Absorption Costing

TABLE OF CONTENTS

INTRODUCTION 2

COMPONENTS, STEPS 3

MEANING 4

OBJECTIVES 6

USAGE & ABSORPTION RATE 7

ADVANTAGES 11

DISADVANTAGES 13

PRO FORMA 16

BIBLIOGRAPHY 17

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Introduction

Absorption costing means that all of the manufacturing costs are absorbed by
the units produced. In other words, the cost of a finished unit in inventory will
include direct materials, direct labor, and both variable and fixed manufacturing
overhead. As a result, absorption costing is also referred to as full costing or the
full absorption method.

Absorption costing is often contrasted with variable costing or direct costing.

Under variable or direct costing, the fixed manufacturing overhead costs are not
allocated or assigned to (not absorbed by) the products manufactured. Variable
costing is often useful for management's decision-making. However, absorption
costing is required for external financial reporting and for income tax reporting.

It is a method for accumulating the costs associated with a production process

and apportioning them to individual products. This type of costing is required by
the accounting standards to create an inventory valuation that is stated in an
organization's balance sheet.

A product may absorb a broad range of fixed and variable costs. These costs are
not recognized as expenses in the month when an entity pays for them. Instead,
they remain in inventory as an asset until such time as the inventory is sold; at
that point, they are charged to the cost of goods sold.

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Absorption Costing Components

The key costs assigned to products under an absorption costing system are:

Direct materials. Those materials that are included in a finished product.

Direct labor. The factory labor costs required to construct a product.

Variable manufacturing overhead. The costs to operate a manufacturing

facility, which vary with production volume. Examples are supplies and
electricity for production equipment.

Fixed manufacturing overhead. The costs to operate a manufacturing

facility, which do not vary with production volume. Examples are rent and
insurance.

Absorption Costing Steps

The steps required to complete a periodic assignment of costs to produced

goods is:

1. Assign costs to cost pools. This is comprised of a standard set of accounts

that are always included in cost pools, and which should rarely be
changed.
2. Calculate usage. Determine the amount of usage of whatever activity
measure is used to assign overhead costs, such as machine hours or
direct labor hours used.
3. Assign costs. Divide the usage measure into the total costs in the cost
pools to arrive at the allocation rate per unit of activity, and assign
overhead costs to produced goods based on this usage rate.

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MEANING:

A managerial accounting cost method of expensing all costs associated with

manufacturing particular product. Absorption costing uses the total direct costs
and overhead costs associated with manufacturing a product as the cost base.
Generally accepted accounting principles (GAAP) require absorption costing for
external reporting. Absorption costing is also known as full absorption costing.
Some of the direct costs associated with manufacturing a product include
wages for workers physically manufacturing a product, the raw materials used
in producing a product, and all of the overhead costs, such as all utility costs,
used in producing a good. Absorption costing includes anything that is a direct
cost in producing a good as the cost base. This is contrasted with variable
costing, in which fixed manufacturing costs are not absorbed byte product.
Advocates promote absorption costing because fixed manufacturing costs
provide future benefits. It is a costing technique where all normal costs whether
it is variable or fixed costs are charged to cost units produced. Unlike marginal
costing which take the fixed cost as period cost. Absorption costing means that
all of the manufacturing costs are absorbed by the units produced. In other
words, the cost of a finished unit in inventory will include direct materials, direct
labor, and both variable and fixed manufacturing overhead. As a result,
absorption costing is also referred to as full costing or the full absorption
method.

Absorption costing is often contrasted with variable costing or direct costing.

Under variable or direct costing, the fixed manufacturing overhead costs are not
allocated or assigned to (not absorbed by) the products manufactured. Variable

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costing is often useful for managements decision-making. However, absorption

costing is required for external financial reporting and for income tax reporting.
A method of costing a product in which all fixed and variable costs are
apportioned to cost enters where they are accounted for using absorption
rates. This method ensures that all incurred costs are recovered from the selling
price of a good or service. Also called full absorption costing.

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Objective & Components

The objective of absorption costing is to include in the total cost of a product an

appropriate share of the organizations total overheads. Overhead is the cost
incurred in the course of making product, providing a service or running a
department, but which cannot be traced directly and fully to the product,
service or department.

Overheads are actually the total of the following:-

1. Indirect materials

2. Indirect labour

3. Indirect expenses

In cost accounting there are two schools of thoughts as to the correct method
of dealing with overheads:-

1. Absorption costing
2. Marginal costing.

An appropriate share is generally taken to mean an amount which reflects the

amount of time and effort which has gone into producing a unit or completing a
job. The theoretical justification for using absorption costing is that all
production overhead are incurred in production of output so each unit of the
product receives some benefits from these cost. Therefore each unit of output
should be charged with some of the overhead costs.

