Absorption and activity based costing — AQA A-Level Accounting

Absorption costing is a traditional inventory valuation method where all manufacturing costs, including both direct expenses and fixed production overheads, are absorbed into individual cost units. It complies with IAS 2 Inventories for financial reporting purposes, ensuring that ending inventory carries a share of fixed manufacturing overheads rather than treating them solely as period expenses.

Activity Based Costing (ABC) emerged as a strategic alternative to address the distortions caused by traditional volume-based absorption in modern manufacturing environments. By allocating indirect costs through distinct cost pools and measurable cost drivers, ABC establishes an accurate cause-and-effect relationship between support activities and final products.

• →Overhead Absorption Rate (OAR): Calculated as Budgeted Overhead divided by Budgeted Basis (e.g. direct labour hours, machine hours, or units) prior to the accounting period.
• →Under- and Over-Absorption: The difference between absorbed overheads (Actual activity x OAR) and actual overheads incurred, requiring adjustment in the income statement.
• →Cost Pools and Cost Drivers: In ABC, a cost pool aggregates costs associated with a specific business activity (e.g. machine setups, purchasing), while a cost driver represents the factor that triggers those costs (e.g. number of setups, purchase orders raised).
• →Product Cost Distortion and Cross-Subsidisation: The systematic error where high-volume simple products absorb excessive overheads, artificially lowering the reported unit costs of low-volume complex products under volume-based systems.

• Charges the whole of a traceable cost to the specific cost unit that caused it.
• Identifies direct materials and direct labour as costs that can be allocated rather than apportioned.
• Distinguishes allocation from apportionment, absorption and activity based costing.
• Selects the option in which a cost is charged in full to the unit it is traceable to.

• 💡Ask whether the cost can be traced to the named unit; if yes, allocation applies.
• 💡Eliminate options that describe sharing or absorbing overheads, since those are not allocation.
• 💡Re-read the stem to confirm which unit caused the cost before choosing.
• 💡In calculation questions, always compute the absorbed overhead first using (Actual Activity x OAR), and then clearly subtract the actual overhead to determine whether the variance is positive (over-absorbed) or negative (under-absorbed).
• 💡When evaluating whether a firm should transition to ABC, balance the benefit of improved pricing decisions against implementation costs, software upgrades, and staff training requirements.

• Apportions a cost that is traceable to one unit; instead allocate the whole cost to that unit.
• Treats allocation as spreading overheads across departments; instead reserve allocation for costs that can be traced directly.
• Charges only a proportion of a direct cost to the unit; instead charge the full traceable amount.
• Believing that Activity Based Costing can completely replace absorption costing for external published accounts. (Correction: ABC is primarily an internal management accounting tool; external financial reporting under IAS 2 requires standard absorption costing including fixed production overheads, making ABC non-mandatory and often too costly for statutory statements.)
• Confusing under-absorption with over-absorption, or assuming over-absorption is a negative financial event. (Correction: Over-absorption occurs when absorbed overheads exceed actual overheads, meaning product costs were temporarily overstated during the period, resulting in a credit adjustment to increase reported profit at period-end.)

1. 1Day 1-3: Master OAR calculations using various bases (direct labour hours, machine hours, percentage of direct materials/labour) and practice under- and over-absorption reconciliations.
2. 2Day 4-6: Practice ABC cost pool and cost driver allocation questions, contrasting the resulting product unit costs with traditional volume-based absorption.
3. 3Day 7-10: Work through 12-mark and 25-mark evaluation essay questions discussing strategic implications such as product discontinuation, pricing strategies, and implementation limitations.

• 📋Multi-step calculation problems: Determining OAR, calculating absorbed overhead, and identifying under- or over-absorption with income statement adjustments.
• 📋Comparative cost tables: Calculating unit costs for two or more products using both traditional absorption and ABC methods from given cost pool and driver data.
• 📋Extended evaluation essays: Assessing the strategic and financial justification of replacing a traditional absorption costing system with activity based costing.