Absorption costing,

Activity Based Costing &

Standard Costing

TASK I
Absorption costing vs.
Activity-Based Costing

Basis for Absorption Costing

Absorption costing is a method of calculating the
cost of a product or enterprise by taking into
account indirect expenses (overheads) as well as
direct costs (Lindberg and McKean 2005: 414)
Absorption costing procedure:
1.
2.
3.
4.

Allocation
Apportionment
Re-apportionment
Absorption

1. Allocation
Allocation of costs to cost centres
Total production costs
Indirect costs

Direct costs

(overheads)

Allocate

COST CENTRES
Allocate
Production 1 Production 2

Service

COST UNITS

2. Apportionment
Two stages of apportionment:
1.Overheads which are unable to allocate to
particular cost centres are assigned to
different cost centres
2.Re-apportionment of service cost centre
overheads to production cost centres

3. Re-apportionment
Allocation of costs to cost centres
Total production costs
Indirect costs

Direct costs

(overheads)

COST CENTRES

1. Allocate
& Apportion

Allocate
Production 1 Production 2
Production 1 Production 2

Service
2. Re-apportion

COST UNITS
6

4. Absorption
Step 1: Identifying absorption base e.g. unit,
labour hour, machine hour, % of direct labour
Step 2: Determining overhead absorption rate =
production overhead / activity level
Step 3: Overhead absorption into cost units

4. Absorption
Allocation of costs to cost centres
Total production costs
Indirect costs

Direct costs

(overheads)

COST CENTRES

1. Allocate
& Apportion

Allocate
Production 1 Production 2
Production 1 Production 2

COST UNITS

Service
2. Re-apportion

3. Absorb
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Advantages & Disadvantages of

Absorption Costing
Advantages

Disadvantages

Incorporation of fixed cost into the unit

cost of production

Only effectively used under constant level

with uniform unit cost for small and
medium sized enterprises

All costs are included in unit price

Cost control and cost comparison are

difficult

Reduced work burden

Fixed costs = period costs; no produce

future benefits

Accrual cost concept

Profit is not accurately computed

Inventory is valued at total cost

Only takes into account production costs

and ignores others

Recognition of effective utilisation of

production resources

Not helpful in managerial decision making

process

It assists in computing gross and net

profits separately

Activity Based Costing (ABC)

In contrast to absorption costing, ABC method first collect
overhead costs for each activity, and then assigns costs to
that activity

10

Advantages & Disadvantages of

ABC System
Advantages

Disadvantages

Accurate costing

Requires extensive budget to implement

Better understanding of overhead costs

Maintenance is costly as well

Uses unit cost instead of total cost

Data can be misinterpreted while decision

making

Integration with continuous improvement

methods such as Six Sigma

ABC reports do not comply with GAAP

Provides better control

Eliminates non-value added activities
Makes all wastages visible

IASB and IRS do not support ABC for

externally publishing financial statements

Supports approaches like Balanced

Scorecard & performance management

More complex approach for management

to understand ABC system

Enables value streams, supply chains &

process costing, process re-engineering
Benchmarking of other products

11

ABC System vs. Absorption

Costing System
Absorption Costing

ABC System

Approach

Allocates costs to units of

production;

Traces the costs of product units

Scope

Determines profitability or
efficiency level but ignores
cost of individual product
units

Identifies of non-profitable or
inefficient products

Methodology

Equally divides fixed

overhead costs by no. of
product units

Identifies real proportion of fixed

overhead costs incurred by the
product unit

Legal validity

Follows GAAP (Generally

Accepted Accounting
Principles)

ABC is not accepted by IASB and

IRS for externally publishing
financial statements

Suitability

- Small and medium firms

- Homogeneous products

- For large enterprises

- Heterogeneous products12

TASK II
Standard Costing &
Variance

13

Standard Costing
The preparation and use of standard costs,
their comparison with actual costs and analysis
of variances to their causes and points of
incidence (Debarshi 2011: 537)
Features
Predetermination of suitable standards for cost and
sales elements
Comparison between actual and predefined
performances
Analysis to assess the causes of variance

14

Advantages of Standard Costs

Improves cost control
& evaluating performance
Provides information
for planning &
decision making