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Practical reasons for using absorption costing- Inventory valuations

Inventory in hand must be valued for two reasons:-

For the closing inventory figure in the statement of financial position

For the cost of sales figure in the statement of comprehensive income

In absorption costing, closing inventory is valued at fully absorbed factory

costs.

Practical reasons for using absorption costing- Pricing decisions

Many companies attempt to fix selling prices by calculating the full cost of
production or sales of each product, and then adding a margin for profit.

Without using absorption costing, a full cost is difficult to ascertain.

Practical reasons for using absorption costing- Establishing profitability of

different products

If a company sells more than one product, it will be difficult to judge how
profitable each individual product is, unless overhead costs are shared on a fair
basis and charged to the cost of sales of each product

Absorption of overheads

Absorption of overheads is charging of overheads from cost centres to

products or services by means of absorption rates for each cost centre which is
calculated as follows:

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Overhead absorption Rate = total overheads of cost centre

Total quantum of base

The base (denominator) is selected on the basis of type of the cost centre and
its contribution to the products or services, for example, machine hours, labour
hours, quantity produced etc.

Overhead absorption

Overhead absorption is the process whereby overhead costs allocated and

apportioned to production cost centres are added to unit, job or batch costs.

Overhead absorption is sometimes known as overhead recovery

Therefore having allocated and/or apportioned all overheads, the next stage is
to add them to, or absorb them into, cost units

Overheads are usually added to costs units using a predetermined overhead

absorption rate, which is calculated using figures from the budget.

Calculation of overhead absorption rate

Estimate the overhead likely to be incurred during the period

Estimate the activity level for the period

Divide the estimated overhead by the budgeted activity level

Absorb the overhead into the cost unit by applying the calculated absorption
rate

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Choosing the appropriate absorption base:

A percentage of direct materials cost

A percentage of direct labour cost

A percentage of prime cost

A rate per machine hour

A rate per direct labour hour

A rate per unit

A percentage of factory cost (for admin overhead)

A percentage of sales or factory cost (for selling and distribution overhead)

Blanket absorption rate and departmental absorption rate:

A blanket overhead absorption rate is an absorption rate used throughout a

factory and for all jobs and units of output irrespective of the department in
which they are produced

If a separate absorption rate is used for each department, charging of

overheads will be fair and the full cost of production of items will represent the
amount of effort and resources put in making them

Blanket overhead rates are not appropriate in the following circumstances:

- There is more than one department

Jobs do not spend an equal amount of time in each department

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Over and under absorption of overheads:

The rate of overhead absorption is based on estimates (of both numerator

and denominator) and it is quite likely that either one or both of the estimates
will not agree with what actually occurs

Over absorption means that the overheads charged to the cost of sales is
more than the overheads actually incurred.

Under absorption means that insufficient overheads have been included in

the cost of sales

The reasons for over/under absorbed overheads:

The overhead absorption rate is predetermined from budget estimates of

overhead cost and the expected volume of activity.

Over or under recovery of overhead will occur in the following circumstances:-

Actual overhead costs are different from budgeted overhead

The actual activity level is different from the budgeted activity level

Actual overhead costs and actual activity level differ from the budgeted
costs and levels

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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
Absorption costing recognizes fixed costs in product cost. As it is suitable
for determining price of the product. The pricing based on absorption
costing ensures that all costs are covered.
Absorption costing will show correct profit calculation than variable
costing in a situation where production is done to have sales in future (
e.g. seasonal production and seasonal sales)
Absorption costing conforms with accrual and matching accounting
concepts which requires matching costs with revenue for a particular
accounting period
Absorption costing has been recognized for the purpose of preparing
external reports and for stock valuation purposes
Absorption costing avoids the separating of costs into fixed and variable
elements.
The allocation and apportionment of fixed factory overheads to cost
centres makes manager more aware and responsible for the cost and
services provided to others
It identifies the importance of fixed costs involved in production.

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The absorption costing method is accepted by Inland Revenue as stock is

not undervalued
The absorption costing method is always used for preparing financial
accounts
The absorption costing method shows less fluctuation in net profits in
case of constant production but fluctuating sales
Contrasting marginal costing which involves fixed cost changing into
variable cost, it is cost into the stock value thus distorting the stock
valuation
Absorption costing offers an advantage when you do not sell all of your
manufactured products during the accounting period. You may have
finished goods in inventory. Because you assign a per-unit amount for
fixed expenses, each product in inventory has value that includes part of
the fixed overhead. You do not show the expense until you actually sell
the items in inventory. This can improve your profits for the period.

