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Question: Briefly explain the concepts of Absorption costing and Activity Based Costing.

08 Oct 2022,10:27 PM

 

Briefly explain the concepts of Absorption costing and Activity Based Costing. Describe the implications for a Company if they decide to switch from Absorption costing to Activity Based costing and evaluate whether you believe the additional costs of Activity Based Costing
outweigh any potential benefits

Understanding ‘Cost Assignment’ is a key aim of the IDMA001 Management Accounting syllabi.
Absorption and Activity Based Costing is a corner stone to understanding cost assignment in the context of management accounting techniques.

 

Expert answer

 

Absorption costing is a costing methodology that traces the costs of all products and services to the periods in which they are used. This approach is also known as full absorption costing. In contrast, activity-based costing (ABC) assigns costs to products and services based on the activities that are required to produce them. ABC can be more accurate than traditional absorption costing because it identifies the specific activities that are driving costs.

 

In traditional absorption costing, all manufacturing costs are assigned to products and services. These include direct materials, direct labor, and overhead costs such as rent, utilities, and property taxes. The thinking behind this approach is that all manufacturing costs must be covered by the selling price of the product or service. Otherwise, the company will have to sell at a loss or go out of business.


While this may seem like a straightforward way to determine the cost of products and services,

 

it can actually lead to some distorted decisions. For example, if a company has two products that require different amounts of direct labor to produce, the one that requires more labor will appear to be more expensive under absorption costing. As a result, the company might decide to discontinue the product that requires more labor, even though it might be more profitable.

 

Activity-based costing avoids this problem by allocating manufacturing costs to products and services based on the specific activities that are required to produce them. For example, if two products require different amounts of direct labor to produce, the cost of direct labor would be allocated

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