University of Manchester

School of Materials
MATS22001
Fashion Business & Analysis

Report:
Absorption and Activity-based Costing

Student: Ernesta Ratkute

Student ID: 9621273
Costing is an essential part of fashion business as it works as a tool
for making pricing, order acceptance and cost control decisions by
manufacturers to ensure a profit for the products made and sold
(Jeffrey and Evans, 2011). The traditional absorption costing and the
activity based costing are costing systems created to allocate direct
production costs and overheads to products in an adequate manner.
Although they share the same purpose, both systems use different
approaches that can produce very different results and affect future
business decisions.
Absorption costing is a traditional approach to costing that involves
allocating direct and indirect expenses to product units by dividing
them equally over the inventory of the firm and directly relates to
the production volume. This approach is successfully used by small
businesses with one or two homogenous products, however when it
comes to modern manufacturers with wider portfolios, the
overheads take-up a larger proportion of overall costs, which makes
it hard to calculate an accurate estimate for each product. This is
where the ABC (Activity-based Costing) is applied to allocate pooled
costs to individual products by attaching an appropriate cost driver.
The more tasks are performed during the manufacturing process,
the more costly the product line becomes. In other words the
activities drive the overhead cost (Innes and Mitchell, 1998). While
absorption costing method can be a simpler and cheaper way of
allocating costs, a more accurate unit cost can be achieved by using

ABC method, which can help in strategic decision making for future
business improvements. However, not all overhead costs can be
allocated to specific activities and the entire process can become
over complicated and the benefits gained by the ABC might not
justify the cost of using this system.
The ability to figure out the exact unit cost can improve the
decision-making and bidding power of the business. If a company
switches from absorption costing to ABC and finds out that a certain
product is actually cheaper to make than it was thought to be, then
they gain a lot of bidding power over their competitors as they can
start offering lower priced product. On the other hand, if the product
is more costly to make than it was thought to be, the company
might have found out the reason for low profits or potential loss
caused. At this stage, the production process would be reviewed for
changes or that item might be eliminated. Therefore, getting the
right unit cost can lead to achieving higher profits and eliminating
unprofitable product lines, as well as the development and design of
new products (Shank and Govindarajan, 1988, pp. 71-79).
All of the above can be found in and applied to the given Excel
spread sheet of the production schedule of the Acompany Ltd.
Firstly, the unit costs of products A, B, C and D were calculated using
the traditional absorption method by adding up direct material,
direct labour and non-production overhead costs of each style and
dividing the sum by the output of each style. The results can be
found in the Table 1.

Product/Style
Direct materials cost
()
Direct labour cost ()
Overheads ()
Total cost ()
Unit cost ()

A
47,250.0
0
13,650.0
0
26,073.0
3
86,973.0
3
8.28

B
32,300.
00
11,050.
00
21,106.
74
64,456.
74
7.58

C
40,300.
00
10,725.
00
20,485.
96
71,510.
96
11.00

D
30,800.
00
9,075.0
0
17,334.
27
57,209.
27
10.40

Secondly, the unit costs of products A, B, C and D were calculated

using the ABC method by working out the exact set-up, machine
activity, receiving and packing and dispatching costs for each
product style individually. For example, the machine set-up cost for
product A was found by dividing total set-up costs by the total
number of set-ups and multiplying it by the number of set-ups

required by product A. The same method was applied to calculate

costs for products B, C and D. All, machine activity, receiving and
packing and dispatching costs were calculated in the same way
using relative data and respective cost drivers. Direct material and
direct labour costs of each style were added to above-mentioned
calculations to find out the total cost of production of each product,
and then it was divided by the number of garments produced in
each line to work out the exact unit cost. The results can be found in
the table below.
Table 2. Acompany Ltd. Activity- based Costing.
Product/Style
Cost Driver
A
B
C
Direct
materials
N/A
47,250.0 32,300.0 40,300.0
cost ()
0
0
0
N/A
13,650.0 11,050.0 10,725.0
Direct labour ()
0
0
0
Number of
Set-up cost ()
set-ups
5333.33 6666.67 4000.00
Machine
activity Machine
cost ()
hours
8784.86 9482.07 9063.75
Number of
production
Receiving cost ()
runs
4000.00 5000.00 3000.00
Packing & dispatch Output
cost ()
5080.65 4112.90 3145.16
N/A
84098.8 68611.6 70233.9
Total cost ()
4
4
1
Unit cost ()
N/A
8.01
8.07
10.81