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Disadvantages of Absorption Costing

Absorption costing, also known as full costing is an accounting method that

includes fixed overhead costs in the cost of goods sold by allocating an equal
portion of the overhead cost teach finished unit of inventory. Absorption
costing is the Generally Accepted Accounting Practices, or GAAP, method and
publicly held companies must use this method on their income statements.
While this system has some advantages, particularly for outside analysts, it also
has a number of disadvantages, such as:

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 is not useful for decision making. It considers fixed
manufacturing overhead as product cost which increase the cost of
output. As a result, it does not help in accepting specially offered price for
the product. Various types of managerial problems relating to decision
making can be solved only with the help of variable costing system.
Absorption costing is not helpful in control of cost and planning and
control functions. Its not useful in fixing the responsibility for incurrence
of costs. It is not practical to hold manager accountable for costs over
which he/she has not control.
Some current product costs can be removed from the income statement
by producing for inventory. As such, managers who are evaluated on the

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basis of operating income contemporarily improve profitability by

increasing production
Since absorption costing emphasized on total cost that is to say both
variables as well as fixed, it is not useful for management to use to make
decision, control, and planning.
Besides, since the manager emphasizes on the total cost, the cost volume
profit relationship is ignored. The manager, therefore, needs to use his
intuition for decision-making
Absorption costing can artificially inflate your profit figures in any given
accounting period. Because you will not deduct your entire fixed
overhead if you havent sold all of your manufactured products, your
profit-and-loss statement does not show the full expenses you had for
the period. This can mislead you when you are analysing your
profitability.

Some of the important disadvantages of absorption costing are as follows:

1) Inadequate for Managerial Decision Making

Because absorption costing allocates fixed overhead costs to the unit
level, it makes it appear although additional units produced add overhead
cost, when in fact they are revenue opportunities. If a company makes
100 baseballs per month for a variable cost of $4 and fixed overhead
costs are $100 per month, absorption costing allocates $1 to each
baseball for a total cost of $5 per baseball. If the company has an
opportunity to sell another 10 baseballs at $4.50 each, absorption costing
makes it look as if the company is taking a loss of $.50 each, when in fact
it is making$.50 each because it is not adding fixed cost by producing 10
more units, only variable cost.

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2) Costs Hides in Inventory

Inventory shows as an asset on a companys balance sheet. Since the
company allocates fixed overhead to the finished unit level in absorption
costing, until the company sells a unit, the cost does not show up as an
expense, or Cost of Goods Sold. This means that if a company builds 10,
000 units of a finished good in a period, with $1 fixed overhead allocated
to each unit, and sells only 1,000 of those units, $9,000 of the fixed
overhead incurred in that period will show on the balance sheet as an
asset, rolled into the cost of inventory, instead of as a cost.

3) Unsuitable for Irregular Volume

In theory, if a company using absorption costing produces and sells an
equal, steady amount of units each period, absorption costing will
accurately reflect the true cost of goods sold. However, if production or
sales are irregular, this method of costing will make it appear that fixed
overhead and variable costs fluctuate with sales. In fact, the level of
production or sales does not affect fixed overhead costs, and only the
level of production affects variable costs. For irregular production and
sales patterns, variable costing gives a much clearer picture of the costs
of running the business.

4) Considerations
Absorption costing has its benefits, particularly for external reporting. The
fact that absorption costing combines variable and fixed costs allows a
company to report its profits to shareholders without disclosing too much
detail to competitors. In addition, since the business includes costs as an

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inventory asset on the balance sheet until it sells the inventory, this
method sometimes benefits a slow quarters metrics. The alternative to
absorption costing, known as variable costing, presents costs in a way
that internal decision makers find useful. A well-informed manager will
look at costs using both methods.

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Absorption costing pro-forma

Rs Rs

Sales Revenue xxxxx

Less Absorption Cost of Sales

Opening Stock (Valued @ absorption cost) xxxx

Add Production Cost (Valued @ absorption xxxx

cost)

Total Production Cost xxxx

Less Closing Stock (Valued @ absorption (xxx)

cost)

Absorption Cost of Production xxxx

Add Selling, Admin & Distribution Cost xxxx

Absorption Cost of Sales (xxxx)

Un-Adjusted Profit xxxxx

Fixed Production O/H absorbed xxxx

Fixed Production O/H incurred (xxxx)

(Under)/Over Absorption xxxxx

Adjusted Profit xxxxx

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Bibliography
www.businessdictionary.com

costaccounting.blogspot.com

www.accountingtools.com

ahmadladhani.files.wordpress.com

uombusiness.webs.com

www.investopedia.com

basiccollegeaccounting.com

accountlearning.blogspot.com

smallbusiness.chron.com

mortgageprocess.wordpress.com

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