Makes inventory
Measurement more
easier & logical

Reduces production
costs

Advantages

Cost savings in
record-keeping
15

Disadvantages of Standard Costs

Focus on
negative
aspects & belief
decrease morale

Disadvantages

Can be tricky
to decide
which variances
are important &
considerable

Focus on negative
aspects & belief may
lead under-reporting.
16

Types of Standard Costs

The standard cost of finish products unit is a sum
of:
1. Standard cost of direct labour

Rate standards (use labour contracts & surveys)

Efficiency standards (use time for each task)

2. Standard cost of direct materials

Price standards (use competitive bids for desired quality

and quantity)
Usage standards (use product design specifications)

3. Standard cost of manufacturing overheads

Standard rate (based on pre-defined output standards)

17

Standard cost
Calculation of direct material
The direct material cost of a single unit of product can be
calculated as Price x Quantity
standard quantity
standard price for
of material
a single unit of material
required for one
unit of product

Example:
6 (price of a ply sheet)

5 sheets

= 6 x 5 = 30
Where,

Standard price is an amount to be paid for every unit of

raw material
Standard quantity shows raw material figure used to
generate a single unit of finished product

18

Standard cost
Calculation of direct labour
The direct labour cost of a single unit of product can be
calculated as Wage rate x No. of labor hours
Standard per hour wage rate

Standard No. of
labour hours

Example:
10 (per hour)

2 (required hours
for each table)

= 10 x 2 = 20
Where,

Standard wage rate shows an amount which is paid to

labour on hourly basis; and
Standard no. of hours demonstrate total time in hours to
produce a single unit of a product
19

Standard cost
Calculation of manufacturing overheads
A manufacturing overhead standard rate needs to be applied on
products each unit

= 5
Where,

Budgeted OH cost is overall figure of overhead cost

which must incur for the year to generate standard
output level
Standards level of output is the perceived level of activity
for cost driver per year
20
20

Standard cost
Example Summary
Standard Costs for producing a single table
Direct materials
6 X 5 sheets

30

10 X 2 hours

20

Direct labor

Manufacturing overhead
5 X 2 labor hours 10
Total standard cost

60
21

Variance and its Types

Variance is a difference between total actual
costs and total standard costs
Unfavorable variances shows over payment of
labour and material or when inefficiencies
exist using materials and labor
Favorable variances shows cost efficiencies
and materials and labor efficiencies
22

Types of Variance

23

Causes of material & Labour

variances
Variance

Favourable

Unfavourable

Material price

Inadequate material quality

Shift to cheaper supplier
Inaccurate budgeting
Discount for bulk purchase

Inaccurate budgeting
Shift to more costly supplier
Unanticipated increase in price
High quality of material

Material usage

Modify product specification

Budgeting incorrect
More efficient material use
High quality of material

Inadequate material quality

Inadequate staff experience for
handling material
Modify product specification
Inaccurate budgeting

Labour rate

Inaccurate budgeting
Overtime/bonus deduction
Unskilled staff

Unexpected rise in wages

Higher skilled staff
Inaccurate budgeting
Overtime/bonus increment

Labour
efficiency

Inaccurate budgeting
Enhanced staff motivation
Higher skilled staff

Inaccurate budgeting
Staff de-motivation
Unskilled staff

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Variance Reduction Strategy

Variances can be mitigated by cautiously adopting
following strategies:
Control material quality
Carefully switch to another supplier
Hire skilled and responsible staff
Carefully adopt bonus/increment strategy
Motivate staff
Accurate budgeting using proper budgeting
techniques
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Material Price Variance

Following information belongs to ABC Corp. about material standard to
produce product A:
1.5 pounds per product at 4.00 per
Data:1700 pounds of material bought in June 6,630 total cost. The
material was utilized to produce 1,000 products in June.

MPV = (AP SP) AQ

Actual Quantity
x Actual Price
(AQ) x (AP)
(1700) x (6630/1700)

Actual Quantity
x Standard Price
(AQ) x (SP)
(1700) x (4)

Materials Price
Variance
(MPV)

(3.9 4) x 1700
-170 (Favorable)

26

Material Usage Variance

Following information belongs to ABC Corp. about material standard to
produce product A:
1.5 pounds per product at 4.00 per
Data:1700 pounds of material bought in June 6,630 total cost. The
material was utilized to produce 1,000 products in June.

