Absorption Costing technique is also termed as Traditional or Full Cost Method.

According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labour, etc. are directly charged to the products, while the fixed costs are apportioned on a suitable basis over different products manufactured during a period. Thus, in case of Absorption Costing all costs are identified with the manufactured products.

Absorption costing principles In product/service costing, an absorption costing system allocates or apportions a share of all costs incurred by a business to each of its products/services. In this way, it can be established whether, in the long run, each product/service makes a profit. This can only be a guide. Arbitrary assumptions have to be made about the apportionment of many of the costs which, given that some costs will tend to remain fixed during a period, will also be dependent on the level of activity. An absorption costing system traditionally classifies costs by function. Sales less production costs (of sales) measures the gross profit (manufacturing profit) earned. Gross profit less costs incurred in other business functions establishes the net profit (operating profit) earned. Using an absorption costing system, the profit reported for a manufacturing business for a period will be influenced by the level of production as well as by the level of sales. This is because of the absorption of fixed manufacturing overheads into the value of work-inprogress and finished goods stocks. If stocks remain at the end of an accounting period, then the fixed manufacturing overhead costs included within the stock valuation will be transferred to the following period. Absorption costing profit statement The first stage in the preparation of absorption costing profit statements is the measurement of the gross profit (manufacturing profit) earned. This requires the calculation of unit production costs, including the establishment of absorption rates for manufacturing overheads. Referring to the example being used for illustration in this article (see earlier), variable manufacturing costs per units are given in the question (at 6.40 per unit). Fixed manufacturing overheads of 92,000 per period are to be absorbed at a unit rate (based on normal production activity of 20,000 units per period). The fixed manufacturing overhead absorption rate is therefore 4.60 per unit (92,000 20,000 units) giving a total manufacturing cost of 11.00 per unit (6.40 + 4.60). The use of normal activity as the basis for overhead absorption is similar to the use of budgeted activity. It is to be expected that actual activity (and indeed actual expenditure also) will be different to normal/budget thus giving rise to overhead over or under absorption. It is important that this is highlighted in profit statements. The use of normal (or budgeted) activity and expenditure to establish the absorption rate not only helps to focus attention on overhead recovery but also has the effect of normalising per unit product/service costs. Advantages of Absorption Costing:

It recognizes the importance of fixed costs in production;

This method is accepted by Inland Revenue as stock is not undervalued; This method is always used to prepare financial accounts; When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit and Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation.

Disadvantages of Absorption Costing:

As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control;

As the managers emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision.

ABSORPTION COSTING PRO-FORMA

Sales Revenue( 2nd) Less Absorption Cost of Sales(no) Opening Stock (Valued @ absorption cost)(1st) Add Production Cost (Valued @ absorption cost) (1st) Total Production Cost(1st) Less Closing Stock (Valued @ absorption cost) (1st) Absorption Cost of Production(1st) Add Selling, Admin & Distribution Cost(1st) Absorption Cost of Sales( 2nd) Un-Adjusted Profit( 2nd) Fixed Production O/H absorbed(1st) Fixed Production O/H incurred(1st) (Under)/Over Absorption( 2nd) Adjusted Profit( 2nd)

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