Businesses analyze their costs regularly in order to make sound decisions. These include product costing, service costing and the cost of internal processes. Absorption costing and activity based costing represent two common methods of cost accounting performed in businesses and used for decision making. Each method approaches costing differently and serves different decision-making purposes. Business owners need to understand how each costing method works in order to maximize the benefits of each method.
Absorption costing, also known as full product costing, considers every cost incurred by the business. The accountant accumulates material, labor and overhead costs throughout the organization. The direct materials and direct labor costs can be traced right to the product or service. Accountants who use absorption costing must allocate the overhead costs to each product being produced. The allocation method represents an arbitrary method of linking the overhead costs to a product.
Companies use absorption costing to report their product costs in the financial records. These product costs appear in the ending inventory balance on the balance sheet and in the cost of goods sold on the income statement. Investors, creditors and government agencies use the company’s financial statements to make decisions. Investors make decisions regarding whether or not to purchase stock from the company. Creditors make decisions regarding whether to extend credit to the business. Government agencies make decisions regarding whether the company qualifies for government programs.
Activity Based Costing
Activity based costing considers the costs associated with various activities. Companies often use activity based costing to analyze the cost of internal processes that occur along the production process or within other company departments. For example, some companies use activity based costing to determine the cost of responding to a customer complaint. Activity based costing only considers costs directly traceable to a product or process. Activity based costing also considers what activity drives the cost. For example, telephone expenses can be traced directly to the employee handling customer complaints. The cost driver might be the number of calls answered on her phone.
These two methods of costing differ in both the users of the cost data and what the cost applies to. Absorption costing focuses on the needs of financial statement users outside of the company, while activity based costing focuses on the needs of financial statement users within the company. Absorption costing bases all costs on the manufactured product, while activity based costing considers the cost of products or processes.