives the cost. Machine hours and assembly hours are two example activities that influence product development; overheads are allocated based upon the hours consumed in each department. The following table summarises the activity levels involved in the production process: Product Units Machine (Hours) Assembly (Hours) Setups Orders Suppliers XYI 50,000 100,000 350,000 120 8,000 3,000 YZT 40,000 200,000 120,000 200 8,000 4,000 ABW 30,000 120,000 60,000 200 16,000 4,200 Total 120,000 420,000 530,000 520 32,000 11,200 When the cost is allocated to each product, finding each product’s contribution towards overhead provides a clearer picture. The following table summarises the total contributions of the three products. Total Contribution Products Selling Price (£) (1) Cost Price (£) (2) Contribution (£) (3)= (1)-(2) Units (4) Total Contribution (5)= (3)x(4) XYI 45 32 13 50,000 650,000 YZT 95 84 11 40,000 440,000 ABW 73 65 8 30,000 240,000 The absorption rate on which the overhead cost is allocated to the products is also important in making the profit and loss statement. Since this involves two significant activities, the overhead is allocated over these two cost drivers. · O/H Absorption rate (Machine Hours) Overheads / machine hours = £504,000 / 420,000 = £1.20/hour · O/H Absorption rate (Assembly Hours) Overheads / assembly hours = £437,000 / 530,000 = £0.8245/hour Based upon absorption rates, the following table summarises the division of overhead costs over the three products. Machine Hours Assembly Hours Products Hours (1) Rate (2) Overheads (3)=(1)*(2) Hours (4) Rate (5) Overheads (6)=(4)*(5) Total O/H (7)=(3)+(6) XYI 100,000 1.20 120,000 350,000 0.8245 288,575 408,575 YZT 200,000 1.20 240,000 120,000 0.8245 98,940 298,940 ABW 120,000 1.20 144,000 60,000 0.8245 49,470 169,470 504,000 436,985 940,985 · Statement of Profit / (Loss) Using Absorption Costing Method Revenue XYI YZT ABW (1) Units 50,000 units 40,000 units 30,000 units (£) (£) (£) (£) (2) Sale Price 45 95 73 (3) Cost Price 32 84 65 (4) Contribution (2) – (3) 13 11 8 Total Contribution (4) * (1) 650,000 440,000 240,000 1,330,000 Overheads * (408,575) (298,940) (169,470) (940,985) Net Profit 241,425 101,060 46,530 389,015 1.2 Activity Based Costing The focus of activity based costing is upon departmentalizing overheads cost; this cost can be attributed to th ...

1. Management Accounting
Activity Based Costing vs Absorption Costing
Table of Contents
Budgeted Profit Statements 1
1.1 Absorption Costing 1
1.2 Activity Based Costing 3
1.3 Comments on the results 5
2.0 Discussion of the statement 6
References 9
0
2
1.0 Budgeted Profit Statements
1.1 Absorption Costing
Traditional absorption costing involves the calculation of
product cost, using direct and indirect variable costs and fixed
and variable overheads, which are substituted over the complete
production. Overhead cost substitution is based upon the
process activity that drives the cost. Machine hours and
assembly hours are two example activities that influence
product development; overheads are allocated based upon the
hours consumed in each department.
The following table summarises the activity levels involved in
the production process:
Product
Units

2. Machine (Hours)
Assembly (Hours)
Setups
Orders
Suppliers
XYI
50,000
100,000
350,000
120
8,000
3,000
YZT
40,000
200,000
120,000
200
8,000
4,000
ABW
30,000
120,000
60,000
200
16,000
4,200
Total
120,000
420,000
530,000
520
32,000
11,200
When the cost is allocated to each product, finding each
product’s contribution towards overhead provides a clearer

3. picture. The following table summarises the total contributions
of the three products.
Total Contribution
Products
Selling Price (£)
(1)
Cost Price (£)
(2)
Contribution (£)
(3)= (1)-(2)
Units
(4)
Total Contribution (5)= (3)x(4)
XYI
45
32
13
50,000
650,000
YZT
95
84
11
40,000
440,000
ABW
73
65
8
30,000
240,000
The absorption rate on which the overhead cost is allocated to
the products is also important in making the profit and loss

