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# Absorption costing

Solution Per-Unit Costs Fixed-overhead per-unit (direct labor + direct materials +variable overhead) + (fixed overhead / number of units) (\$210) + (\$20) Absorption cost per unit: \$230 Absorption Cost Unit Pricing In addition to determining the overall cost of a singular product, absorption cost accounting gives one the ability to determine the appropriate selling price of a unit as well. As long as there is a target profit, the absorption costing method can calculate the appropriate price. For example, Bizzo Company desires a profit of \$180,000 while producing 10,000 products. In addition, each product costs \$150 to produce in total. In order to determine the appropriate selling price, first, profit must be divided by the number of products. That number must be added to the original product cost in order to achieve the correct product price. The solution is worked out below. Solution ((Desired Profit) / (Number of Units)) + (Product Cost Per-Unit) ( \$180,000 / 10,000 ) + ( \$150 ) Target Product Price= \$168 Absorption Costing Formulas (Absorption Cost per-unit) = (Per-Unit Variable Costs) + (Per-Unit Fixed Overhead) Sales Price = (Manufacturing Cost Per-Unit) + (Sales and Administrative Cost Per-Unit) + (Profit Markup)

## An overview of absorption costing

The absorption costing approach charges cost by functions and a function's cost may include both variable and fixed overhead costs. Whereas in marginal costing approach, variable overhead costs are charged to cost units but fixed overhead costs are written-off in full. In a way, we can say the difference between the two is the way fixed costs are treated. Absorption costing \$ Sales Less production cost of sales Opening stock Production less closing stock Gross profit Less non-production costs Net profit xx x x -x xx xx -x xx

## Cost ascertainment using absorption costing

The following is the cost build up format to be followed. Note the separation of overhead costs by function (production and non-production).

Cost Unit Direct materials Direct labor Direct expenses Prime cost Production overhead absorbed Total production cost General overhead Total cost Profit Price

\$ x x x x x x x x x x x x x x Also known as factory or works cost Covers all non-production overheads Maybe margin or mark up

The lessons following this will focus on direct materials and labor. Direct expenses is for non material or labor items that can be identified with a cost unit. E.g. include royalty payments, equipment rentals, etc. For examination purposes, direct expenses in questions are kept brief with short calculations. A lesson will then cover how overheads or indirect costs like utility bills, rentals, insurance are chargeable to a cost unit via overhead absorption. Profit is then calculated as a mark up or margin to arrive at a price. The valuation of the finished goods in the production cost of sales is calculated using the "Total production cost" as shown above.

## Absorption Costing Components

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. It is possible to use activity-based costing (ABC) to allocate overhead costs for inventory valuation purposes under the absorption costing methodology. However, ABC is a timeconsuming and expensive system to implement and maintain, and so is not very costeffective when all you want to do is allocate inventory to be in accordance with GAAP or IFRS.We should charge sales and administrative costs to expense in the period incurred; do not assign them to inventory, since these items are not related to goods produced, but rather to the period in which they were incurred.

## Absorption Costing Steps

The steps required to complete a periodic assignment of costs to produced goods is: 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. 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. 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.