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Absorption costing

Meaning and definition of Absorption Costing 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 managements decision-making. However, absorption costing is required for external financial reporting and for income tax reporting. Absorption costing is a method that charges all costs to products. Under this approach product/service is charged with prime cost and all overheads. Overheads are of two types fixed and variable. Overheads may be linked to product or they may be fixed in nature within a capacity range. in absorption costing this distinction is ignored. Overheads are analysed and charged to product/service on a suitable basis. This absorption costing is an all-cost approach. Absorption costing, also known as full absorption costing, can be defined as a managerial accounting cost method of expensing all costs related to manufacturing of a specific product. The absorption costing method involves the use of total direct costs and overhead costs related to the manufacturing of a product as the cost base. Besides, absorption costing is also required by the Generally Accepted Accounting Principles (GAAP). As presented by Investopedia, some of the direct costs related to manufacturing a product consist of wages for workers involved physically in manufacturing a product, the raw materials involved in production, as well as the overhead costs, like utility costs. Moreover, absorption costing counts anything that is a direct cost in production of goods. Besides, absorption costing is promoted by the advocates for the future benefits provided. Absorption costing is, therefore, different from the other costing methods as it takes into account fixed manufacturing overhead (counting expenses like factory rent, utilities, amortization). It is, moreover, difficult to factor in the fixed manufacturing overhead expenses into computing the per unit price of goods, which are not accounted for by other methods like Variable costing.

Absorption costing is a costing technique in which all of the costs associated with the production of a good or service are accounted for. This is in contrast with variable costing, which only includes certain types of associated costs. Absorption costing is also known as full costing or full absorption costing, and it is used in a variety of ways by companies which wish to create a complete picture of their financial situation, including in the calculation of taxes and sales reports. With absorption costing, the variable manufacturing costs, being raw materials and labor, are only one part of the cost. This technique also considers variable and fixed overhead to be part of the overall cost of the product or service being offered. To put it bluntly: if making awidget requires X in raw materials and Y in labor, the widget couldn't be made without the overhead necessitated by the widget factory in which is it made, which is where absorption costing comes into play. One way in which absorption costing can be helpful is when a company wants to make sure that a retail price accurately reflects the costs involved in the production of a good. This can be especially critical with small companies which lack financial reserves, and therefore cannot afford to take a loss or to sell products without accounting for overhead. For example, a garment manufacturer might think not just about the cost of wool and labor for making a sweater, but also the costs of knitting machines, the factory where the machines are installed, the cost of running the machines, insurance, and other types of overhead costs. In our widget example about, absorption costing would require the company to determine overall fixed and variable overhead, and to figure out how much overhead was involved in the production of a particular widget. The absorption costing would include this number along with X and Y. The more widgets a factory can make, the lower the perwidget cost becomes, in terms of overhead, and if the company also starts making gadgets and doo-dads, it can distribute the cost of overhead even further, cutting down on the costs associated with the production of its products. . When people start throwing costing numbers around, it is important to determine which costing method was used, and to make sure that the method use remains consistent throughout a report, unless there is a good reason for changing methods. Clever manipulation of costs can be accomplished by changing costing methods, creating misleading information which may confuse people.

Definition of 'Absorption Costing' A managerial accounting cost method of expensing all costs associated with manufacturing a 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. Absorption costing is a method for accumulating fixed and variable costs associated with the production process and apportioning them to individual products. Thus, a product may absorb a broad range of 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 cost of goods sold. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) require that an entity use absorption costing to record the value of inventory in its financial statements. Example For absorption costing, Products A and B have to bear share of fixed cost over and above their respective direct cost. For allocation of fixed overheads you need to choose appropriate bases. Overheads Base A Fixed Production overhead Production hours 2000 Admn. overheads Time spent ratio 3 S & D OH Time spent ratio 1 Accordingly share of overhead of product A & B are as follows. A B $ $ Direct Cost 1,05,000 1,09,000 Fixed production overheads (1:1) 15,000 15,000 Fixed Admn OH (3:2) 24,000 16,000 Fixed S & D OH (1:1) 10,000 10,000 Total 1,54,000 1,50,000 Cost per unit (absorption costing method) 154 75 Cost pr unit (direct costing method) 105 54.50 B 2000 2 1