4. statement. Since this involves two significant activities, the
overhead is allocated over these two cost drivers.
· O/H Absorption rate (Machine Hours)
Overheads / machine hours = £504,000 / 420,000 = £1.20/hour
· O/H Absorption rate (Assembly Hours)
Overheads / assembly hours = £437,000 / 530,000 =
£0.8245/hour
Based upon absorption rates, the following table summarises the
division of overhead costs over the three products.
Machine Hours
Assembly Hours
Products
Hours
(1)
Rate
(2)
Overheads
(3)=(1)*(2)
Hours
(4)
Rate
(5)
Overheads
(6)=(4)*(5)
Total O/H
(7)=(3)+(6)
XYI
100,000
1.20
120,000
350,000
0.8245

5. 288,575
408,575
YZT
200,000
1.20
240,000
120,000
0.8245
98,940
298,940
ABW
120,000
1.20
144,000
60,000
0.8245
49,470
169,470
504,000
436,985
940,985
· Statement of Profit / (Loss)
Using Absorption Costing Method
Revenue
XYI
YZT
ABW

6. (1) Units
50,000 units
40,000 units
30,000 units
(£)
(£)
(£)
(£)
(2) Sale Price
45
95
73
(3) Cost Price
32
84
65
(4) Contribution (2) – (3)
13
11
8
Total Contribution (4) * (1)
650,000
440,000
240,000
1,330,000
Overheads *
(408,575)
(298,940)
(169,470)
(940,985)
Net Profit

7. 241,425
101,060
46,530
389,015
1.2 Activity Based Costing
The focus of activity based costing is upon departmentalizing
overheads cost; this cost can be attributed to the cost driver,
based upon the overhead rate. This method involves the
identification of all activities, with a cost, that are involved in
the process. For instance, apart from machinery hours and
assembly hours exclusive to the manufacturing process, there is
a setup cost each time a production schedule is initiated;
receiving customer orders and generating purchase orders
involve significant costs, which can be associated with the
production of each of the three product quantities.
The following table summarises the absorption rates for the
activities involved, based upon the cost pool (overall cost), and
the cost drivers (activities that trigger cost).
Overheads Absorption Rates:
Cost Pool
(1)
Cost Driver
(2)
Overhead Rate
(3)=(1)/(2)
Machinery Hours (ABR1)
357,000
420,000
0.85
Assembly Hours (ABR2)
318,000
530,000
0.60

8. Setups (ABR3)
26,000
520
50
Customer Orders (ABR4)
156,000
32,000
4.875
Purchase Orders (ABR5)
84,000
11,200
7.50
All absorption rates were calculated. The overhead costs
associated with each product category are summarized in the
following table.
Absorption Rate with Respect to Each Product:
XYI
YZT
ABW
TOTAL
Machinery
ABR1 x No. of hours x No. of units
ABR1 x No. of hours x No. of units
ABR1 x No. of hours x No. of units
0.85 x 2 x 50000
0.85 x 5 x 40000
0.85 x 4 x 30000
85,000
170,000
102,000

9. (357,000)
Assembly
ABR2 x No. of hours x No. of units
ABR2 x No. of hours x No. of units
ABR2 x No. of hours x No. of units
0.60 x 7 x 50000
0.60 x 3 x 400000
0.60 x 2 x 30000
210,000
72,000
36,000
(318,000)
Setups
ABR3 x No. of setups for product
ABR3 x No. of setups for product
ABR3 x No. of setups for product
50 x 120
50 x 200
50 x 200

10. 6,000
10,000
10,000
(26,000)
Cust. Orders
ABR4 x No. of cust. orders for product
ABR4 x No. of cust. orders for product
ABR4 x No. of cust. orders for product
4.875 x 8000
4.875 x 8000
4.875 x 16000
39,000
39,000
78,000
(156,000)
Supp. Orders
ABR5 x No. of Supp. orders for product
ABR5 x No. of Supp. orders for product
ABR5 x No. of Supp. orders for product

11. 7.50 x 3000
7.50 x 4000
7.50 x 4200
TOTAL
22,500
30,000
31,500
(84,000)
· Statement of Profit / (Loss)
Using Activity Based Costing
XYI - £
YZT - £
ABW - £
(1) Revenue
50000 x 45
40000 x 95
30000 x 73
2,250,000
3,800,000
2,190,000
8,240,000
(2) Direct Cost
50000 x 32
40000 x 84
30000 x 65
1,600,000
3,360,000
1,950,000

12. (6,910,000)
(3) Gross Profit
(1) – (2)
650,000
440,000
240,000
1,330,000
Machinery
85,000
170,000
102,000
(357,000)
Assembly
210,000
72,000
36,000
(318,000)
Setups
6,000
10,000
10,000
(26,000)
Cust. Orders
39,000
39,000
78,000
(156,000)
Supp. Orders
22,500
30,000
31,500
(84,000)

