If you don't know how your business spends its money, you can't budget effectively. Absorption costing and activity-based costing, or ABC, both show you how much particular operations and products cost your company. One difference between ABC and absorption costing is that businesses rely on the absorption-costing formula for keeping the books accurate and ABC for making management decisions.

Tip

Absorption costing is a tool for figuring the cost of manufacturing products, including overhead. Its primary use is to calculate the cost of goods sold for your income statement. Activity-based costing is much more effective at identifying which exact costs are tied to which products. It's a better tool for management decision making.

Absorption-Based Costing

Businesses that use generally accepted accounting principles, or GAAP, use the absorption-costing formula to figure out how much they're spending on production processes and individual products. Those figures become the basis of your cost of goods sold, an essential figure in calculating your net income. You can meet GAAP requirements with activity-based costing, but most companies find that approach way too cumbersome to be practical.

Absorption-based costing is based on the materials and labor that directly contribute to a product plus the fixed overhead and the variable overhead. Fixed overhead includes things like rent and insurance on a factory, which don't vary with output. Variable overhead is affected by output — for example, the electricity and maintenance the assembly line requires.

• The first step in the formula is to assign the various costs to cost pools, such as maintenance.

• Next, calculate the usage figures that you use to assign overhead costs. A typical usage figure might be the hours a particular piece of equipment runs in a month or the direct labor hours used in production.

• Divide the usage figure into the assigned costs. For an absorption costing example, assume you have \$50,000 in costs and 500 labor hours. Each hour of work then absorbs \$100 in costs. If an item takes half an hour to manufacture, that item would absorb \$50.

• When you draw up your income statement, you use the absorbed cost data to calculate the cost of goods sold, which you subtract from net sales revenue.

ABC vs. Absorption Costing

Activity-based costing allows you to allocate your overhead costs more precisely than just assigning them to hours of labor. Under absorption costing, two products that take the same amount of time to make absorb the same costs but not with ABC. That's the difference between ABC and absorption costing.

For example, suppose you have two products that both take 90 minutes to manufacture. One, however, is a specialty item made in small batches, so the production line requires extra setup time and product testing. Absorption costing based on labor hours would assign the overhead equally to both products, but ABC assigns more of it to the specialty item.

The steps to assign activity-based costing are lengthier and more demanding than the absorption-costing formula:

• Identifying costs is the first step. As you're not assigning them to your products uniformly, it will take research, thought and number crunching to get it right.

• Create the relevant cost pools. Primary cost pools relate directly to the product lines, such as advertising and research and development. Administrative and IT services go into secondary cost pools.

• Identify the activity drivers that tap the secondary cost pools. For example, the square footage used for production affects the amount of rent and utilities that the production process costs.

• Use the activity drivers to assign costs in the secondary pools to the primary pools.

• Assign the costs to specific objects or processes. Unlike absorption costing, you can use this for things other than manufacturing — for example, assessing the costs of distribution channels or retail outlets.

The Role of Absorption Costing

Another difference between ABC and absorption costing is how you use them in your business. They're different tools that are good for different jobs.

Absorption-based costing's most important job is figuring the cost of goods sold. Figuring out how much you spent on the inventory you sold this quarter or this year is a necessary step for calculating your profits for the period. You can use cost of goods sold based on absorption costing to draw up your financial statements or for stock valuation.

Knowing the costs can help you set the price for your products. However, absorption costing has drawbacks as a tool for making management decisions:

• Unlike ABC, the absorption-costing formula doesn't get into the details of how much cost each product generates. If you're comparing the costs of different product lines and deciding which one to drop, absorption costing can't tell you that.

• If products aren't sold, the associated fixed overhead doesn't get subtracted from earnings. By assigning a little more overhead to products sitting in the warehouse, a company can keep those overhead costs off the income statement, making the business look more profitable than it is.

The Role of ABC

Absorption costing is important for accurate financial statements. Activity-based costing is a much better tool for management decisions. As ABC assigns costs and overhead to specific products and processes, it's much more helpful in showing you where you need to cut expenses or maybe even trim your product line.

• Using ABC, you can compare your activity costs to industry norms. If your expenses are subpar, you know you need to cut costs somewhere.

• If you have a major customer requiring extra costs, such as a lot of returns or special attention, ABC lets you assign those expenses to the customer and assess whether the customer is profitable.

• Whether you sell via your website, a store or through sales calls, ABC can evaluate the overhead for each sales channel so you can compare it to revenue generated.

• ABC's data on manufacturing products may show you that it's more cost effective to outsource them.

• If you know the exact costs assigned to a given product, you know the absolute minimum for which you can sell it and turn a profit.

• You can compare the costs of different production facilities, see which is most efficient and use that to make decisions about the others.

Drawbacks of ABC

Like absorption-based costing, the ABC method does have drawbacks.

• To assign costs effectively, you need a lot of individual cost pools. The more cost pools, the more complex the system and the more work and expense it will require to gather data.

• Small, targeted ABC systems work well. Large, company-wide systems can take years to install. It's also hard to maintain the management and budgetary support a big ABC system requires.

• ABC requires input from multiple departments. Some of them may decide they have higher priorities and fall behind in providing you with the necessary data.

• Companies may set up an ABC system for a specific purpose and then decide not to update it or keep it current after that, rendering it useless.

• Labor hours gathered for ABC may not be accurate. Employees won't usually admit that they were surfing the net or chatting with co-workers on company time and may assign those hours to something more acceptable. That can skew how many labor hours you assign to projects and processes.

• Unlike absorption-based costing, ABC usually requires its own database rather than drawing data from the general ledger.

• If you only have one or two product lines and a fairly simple manufacturing system, you may be able to gather information for decision making without establishing ABC.