What Is Activity-Based Costing (ABC)?

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

How Activity-Based Costing (ABC) Works

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.

This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. 

The formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity. 

The ABC calculation is as follows:  

1. Identify all the activities required to create the product. 
2. Divide the activities into cost pools, which includes all the individual costs related to an activity—such as manufacturing. Calculate the total overhead of each cost pool.
3. Assign each cost pool activity cost drivers, such as hours or units. 
4. Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers. 
5. Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate. 
6. Multiply the cost driver rate by the number of cost drivers. 

As an activity-based costing example, consider Company ABC that has a $50,000 per year electricity bill. The number of labor hours has a direct impact on the electric bill. For the year, there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ, the company uses electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.

Requirements for Activity-Based Costing (ABC)

The ABC system of cost accounting is based on activities, which are any events, units of work, or tasks with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. Activities consume overhead resources and are considered cost objects.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders.

There are two categories of activity measures: transaction drivers, which involves counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count, such as machine hours and/or direct labor hours to allocate indirect or overhead costs to products, the ABC system classifies five broad levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.

Benefits of Activity-Based Costing (ABC)

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. 

Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures, such as machine hours or direct labor costs. 

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation, utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

What Is a 5/1 Hybrid Adjustable-Rate Mortgage (5/1 ARM)?

A 5/1 hybrid adjustable-rate mortgage (5/1 ARM) begins with an initial five-year fixed interest rate period, followed by a rate that adjusts on an annual basis. The “5” in the term refers to the number of years with a fixed rate, and the “1” refers to how often the rate adjusts after that (once per year). As such, monthly payments can go up—sometimes dramatically—after five years.

How a Hybrid Adjustable-Rate Mortgage (Such as a 5/1 Hybrid ARM) Works

The 5/1 hybrid ARM may be the most popular type of adjustable-rate mortgage, but it’s not the only option. There are 3/1, 7/1, and 10/1 ARMs as well. These loans offer an introductory fixed rate for three, seven, or 10 years, respectively, after which they adjust annually.

Also known as a five-year fixed-period ARM or a five-year ARM, this mortgage features an interest rate that adjusts according to an index plus a margin. Hybrid ARMs are very popular with consumers, as they may feature an initial interest rate significantly lower than a traditional fixed-rate mortgage. Most lenders offer at least one version of such hybrid ARMs; of these loans, the 5/1 hybrid ARM is especially popular.

Other ARM structures exist, such as the 5/5 and 5/6 ARMs, which also feature a five-year introductory period followed by a rate adjustment every five years or every six months, respectively. Notably, 15/15 ARMs adjust once after 15 years and then remain fixed for the remainder of the loan. Less common are 2/28 and 3/27 ARMs. With the former, the fixed interest rate applies for only the first two years, followed by 28 years of adjustable rates; with the latter, the fixed rate is for three years, with adjustments in each of the following 27 years. Some of these loans adjust every six months rather than annually.

Example of a 5/1 Hybrid ARM

Interest rates change based on their marginal rates when ARMs adjust along with the indexes to which they’re tied. If a 5/1 hybrid ARM has a 3% margin and the index is 3%, then it adjusts to 6%.

But the extent to which the fully indexed interest rate on a 5/1 hybrid ARM can adjust is often limited by an interest rate cap structure. The fully indexed interest rate can be tied to several different indexes, and while this number varies, the margin is fixed for the life of the loan.

A borrower can save a significant sum on their monthly payments with a 5/1 hybrid ARM. Assuming a home purchase price of $300,000 with a 20% down payment ($60,000), a borrower with very good/excellent credit can save 50 to 150 basis points on a loan and more than $100 per month in payments on their $240,000 loan. Of course, that rate could rise, so borrowers should anticipate a rise in their monthly payment, be prepared to sell their home when their rate goes up, or be ready to refinance.

Advantages and Disadvantages of a 5/1 Hybrid ARM

In most cases, ARMs offer lower introductory rates than traditional mortgages with fixed interest rates. These loans can be ideal for buyers who plan to live in their homes for only a short period of time and sell before the end of the introductory period. The 5/1 hybrid ARM also works well for buyers who plan to refinance before the introductory rate expires. That said, hybrid ARMs like the 5/1 tend to have a higher interest rate than standard ARMs.

There’s also a chance that the interest rate might decrease, lowering the borrower’s monthly payments when it adjusts. But in many cases, the rate will rise, increasing the borrower’s monthly payments.

If a borrower takes out an ARM with the intention of getting out of the mortgage by selling or refinancing before the rate resets, then personal finances or market forces might trap them in the loan, potentially subjecting them to a rate hike that they can’t afford. Consumers considering an ARM should educate themselves on how they work.

5/1 Hybrid ARM vs. Fixed-Rate Mortgage

A 5/1 hybrid ARM may be a good mortgage option for some homebuyers. But for others, a fixed-rate mortgage may be more appropriate. A fixed-rate mortgage has one set interest rate for the life of the loan. The rate is not tied to an underlying benchmark or index rate and doesn’t change; the interest rate charged on the first payment is the same interest that applies to the final payment.

A fixed-rate mortgage could yield advantages for a certain type of homebuyer. If you’re interested in predictability and stability with mortgage rates, for example, then you might lean toward a fixed-rate loan instead of a 5/1 hybrid ARM. Comparing them side by side can make it easier to decide on a mortgage option.

What Is Absorption Costing?

Absorption costing, sometimes called “full costing,” is a managerial accounting method for capturing all costs associated with manufacturing a particular product. All direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for when using this method.