D
30,800.0
0
9,075.00
4000.00
7669.32
3000.00
2661.29
57205.6
1
10.40

By looking at the tables above it is clear that total costs and unit
costs calculated using absorption costing differ to the ones
determined by ABC method. Assuming that Acompany Ltd. is
switching from traditional costing to ABC method, the cost of
products A and C turned out to be lower than they were thought to
be, therefore the firm could now bid a lower price to secure orders
and make a possibly higher profit. The firm had priced product D
very accurately, as both costing methods meet at the same unit
cost. However, the ABC method has disclosed that the cost of
product B is actually 0.09 per unit higher than it was thought to be,
which suggests that the product has been spreading its overhead
costs over other more profitable products; therefore it should be repriced, its production method reviewed or considered for
discontinuation.
Although, the absorption costing is an easier approach to product
costing, the information it accumulates is not useful for strategic
planning decisions of the firm. ABC, on the other hand, provides
information that is used to practise activity-based management. For
example, now that the cost of machine set-up has been measured,

the management can look for ways to reduce that expense, or reprice its products in order to sufficiently cover those set-up
expenses that were hidden behind the overall machine-hour
overhead rate while using the absorption costing.
Production costs can be widely influenced by macroeconomic factors
that are out of business control. For example, if the firm is buying its
materials from a local source, the direct material cost is going to be
influenced by the success of the harvest and overall material
demand worldwide. However, if the firm is importing materials from
another country - prices can be influenced by agreements between
those countries. For example, if one country decides to increase
tariffs or restrict exports of certain materials, the overall cost of
materials to the firm is going to increase. On the other hand, costs
of direct materials can be reduced if those countries sign a free
trade agreement like ASEAN China Free Trade Area, which reduced
import tariffs to zero on 7,881 goods traded between 11 member
countries (China.org.cn., 2015). Also, when importing materials, the
costs can be highly influenced by worldwide exchange rates and the
strength of the local currency. Stronger currency means cheaper
materials and vice versa. Chinese economy is a great example of
keeping their currency undervalued to maintain low exchange rates
and increase a worldwide demand for Chinese goods (The Guardian,
2015). Such actions by a supplying country lead to cheaper
materials for the business. Direct labour costs can also be out of the
business control. For example, if the local government decides to
increase the minimum salary payable to employees, the direct cost
of labour is going to increase. A great example is the United
Kingdom, where the minimum wage is being reviewed by the
government each year and is updated every October. During the
past ten years alone the minimum wage per hour has increased by
1.65, which, understandably, has had major implications on direct
labour costs (Gov.uk., 2015). Such government actions can force
businesses to decrease demand for labour by replacing people with
machines or make them relocate in search of cheaper labour. Other
macroeconomic factors that can influence costs can be government
regulations towards business taxes and subsidies, environmental
protection and waste management.
In conclusion, costing is a very important part of the fashion
business and to maximise profits of the business, it is of crucial
importance to choose the right costing method depending on the
needs of the firm. Both absorption and activity-based costing can be
beneficial if used in an adequate manner. While ABC method is more
precise in getting an accurate unit cost and revealing possibilities
for activity-based management, absorption method brings simplicity
to product costing. Costs can also be influenced by outside factors
like government trade policies, minimum wage legislations and
currency exchange rates, which are out of business control. For the

company to stay competitive, it has to manage both direct and

indirect costs well and adapt their business model to stay
competitive within the fast-paced industry of fashion.
References
China.org, (2015). Backgrounder: Upgraded version of ASEAN-China
FTA.
China.org.cn.
Available
at:
http://www.china.org.cn/world/Off_the_Wire/201511/22/content_37128197.htm [Accessed: 16 December, 2015].
Gov.uk, (2015). National Minimum Wage rates. Gov.uk. Available:
https://www.gov.uk/national-minimum-wage-rates [Accessed: 16
December, 2015].
Inman, P., The Guardian, (2015). Why has Chine devalued its currency
and what impact will it have? Theguardian.com. Available:
http://www.theguardian.com/business/2015/aug/11/china-devaluesyuan-against-us-dollar-explainer [Accessed: 16 December, 2015].
Innes, J., Mithchel, F., (1998). A Practical Guide to Activity-based
Costing: Implementation and Operational Issues. 1st edn. London,
UK: Kogan Page Limited.
Jeffrey, M., Evans, N., (2011). Costing for the Fashion Industry. 1 st edn.
Oxford, UK: Berg Publishers.
Shank, J.K., Govindarajan, V., (1988). The Perils of Cost Allocation
Based on Production Volumes. Accounting Horizons, December,
1988, pp. 71-79.