MCAFR

[PRODUCT COSTING - ABSORPTION OR ACTIVITY BASED]

[Name of the institute]

Table of Contents

Purpose1

Introduction3

Discussion4

Advantages and Disadvantages of traditional costing system6

Advantages and Disadvantages of Activity Based Costing7

Comparison between Activity Based Costing and Traditional Costing System8

Example of traditional Costing and Activity Based Costing9

Activity Based costing approach10

Summary and Conclusion12

Reference13

Purpose

Accounting is considered to be among one of the most important functions of the business. It is necessary for the business to account for correct cost when producing a product. A business which bases its selling price on the cost of a product, its success or its failure will depend on the costing of the products that are manufactured by the business.

Previously, companies only used the traditional method of costing. That method focused on simple production processes. Along with this a higher amount of labour was being in the manufacturing process. But with the passage of time, complexities in manufacturing increased. There was a shift from a labour intensive manufacturing environment to a capital intensive manufacturing environment, with automated manufacturing technology being used. As a result the indirect costs increased, while direct costs started to go down slowly. In order to account for the above, a costing method was required. Thus, Activity based costing was introduced. This method of costing divided the indirect cost in to different cost pools and based on the cost driver it allocated the cost to the cost pools. Another good thing about this method of costing was that it took in to account not only production related activities but also non production related activities.

However, the traditional method of costing is still being used in some organization. The argument is whether a company should go for tradition costing method or Activity based costing method. Therefore, this paper is aimed at comparing and contrasting the alternative approaches of product costing in a manufacturing industry. Both methods have their advantages and disadvantages. The first part gives the introduction to costing, its importance, usage, types and the process of determining it in a manufacturing industry. The second part compares and contrasts the traditional costing with ABC and the last part draws a conclusion.

Introduction

Costing can be defined to as process of calculating the cost price of a product or service. In a manufacturing concern the cost of the product is determined after adding direct material cost with direct labour cost and factory overheads or the indirect costs (Cokins, 1998, Drucker, 1990). All of these costs include the fixed as well as the variable cost. The difference that arises is in the calculation of overheads. There the concept of absorption costing (traditional costing) and Activity Based Costing applies.

Costing is very important as it helps in setting the selling price of the product as well as valuing the inventory. This is because a mark up is added to the cost of product and then the selling price is determined. There are other methods as well, but this is one of the most common methods of determining the price of the product. According to (Cokins & Hicks, 2007, ...