4.2 Absorption and Activity Based Costing
This lesson introduces two critical costing methods used in management accounting: Absorption Costing and Activity-Based Costing (ABC). Both methods play vital roles in understanding product costsThe sacrifices made when choosing a particular option, which may include money spent, time used, or resources consumed. and profitability but differ significantly in their approach and application.
Absorption Costing
Absorption costing, also known as full costing, is a methodHow a writer presents perspective or viewpoint through language/structure. that assigns all manufacturing costs (both fixed and variable) to a product. This includes direct costs (e.g., materials and labor) and allocated overhead costs (e.g., factory rent, utilities). This means the unit cost is calculated as:
\(\text{Unit Cost}=\frac{\text{Total Direct Costs}+\text{Allocated Overheads}}{\text{Units Produced}}\)
Some benefits of absorption costing is that it ensures full recovery of all production costs, complies with external reporting requirements and provides a simple method of costing. However, the overhead allocation may not accurately reflect the resource usage, in addition to this, overproduction as unsold inventory carries fixed costs, which would increase profitThe difference between the total revenue a business receives from sales and its total costs of production. on paper.