Activity Based Costing vs. Absorption Costing: Comparing Product Costs

Activity Based Costing vs. Absorption Costing: A Practical Example with Duff Co.

This guide walks through a practical example of calculating product costs using both traditional absorption costing and activity-based costing (ABC). We'll use the case of Duff Co., a manufacturer of three products: X, Y, and Z.

Understanding the Problem

Duff Co. uses the same materials and direct labor for all its products but in varying quantities. Currently, they employ absorption costing based on direct labor hours to allocate overheads. However, they're considering switching to ABC to gain a more accurate understanding of their product costs and potentially adjust their pricing strategy.

Here's the key data we'll be working with:

• Budgeted Production: X - 20,000 units, Y - 16,000 units, Z - 22,000 units* Direct Costs per Unit: * X: $25 materials, $30 labor ($12/hour) * Y: $28 materials, $36 labor ($12/hour) * Z: $22 materials, $24 labor ($12/hour)* Budgeted Indirect Production Costs: $1,377,400* Cost Pools and Drivers: * Machine Setup: $280,000, driven by the number of batches * Material Ordering: $316,000, driven by the number of purchase orders * Machine Running: $420,000, driven by machine hours * General Facility: $361,400, driven by machine hours* Product Specific Data: * Batches: X - 40, Y - 20, Z - 55 * Purchase Orders: X - 160, Y - 100, Z - 220 * Machine Hours per Unit: X - 1.5, Y - 1.25, Z - 1.4

Part (a): Absorption Costing

1. Calculate Total Budgeted Direct Labor Hours: * X: 20,000 units * 1.5 hours/unit = 30,000 hours * Y: 16,000 units * 1.25 hours/unit = 20,000 hours * Z: 22,000 units * 1.4 hours/unit = 30,800 hours * Total: 30,000 + 20,000 + 30,800 = 80,800 hours

2. Calculate the Overhead Absorption Rate: * $1,377,400 / 80,800 hours ≈ $17.03 per direct labor hour

3. Calculate Budgeted Full Production Cost per Unit: * Product X: $25 (materials) + $30 (labor) + ($17.03 * 1.5 hours) ≈ $80.55 * Product Y: $28 (materials) + $36 (labor) + ($17.03 * 1.25 hours) ≈ $85.29 * Product Z: $22 (materials) + $24 (labor) + ($17.03 * 1.4 hours) ≈ $69.84

Part (b): Activity-Based Costing

1. Calculate Cost Driver Rates: * Machine Setup: $280,000 / 115 batches ≈ $2,434.78 per batch * Material Ordering: $316,000 / 480 orders ≈ $658.33 per order * Machine Running: $420,000 / 81,800 hours ≈ $5.13 per machine hour * General Facility: $361,400 / 81,800 hours ≈ $4.42 per machine hour

2. Allocate Overhead Costs to Each Product: * Product X: * Setup: 40 batches * $2,434.78/batch ≈ $97,391.20 * Ordering: 160 orders * $658.33/order ≈ $105,332.80 * Running: 30,000 hours * $5.13/hour ≈ $153,900 * Facility: 30,000 hours * $4.42/hour ≈ $132,600 * Total Overhead: $489,224 * Repeat for Products Y and Z.

3. Calculate Budgeted Full Production Cost per Unit (ABC): * Product X: $25 (materials) + $30 (labor) + ($489,224 / 20,000 units) ≈ $79.46 * Repeat for Products Y and Z.

Conclusion

By comparing the results of both costing methods, Duff Co. can make more informed decisions. They may find that certain products are over- or under-costed using their current absorption costing system, leading to potential adjustments in pricing strategies for improved profitabilit