Under generally accepted accounting principles (GAAP), U.S. companies may use absorption costing for external reporting, however variable costing is disallowed.

Understanding Absorption Costing

Absorption costing includes anything that is a direct cost in producing a good in its cost base. Absorption costing also includes fixed overhead charges as part of the product costs. Some of the costs associated with manufacturing a product include wages for employees physically working on the product, the raw materials used in producing the product, and all of the overhead costs (such as all utility costs) used in production.

In contrast to the variable costing method, every expense is allocated to manufactured products, whether or not they are sold by the end of the period.

Components of Absorption Costing

The components of absorption costing include both direct costs and indirect costs. Direct costs are those costs that can be directly traced to a specific product or service. These costs include raw materials, labor, and any other direct expenses that are incurred in the production process.

Indirect costs are those costs that cannot be directly traced to a specific product or service. These costs are also known as overhead expenses and include things like utilities, rent, and insurance. Indirect costs are typically allocated to products or services based on some measure of activity, such as the number of units produced or the number of direct labor hours required to produce the product.

In absorption costing, both direct and indirect costs are included in the cost of a product. This means that the cost of each unit of a product includes not only the direct costs of producing that unit, but also a portion of the indirect costs that were incurred in the production process. The total manufacturing costs are then divided by the number of units produced to determine the cost of each unit. The formula for absorption costing can be written as follows:

Absorption cost = (Direct labor costs + Direct material costs + Variable manufacturing overhead costs + Fixed manufacturing overhead) / Number of units produced.

Absorption Costing vs. Variable Costing

Absorption costing and variable costing are two different methods of costing that are used to calculate the cost of a product or service. While both methods are used to calculate the cost of a product, they differ in the types of costs that are included and the purposes for which they are used. The differences between absorption costing and variable costing lie in how fixed overhead costs are treated.

Under absorption costing, all manufacturing costs, both direct and indirect, are included in the cost of a product. This means that the cost of each unit of a product includes not only the direct costs of producing that unit, such as raw materials and labor, but also a portion of the indirect costs that were incurred in the production process, such as overhead expenses. Absorption costing is typically used for external reporting purposes, such as calculating the cost of goods sold for financial statements.

Variable costing, on the other hand, only includes direct costs in the cost of a product. Indirect costs, or overhead expenses, are not included in the cost of the product under variable costing. Instead, they are treated as a period expense and are recorded in the income statement in the period in which they are incurred. Variable costing is typically used for management decision-making and planning purposes, as it provides a more accurate representation of the incremental costs associated with producing an additional unit of a product.

Variable costing does not determine a per-unit cost of fixed overheads, while absorption costing does. Variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income on the income statement. Absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.

Advantages and Disadvantages of Absorption Costing

Assets, such as inventory, remain on the entity’s balance sheet at the end of the period. Because absorption costing allocates fixed overhead costs to both cost of goods sold and inventory, the costs associated with items still in ending inventory will not be captured in the expenses on the current period’s income statement. Absorption costing reflects more fixed costs attributable to ending inventory.

Absorption costing ensures more accurate accounting for ending inventory because the expenses associated with that inventory are linked to the full cost of the inventory still on hand. In addition, more expenses are accounted for in unsold products, which reduces actual expenses reported in the current period on the income statement. This results in a higher net income calculation compared with variable costing calculations.

Because absorption costing includes fixed overhead costs in the cost of its products, it is unfavorable compared with variable costing when management is making internal incremental pricing decisions. This is because variable costing will only include the extra costs of producing the next incremental unit of a product.

In addition, the use of absorption costing generates a situation in which simply manufacturing more items that go unsold by the end of the period will increase net income. Because fixed costs are spread across all units manufactured, the unit fixed cost will decrease as more items are produced. Therefore, as production increases, net income naturally rises, because the fixed-cost portion of the cost of goods sold will decrease.

Example of Absorption Costing

Assume that ABC Company makes widgets. In January, it makes 10,000 widgets, of which 8,000 are sold by the end of the month, leaving 2,000 still in inventory. Each widget uses $5 of labor and materials directly attributable to the item. In addition, there are $20,000 of fixed overhead costs each month associated with the production facility. Under the absorption costing method, ABC will assign an additional $2 to each widget for fixed overhead costs ($20,000 total ÷ 10,000 widgets produced in the month).

The absorption cost per unit is $7 ($5 labor and materials + $2 fixed overhead costs). As 8,000 widgets were sold, the total cost of goods sold is $56,000 ($7 total cost per unit × 8,000 widgets sold). The ending inventory will include $14,000 worth of widgets ($7 total cost per unit × 2,000 widgets still in ending inventory).

The Bottom Line

Absorption costing is a method of costing that includes all manufacturing costs, both fixed and variable, in the cost of a product. It is also known as full costing or full absorption costing. Absorption costing is used to determine the cost of goods sold and ending inventory balances on the income statement and balance sheet, respectively. It is also used to calculate the profit margin on each unit of product and to determine the selling price of the product.

Under absorption costing, the fixed manufacturing overhead costs are included in the cost of a product as an indirect cost. These costs are not directly traceable to a specific product but are incurred in the process of manufacturing the product. The fixed manufacturing overhead costs are allocated to each unit of product based on a predetermined overhead allocation rate, which is calculated by dividing the total estimated fixed manufacturing overhead costs by the total number of units that are expected to be produced. In addition to the fixed manufacturing overhead costs, absorption costing also includes the variable manufacturing costs in the cost of a product. These costs are directly traceable to a specific product and include direct materials, direct labor, and variable overhead.