Absorption Costing

Comparing ABC with Absorption Costing — Benefits and Limitations

ABC vs Absorption Costing — Profit Comparison

Example — Pemberton Products Ltd (Alpha: 8 000 units; Beta: 2 000 units; total overheads £144 000)

Under absorption costing, Beta appears more profitable. Under ABC, Alpha is more profitable — a reversal caused by Beta's smaller batches consuming proportionally more set-up cost.

Cross-Subsidisation

When a single volume-related OAR is used:

• High-volume, large-batch products are over-charged (subsidisers)
• Low-volume, small-batch products are under-charged (subsidised)

The subsidised product appears artificially profitable, which can lead to mispricing and wrong decisions about which products to promote or discontinue.

When ABC ≈ Absorption Costing

ABC gives similar results to absorption costing when:

• All products consume overhead-driving activities in proportion to their volume
• The business produces only one product
• Overhead costs are genuinely volume-driven (e.g. machine running costs only)

Benefits of ABC

• More accurate product costs → better pricing decisions
• Reveals cross-subsidisation between products
• Identifies the cost of individual activities → management can reduce non-value-adding activities
• Useful for customer and product profitability analysis

Limitations of ABC

• More expensive and time-consuming to implement and maintain than traditional absorption costing
• Requires identification of cost drivers — not always straightforward; some drivers are subjective
• Cost driver rates are still based on budgeted data — over/under-absorption can still occur
• May not be cost-effective for businesses with simple, homogeneous product ranges
• Does not eliminate all arbitrary allocation — some overheads (e.g. building costs) still require apportionment

Uses and Limitations of Absorption Costing