13. (4) Total O/Hs
362,500
321,000
257,500
(941,000)
Net Profit
(3) – (4)
287,500
119,000
(17,500)
389,000
1.3 Comment on the results
The two techniques of allocating the overheads cost produced
different results even though both had the same overall profit (
Absorption being rounded at 389,015 and ABC 389,000).
Absorption costing revealed that all of the products were
generating profits, and contributing positively to the growth of
the overall net profit. However, careful analysis of cost pools,
using activity based costing, revealed different results. When
each cost centre was allocated to the product appropriately,
product ABW was actually operating at a loss of £17,500.
Specifically, under the current profit margin, ABW is operating
under the breakeven quantity for which either the volume or the
price of the product needs to be increased (17500/30000) by
£0.58/unit at this level (30,000 units). It also revealed that
product XYI is making far more profit than estimated;
therefore, focusing upon increasing the sale of this product
could likely boost the company’s overall profitability.
This form of costing is critical to understanding the real
performance of the products/departments, so management can
pinpoint areas needing consideration. As ABC highlighted, one
of the products was actually operating at a loss, and another was
making more profit than anticipated. Such findings are critical

14. to the allocation of resources on products that have higher
contribution margins, and will maximize overall profitability.
2.0 Discussion of the statement
“It has been said that modern developments, such as ABC, are
sometimes implemented because they are fashionable and not
because they provide extra information to management.”
The primary purpose of clothing is to cover the body; fashion
and style are choices we make. Some choices are due to an
influence from our surroundings; some are necessary, others are
not. For instance, although holding an umbrella seems natural
when it is raining, it is also a choice to not let oneself be
impacted by harsh environmental conditions.
Similarly, in cost accounting, we make choices based upon
need. Every investor wants to know where his money is being
invested, how much the return has galloped, and whether there
is a potential for more. Although traditional absorption costing
provides us an overall image of what is happening, paying
attention to the details can help better understand what the cost
centres are, and how the cost pools are being allocated to
revenue generation activity.
Absorption costing allocates overheads to all the units produced
equally, such that each unit produced gets its share of overheads
absorbed. Based on absorption rate, all fixed and variable
overheads are applied to each unit; therefore, the overall
product cost includes both direct and indirect costs. This type of
costing can be misleading, since a significant amount of cost is
involved in the retained inventory. Moreover, since the cost is
additionally determined through the allocation of fixed
overheads, the information can lead management to rejecting an
offer that should have been accepted to cover the fixed cost.
Since the cost continuously changes depending upon the activity
level, this kind of costing is especially confusing when
production levels vary. Although quick, this method could be
deceptive for outside parties. Nonetheless, the high costs of

15. inventory balance can ratify the damages of a poor quarter
(Cokins, 2001).
Activity based costing is based upon activities associated with
manufacturing/producing and selling/delivering of any product
or service. Some terms pertain specifically to activity based
costing: cost objects, activities, cost pool, cost drivers, and cost
hierarchies (Michael et al., 2012).
Cost objects are the entities that trigger the activities for which
costs can be attributed, individually, in most cases, for instance,
products, services, customers, etc.
Activities are the associated tasks or routines involved in
supporting the manufacturing process. Supporting activities
include such things as checking the machine before operation.
Assembled output, in comparison, is a process activity.
Cost pools are somewhat similar to cost objects; however, they
are typically groups of similar activities, regardless of the
departments involved (Cokins, 2001). For instance, in any
automobile manufacturing environment, the cost pool of
painting the vehicles will include the inspection and the
painting cost. To understand how much cost can be allocated to
the particular activity (for instance, painting one type of car, as
compared to another), this can be allocated to each segment of
the product line.
In this case, since the amount of surface to be painted, and the
amount of paint used, will vary based upon type of car, it
casually drives the cost associated to the cost of the car.
Therefore, painting a car is a cost object. Finally, these costs
can be categorized based upon their necessity of use, the level
of activity in which they are involved, or the costs versus
effects relationship (Michael et al., 2012).
In reality, ABC application is subjective. It is about
understanding the concept, as these essential terms need to be
defined to make a sound judgement regarding the allocation of
costs to each unit. This takes a significant amount of time,
effort, and close collaboration within the departments.
Likewise, the definition of cost drivers takes a closer look at

