Absorption and activity-based costing

Absorption Costing

Absorption costing is a method of assigning all production costs to products or services. It includes both variable and fixed production costs.
This costing system is based on the idea that each product or service, in one way or another, utilizes all resources of the firm.
The main purpose of absorption costing is to distribute all costs of manufacturing, both fixed and variable, to individual products. It can assist in showing a greater net profit when sales are greater than production.
Absorption costing is required by generally accepted accounting principles (GAAP) as part of full-cost accounting.

Activity-based costing (ABC) is a method for assigning costs to products and services depending on the resources that they consume. It’s designed to provide more accurate information about product costs.
Cost pools and cost drivers are the two primary elements of ABC. A cost pool is a total amount of expenses, while a cost driver is the basis for allocation of costs.
ABC is especially useful when overhead costs are a significant portion of total costs, and there is a diversity in the range of products, customers, or order sizes.
Unlike absorption costing, ABC system can reveal unnecessary or inflated costs and help management make the operational adjustments necessary to improve profitability.

The key difference between these two methods is the treatment of overheads. Absorption costing allocates overheads based on output volume while ABC bases overheads on activities.
ABC gives a more accurate cost per unit than absorption costing when different products use overhead resources at different rates.
When production levels greatly vary but sales remain relatively stable, absorption costing may show erratic product costs, while ABC would maintain consistent costs.
The information from ABC can be more helpful for managerial decision making, but may be more complex and costly to implement.