ABSORPTION COSTING

• Kyambadde edward
 Absorption costing

• Is a cost accounting technique that charges both fixed

and variable production costs to cost units.

or
• Is a method of costing in which the costs of an
item (product or service) are built up as
the sum of direct costs and a fair share of
overhead costs, to obtain a full cost or a
fully-absorbed cost
 Key features of absorption costing

• Its recommended by GAAP for external

financial reporting
• All variable and fixed costs are charged to the
product
• Stock of work in progress and finished goods
contain fixed costs
• If stock increases during the period , it will
show gain on a profit
 Advantages of absorption costing
• It recognizes the importance of fixed costs
• Prices are set by reference to fixed costs
• Almost like preparing financial account
 Disadvantages
• It’s not useful in planning, control and
managerial decision making as costs are not
differentiated in to fixed and variable costs
• Ignored the administration, selling and
distribution costs
• Pricing decisions manager has no direct
knowledge of cost volume profit relationship
 over heads Absorption is a means of
attributing overheads to a pdct/service
overheads
• Overheads are another term for indirect costs
• Costs that cannot be allocated directly to cost
units
• Overhead costs are charged to cost centers
Classification of Overhead Costs
By Function
• Production
• non production
 Production Overhead

• Also called manufacturing overhead Includes

costs of:
• Indirect materials, Indirect wages, Indirect
expenses attributable to production.
• A share of production overheads is added to
the product costs
 Steps in involved in absorption
costing of overheads
• Allocation and appropriation of overheads
• Reapportionment of service cost centre
overheads
• Absorption of overheads
Allocation
involves charging overheads directly to specific
cost unit or cost centre.
• collection of costs by type
• allocation of as many costs as possible directly
to cost centers.
 Apportionment

• Procedure whereby indirect costs are spread

fairly between cost centers .if overheads
relate to more than one specific department
then they must be apportioned shared
between these department using and method
known as apportionment.
 re-apportionment of service cost
centre
• overheads to production cost centers.
Products/services pick up overhead costs out
of the production cost centers via overhead
absorption, as production occurs.
 Methods of re-apportionment
Reapportionment: Method 1
• Take each cost and decide how the cost

should be shared by the production

departments

Under this costs are reapportioned only once

 Reapportionment: Method 2
(Reciprocal)
• Service department costs are apportioned

in a way that recognizes the amount of work

done by each service department for other
service departments as well as production
departments
 Absorption

• establishing an absorption rate for each

production cost centre
• absorption of overheads into cost units.
Over heads Absorption rate(OAR)
• For determining the OH to be absorbed by a
cost unit.
• Its calculated using two factors
The over heads attributed to a given cost
center
The number of units of the absorption base
 Formula for OAR
• OAR= total OH of a cost center
total No of units of absorption base
applicable to cost center
Overheads absorption rate can be calculated
on;
Departmental OAR
Blanket/single factory OAR
 Pre-determined OAR
• In most cases OH are pre-determined i.e.
calculated prior to the accounting period,
using estimated or budgeted figures
• Predetermined OAR=
budgeted total OH for cost center
Budgeted total no of units of absorption base
 Under-absorbed and Over-absorbed
Overhead

Under-absorbed Overhead:
If the total amount of overhead costs absorbed
into production costs is less than the actual
overhead expenditure
Over-absorbed Overhead: If the total amount
of overhead costs absorbed into production
costs is more than the actual overhead
expenditure
 Absorption of overheads.
Overheads absorbed =
predetermined OAR x Actual level of activity.
NOTE
• The amount of under absorbed overheads
should be added to the total costs before
profit is calculated
• The amount of over absorbed OH should be
subtracted from total costs
 ILLUSTRATION
• The following relates to X Ltd
Budget Actual
Overheads $280,000 $315,000
Labor hrs worked 40,000 52,800
• Required.
• Determine amount of over or under
absorption.
 SOLUTION
• Predetermined OAR = 280,000
40000
= 7
Over heads absorbed= 7 X 52,800
= 369,600
Over absorbed overheads=369600-280000
= 89,600
 Causes of Under- and Over-
Absorption
• Poor control over overhead spending
• Too much control over overhead
spending
• Poor budgeting of overhead spending
• Operational reasons known only to
production manager
• Poor budgeting of volume of activity