16. how activities flow; not all of the activities are directly related
to products, and not all of the activities can be directly
attributable to cost objects. Likewise, the fixed overheads are
allocated to the products, which can be misleading. The fixed
costs do not typically change until a certain activity level is
achieved. Ultimately, it may not be sufficiently beneficial to
outweigh the investment in it. Moreover, resistance is likely
from managers if consensus is not reached about defining cost
centres. Whereas one product may be better off under
absorption costing, activity based costing may limit the
performance based bonus value.
In reality, for a company, where there are many different
products, and activities are relatively straightforward, ABC is
the way to go. It provides better understanding of cost structure,
and assists in decisions pertaining to continuing or shutting
down part of the business. Moreover, more information leads to
better decisions for the company. For instance, a product having
a lesser cost through ABC compared to absorption costing may
be re-priced to attract more customers (Rajasekaran & Lalitha,
2011). Likewise, while developing new products, management
will have a better understanding of the actual cost of a product,
and whether it may be viably sold at a price that the market will
be willing to pay (Cokins, 2001).
Determining costs through ABC involves more than just finding
the cost. The study of process provides a better understanding
of how activities are running, and if their efficiency is being
compromised. Moreover, the assessment of costs involved
allows management to determine the value chain of each
activity, so activities that are not adding any value for the
business can be eliminated (Heisinger, 2010). Once management
has a comprehensive outlook of the processes involved, it will
be easier to implement performance evaluation techniques and
monitor continuous improvement (Cokins, 2001).
After weighing the advantages and disadvantages of activity
based costing, the statement claiming that ABC is fashion
oriented is only contextual in nature. If a small company with

17. very few product lines and relatively simplified activities
implements activity based costing, it will not make a notable
difference to them. However, if a large company with various
product lines across different brands are considering such a
move, it will provide them better control over the operations
involved, the result will be beneficial for the company, and will
eventually help the consumer as well (Michael et al., 2012).
Shifting the cost mechanism to ABC is much like an investment
for the company; for it, they will get more precise knowledge of
what is happening and how is it costing them. This information
will allow them to better control the proceedings. However,
although cost benefit analysis is essential, fashion is not for
everyone. It is only for those who can afford it.
1.0 References:
Cokins, G. 2001. Activity-based cost management: An
executive’s guide. NY: John Wiley & Sons.
Heisinger, K. 2010. Essential of managerial accounting. USA:
South Western Congage Learning.
Maher, M., Stickney, C., & Weil, R. 2012. Managerial
accounting: An introduction to concepts, methods and uses. 11th
Ed. Canada: Nelson Publishing Ltd.
Rajasekaran, V. & Lalitha, R. 2011. Cost accounting. India:
Pearson Education.
1
ASB 4420 Assignment
You have been appointed as the management accountant at
Riptide Plc and have been asked to provide information on

18. overhead absorption.
The following budgeted information relates to the forthcoming
period:
Products
XYI
(000)
YZT
(000)
ABW
(000)
Sales and production (units)
50
40
30
£
£
£
Selling price (per unit)
45
95
73
Variable cost (per unit)
32
84
65
Hours
Hours
Hours
Machine department (machine hours per unit)
2

19. 5
4
Assembly department (direct labour hours per unit)
7
3
2
Overheads allocated and apportioned to production departments
were as follows:
Machine department
£504,000
Assembly department
£437,000
You ascertain that the above overheads could be re-analysed
into ‘cost pools’ as follows:
Cost pool
£000
Cost driver
Quantity for the period
Machining services
357
Machine hours
420,000
Assembly services
318
Direct labour hours
530,000
Set-up costs
26
Set-ups
520
Order processing
156

20. Customer orders
32,000
Purchasing
84
___
Suppliers’ orders
11,200
941
___
You have also been provided with the following estimates for
the budget period:
Products
XYI
YZT
ABW
Number of set-ups
120
200
200
Customer orders
8,000
8,000
16,000
Suppliers’ orders
3,000
4,000
4,200
Required:

21. 1. Prepare and present budgeted profit statements using:
(a) conventional absorption costing; and
15%
(b) activity based costing (ABC)
30%
(c) Comment on these results.
15%
2. The Managing Director at Riptide plc has commented
to you that he believes that Activity Based Costing is often
implemented because it’s fashionable and not because it
provides extra information to management.
Discuss the above statement.
40%
The assignment deadline date is 5pm Wednesday 15th April
2015. The assignment should be submitted by hardcopy and
also via turnitin.
The word count for part 2, should not exceed 2000 words