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Absorption costing (Full costing)

Absorption costing is 'a method of costing that, in addition to direct costs, assigns all or a proportion of, production
overhead costs to cost units by means of one or a number of overhead absorption rates'.
The objective of absorption costing is to include in the total cost of a product or service an appropriate (fair) share
of the organisation's total overheads. All production overheads are incurred in the production of the organisation's
output and so each unit of the product should be charged with some of the overhead costs.
The practical reasons for using absorption costing:
 Full cost plus pricing (i.e. fix selling price by adding a margin to full cost for profit) can be particularly useful
for companies which do jobbing or contract work.
 Profitability of different products/services can be found if overhead costs are shared on a fair basis and
charged to the cost of sales of each product/service.
In absorption costing, all production costs (whether variable or fixed) are charged to product costs. (Closing
inventories of work in progress or finished goods are valued at full production cost.) Non-production costs are treated
as period costs, and are charged in full to the profit and loss account of the accounting period in which they are incurred.

Total costs

Product cost Period cost

Direct materials Variable non-production overheads

Direct labour Fixed non-production overheads
Direct expenses
Variable production overheads
Fixed production overheads
Overhead absorption
 The total overheads which have been allocated and apportioned to production cost centers must be shared out or
absorbed into the cost units passing through the cost center.
 All overheads are added to (absorbed into) the cost of production or sales.
 Production overheads are added to the prime cost to get factory cost (cost of production). They are therefore
included in the value of inventory of finished goods.

Marginal costing (Variable costing)

Contribution (Contribution margin) = Sales revenue - Variable cost (production and non-production cost)
(Contribution = Sales – Variable production cost of sales – Variable non-production cost)
Marginal costing is 'the accounting system in which variable costs are charged to cost units and fixed costs of the period
are written off in full against the aggregate contribution. Its special value is in recognizing cost behaviour, and hence
assisting in decision-making'.
In marginal costing, only variable production costs are charged to product costs and closing inventories of work in
progress or finished goods are valued at variable production cost. Variable non-production costs are further deducted
to arrive at the contribution margin. Fixed costs (whether production or non-production) are treated as period
cost, and are charged in full to the profit and loss account of the accounting period in which they are incurred.

Total costs

Product cost Period cost

Direct materials (variable) Fixed production overheads

Direct labour (variable) Variable non-production overheads
Direct expenses (variable) Fixed non-production overheads
Variable production overheads
N.B. 1. Contribution = contribution to cover fixed overheads and make a profit
2. Only variable production cost is included in cost of inventories; non-production cost should not be included.

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Example:
Variable production cost = $6 per unit
Variable non-production cost = $1 per unit (sold)
Sales price = $10 per unit
Fixed costs = $45000 (production $40000 and non-production $5000)
Volume of production=20000 units
Solution:
15000 units 20000 units
$ $ $ $
Sales (at $10) 150000 200 000
Less: Variable production cost of sales
Opening inventory 0 0
Variable production cost 120 000 120 000
120 000 120 000
Less: closing inventory
(at variable production cost) 30 000 0
(90 000) (120 000)
60 000 80 000
Less: Variable non-production cost (15 000) (20 000)
CONTRIBUTION MARGIN 45 000 60 000
Less: Fixed costs (45 000) (45 000)
Profit/(loss) 0 15 000
Profit/(loss) per unit $0 $0.75
Total Contribution per unit $3 $3
Conclusions:
1. The profit per unit varies at different levels of sales but the contribution per unit is constant at all levels of
output and sales. Total contribution increases in direct proportion to the volume of sales.
2. Since the contribution per unit does not change, expected profit at any level of output and sales can be found by
calculating the total contribution and then deducting fixed costs.
e.g. expected profit from the sale of 17000 units = 17000x$3 - $45000 = $6000
3. -If total contribution exceeds fixed costs, a profit is made.
-If total contribution equals fixed costs, breakeven point is reached (i.e. no profit and no loss).
-If total contribution is less than fixed costs, there will be a loss.
4. The marginal costing profit varies with sales and costs, not with production level, i.e. when sales increase, profit
increases and when sales decrease, profit decrease. This may not be the case when absorption costing is used.
(Ex. 1: Calculate the absorption costing profit when sales = 20000 units and volume of production = 20000 units;
Ex. 2: Calculate the absorption costing profit when sales =15000 units and volume of production = 25000 units.
Answers on last page)

Absorption costing:
How costs are assigned to a product? (Cost assignment/accumulation)
Production cost (Manufacturing cost) = Direct costs + Indirect costs (Manufacturing overheads only)
Direct costs (direct materials, direct labour, etc.) are assigned to cost objects using cost tracing (i.e. direct tracing).
Indirect costs (manufacturing overheads) are assigned to cost objects using cost allocation/apportionment/absorption.
Overheads (Indirect costs) have to be shared out as fairly as possible over the different cost centres and cost units that
use the particular resource(s) in question. The basis that is used to assign costs to cost objects is called an
allocation/apportionment base or cost driver. Cause-and-effect allocations (i.e. allocation/apportionment bases are
significant determinants of the costs) can provide more accurate assignment of indirect costs than arbitrary allocations.
For decision-making purposes, accurate product costs are required to find out whether the products are profitable or not.
Steps of overhead costs assignment process (in absorption costing):
1. manufacturing overheads are allocated/apportioned to production and service cost centres (departments)
2. costs allocated to service cost centres are apportioned to production cost centers
3. cost centres overheads are absorbed to products or cost objects using separate overhead rates for each production
cost centers

Allocate: to assign directly attributable overheads to specific cost centres (production/service).