What is the formula of absorption costing? It involves 3 principle stages. Firstly the overheads (the indirect costs) are allocated or apportioned to all production departments (or profit centres) and to all service departments using logical bases for doing so. The overheads allocated or apportioned to the service departments are then re-apportioned to the production departments (or profit centres). The total cost of the overheads should now all be in the production departments or profit centres. These totals are then divided by a factor such as the budgeted direct labour hours or machine hours to obtain an overhead absorption rate of x per direct labour hour of machine hour as appropriate. Overheads can then be charged to each unit produced depending upon the number of labour hours or machine hours used to make the product. The process is normally all based on budgeted overhead costs and budgeted production levels. There are plenty of examples and more detailed explanation on the internet Absorption Cost Accounting Absorption cost accounting (also known as the Cost-Plus approach), is a method that is centered upon the allocation of Manufacturing Costto the product. This method is important for situations when a company needs to decide if it can be competitive in a market, or when the company has control over the pricing in general. This means that Direct Labor, Direct Materials, as well as fixed and variable Overhead are all absorbed into product pricing as well as product costing. Absorption Cost Per Unit Because absorption cost accounting is a per-unit method, it is necessary to understand how to determine the absorption cost per unit. So the fair question remains: What is the absorption cost approach? Ultimately, as you will see, all of the calculations are done on a Per-Unit basis. For example, Wintax Company creates 5,000 products with Variable Cost per unit being $60 direct materials, $110 direct labor, and $40 variable overhead. In addition to the per-unit costs, the fixed overhead is $100,000. In order to obtain the product cost under absorption costing, first the per-unit costs are added together (direct labor, direct materials, variable overhead). After that, per-unit costs need to be obtained from the fixed overhead so that the per-unit overhead can be applied to the per-unit cost. Adding the overhead to the per-unit costs completes what is absorption costing per unit. The problem is worked out below

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.

Advantages and disadvantages of Absorption Costing


Advantages The key advantages of absorption costing include: It identifies the importance of fixed costs involved in production. 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. It recognizes the importance of fixed costs in production; is method is accepted by Inland Revenue as stock is not undervalued;

Absorption is method is always used to prepare financial accounts; Absorption When production remains constant but sales fluctuate absorption costing will show less fluctuation in net profit This method recognizes the importance of fixed costs. Selling price per unit according to absorption costing looks more logical. It helps in correct estimation of profits. This method is simple to understand and apply as no distinction is to be made between fixed and variable costs. This method confirms the matching principle of accountancy under which the costs of a particular period are matched with the revenue of that period. It enables to compare the results of the business and thus calculate deviation from planned level. It discloses the under or over utilization of capacity.

Disadvantages
The main drawbacks of Absorption Costing include: Since absorption costing emphasized on total cost that is to say both variable 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. Inadequate for Managerial Decision Making Because absorption costing allocates fixed overhead costs to the unit level, it makes it appear as though 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. 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 Costs Hide in Inventory Inventory shows as an asset on a company's 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

Why does the company need either absorption costing or ABC?


Its very important for managers to have an idea of the actual cost of processes, departments, operations or product which is the foundation of their budget. and in order to achieve that they need to have a cost accounting system; such as absorption coting or activity based costing. Here are the advantages of having such systems and their disadvantages The advantages of Absorption Costing: It recognizes the importance of fixed costs in production; is method is accepted by Inland Revenue as stock is not undervalued; is 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 The 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. The advantages of Activity Based Costing: More accurate costing of products/services, customers, SKUs, distribution channels. Better understanding overhead. Easier to understand for everyone. Utilizes unit cost rather than just total cost. Integrates well with Six Sigma and other continuous improvement programs. Makes visible waste and non-value added activities. Supports performance management and scorecards Enables costing of processes, supply chains, and value streams Activity Based Costing mirrors way work is done Facilitates benchmarking The disadvantages of activity based costing: It costs a lot to maintain it, it takes a lot of time and resources to collect, check and enter it into the system for the date needed to measure activity based costing. Is not accepted by GAAP (accepted accounting principles) therefor companies need to have a different system when preparing external reports.