MQV = (AQ SQ) SP

Actual Quantity
x Standard Price
(AQ) x (SP)
(1700) x (4)

Standard Quantity
x Standard Price
(SQ) x (SP)
(1000x1.5) x (4)

Materials
Qty Variance
(MQV)
(1700 1500) x 4
+800 (Unfavorable)
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Total Material Variance

Following information belongs to ABC Corp. about material standard to
produce product A:
1.5 pounds per product at 4.00 per
Data:1700 pounds of material bought in June 6,630 total cost. The
material was utilized to produce 1,000 products in June.

TMV = (AQ x AP) - (SQ x SP)

Actual Quantity
x Actual Price
(AQ) x (AP)
(1700) x (6630/1700)

Std. Quantity
x Std. Price
(SQ) x (SP)
(4) x (1000x1.5)

Total Material
Variance
(TMV)
6630 6000 =
30 (Favorable)
28

Labour Price Variances

Following information belongs to ABC Corp. about material standard
to produce product A:
1.5 standard hours for each product at 6.00 per hour
Payroll data:1450 hours completed at labour cost 8990 to
produce 1000 products

LPV = (AR SR) AH

Actual Hours
x Actual Rate
(AH) x (AR)
(1450) x (8990/1450)

Actual Hours
X Standard Rate
_
(AH) x (SR)
(1450) x (6)

Labor Price
Variance
(LPV)
(6.2 6) x 1450
+290 (unfavorable)

29

Labour Efficiency Variances

Following information belongs to ABC Corp. about material standard
to produce product A:
1.5 standard hours for each product at 6.00 per hour
Payroll data:1450 hours completed at labour cost 8990 to
produce 1000 products

LEV = (AH SH) SR

Actual Hours
x Standard Rate
(AH) x (SR)
(1450) x (6)

Standard Hours
x Standard Rate
(SH) x (SR)
(1000x1.5) x 6

Labor
Efficiency Variance
(LFV)
(1450 1500) x 6
-300 (favorable)

30

Total Labour Variances

Following information belongs to ABC Corp. about material standard
to produce product A:
1.5 standard hours for each product at 6.00 per hour
Payroll data:1450 hours completed at labour cost 8990 to
produce 1000 products

TLV = (AH x AR) - (SH x SR)

Actual Hours
x Actual Rate
(AH) x (AR)
(1450) x (8990/1450)

Standard Hours
x Standard Rate
(SH) x (SR)
(1000x1.5) x 6

Total Labour
Variance
(TLV)
1450 9000
-7550 (Unfavorable)

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References

Banerjee, B. (2006). Cost accounting: theory and practice. 12th edition, PHI Learning
Pvt. Ltd
Bendrey, M., Hussey, R. and West, C. (2003). Essentials of Management Accounting
in Business. Cengage Learning EMEA
Berger, A. (2011). Standard Costing, Variance Analysis and Decision-Making. GRIN
Verlag
Cokins, G. (2002). Activity-Based Cost Management: An Executive's Guide. John
Wiley & Sons
Debarshi, B. (2011). Management accounting. Pearson Education India
Drury, C. (2005). Management and Accounting for Business. Cengage Learning
EMEA
Hilton, R.W. and Platt, D.E. (2011). Managerial Accounting: Creating Value in a
Global Business Environment. McGraw-Hill Irwin

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References

Kaplan Financial Knowledge Bank (2014). Variance analysis. [online]. Available at:
http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Variance%20Analysis.asp
x
(Accessed 06 February 2014)
Lewis, R.J. (1995). Activity-based Models for Cost Management Systems.
Greenwood Publishing Group
Lucey, T. and Lucey, T. (2002). Costing. Cengage Learning EMEA
Lindberg, C.A. and McKean, E. (2005). The Office Professional's Guide. Oxford
University Press
Sheeba, K. (2011). Financial management. Pearson Education India
Weygandt, J.J., Kimmel, P.D. and Kieso, D.E. (2009). Managerial Accounting: Tools
for Business Decision Making. 5th edition, John Wiley & Sons

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Questions

?
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