(e.g. indirect material is used in department A only and therefore the cost is allocated to department A)
Apportion: to spread overheads that are not directly attributable over two or more cost centres (production/service).
(e.g. factory is shared by all departments and therefore factory rent is apportioned to department A, B, C, etc.)

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Absorb: to attach overheads to products or services on the basis of overhead absorption rate.
(e.g. overheads of department A are absorbed into each unit of product that is produced in that department
based on an absorption rate per direct labour hour)

Overhead allocation/apportionment/assignment
All overhead costs are identified and allocated/apportioned to different cost centres. Manufacturing overheads are
allocated/apportioned to production and/or service cost centres (cost pools). Other non-manufacturing overheads are
charged to administration department and selling and distribution department. The bases for apportioning costs
should reflect, with reasonable accuracy, the benefit obtained by that centre from the cost incurred.
Common bases of apportionment:
Overhead to which the basis applies Basis
Rent and rates, heat and light, depreciation of building Floor area occupied by each cost centre
Depreciation, insurance of plant and machinery Cost or book value of plant and machinery
Production supervisor’s salary Number of employees in each cost centre
Carriage inwards Value of material issues to each cost centre

Overhead absorption (recovery)

The costs accumulated in the cost centres are attached to cost objects using selected absorption base/cost drivers (e.g.
direct labour hours). Overhead absorption rate has to be established for each production cost centre so that
overheads can be absorbed into products passing through that centre. This is called absorption costing (full costing)
as the costs of an item are built up as the sum of direct costs and a fair share of overhead costs to obtain a full cost.

Blanket (plant-wide) vs departmental overhead absorption rate

A blanket overhead rate is a single overhead rate established to assign overheads to cost objects for the organization
as a whole. It is an overhead rate used throughout a factory and for all jobs and units of output irrespective of the
department in which they are produced. Such a rate may not be appropriate because
1. units of output may not spend an equal amount of time in different department;
2. it does not distinguish between running costs of particular departments when absorbing costs into cost objects.
If a single factory overhead rate is used, some products may be over-charged whereas other products may be under-charged.
If departmental absorption rate is used, charging of overheads will be calculated by a separate overhead rate for each
department. Thus the absorption of overheads will be fairer and the full cost of production of items will be more
representative of the cost of the efforts and resources put into making them.

Actual vs predetermined (budgeted) overhead absorption rate

In financial accounting we would wait until the end of the period to calculate the actual overhead costs (actual costing);
in cost accounting, we need to inform customers of prices NOW, so we use budgets (estimates) to show what we think
future costs will be. Overheads are not absorbed on the basis of the actual overheads incurred but on the basis of
estimated or budgeted figures set prior to the beginning of the period. This is called normal costing.
Predetermined overhead absorption rate (P.O.A.R.)

= Budgetedoverhead costs
Budgetedlevel of activity (i.e. labour hours, machine hours, direct costs, etc.)

Overhead absorbed = P.O.A.R. x ACTUAL activity level (e.g. labour hours, machine hours, etc.)

Common bases of overhead absorption/recovery

 Percentage of direct materials cost / direct labour cost / prime cost
 Rate per machine hour / direct labour hour
 Rate per unit
Predetermined overhead absorption rate is used because timely information is required for invoicing, pricing,
cost control and profit calculations. Goods are produced and sold throughout the year, but actual volume and
overheads are not known until the end of the period (i.e. the actual overhead absorption rate (OAR) cannot be
calculated) while predetermined OAR can be calculated prior to the accounting period using estimated or budgeted
figures for overheads and units of the absorption base chosen. Moreover, it is less volatile than the use of the actual
OAR as actual overheads are subjected to seasonal fluctuations.
General rules of selecting the appropriate overhead absorption base:
 A direct labour hour basis is most appropriate in a labour intensive environment.
 A machine hour rate would be used in departments where production is relied on machines (machine intensive).
 Each production center should choose the bases (cost drivers) that reflect the benefit derived from the overhead costs.
Note: The total cost of production overheads is the budgeted amount, no matter what basis of absorption is selected. The
choice of overhead absorption basis will only affect the relative share of overhead costs borne by individual products.

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Over and under absorption (recovery) of overheads

Over- or under-absorbed overhead is 'the difference between overhead incurred and overhead absorbed, using an
estimated rate, in a given period'. Actual overheads incurred are likely to be different from budgeted overheads
because the overhead rate is based on estimates, and/or actual activity level is different from budgeted activity level.
 Over-absorption* means that the overheads charged to the cost of production are greater than the overheads
actually incurred. (Absorbed > Actual)
*occurs when actual activity level is higher than budgeted activity level or/and actual overheads incurred is less
than budgeted overheads
 Under-absorption* means that insufficient overheads have been included in the cost of production.
(Absorbed < Actual)
*occurs when the actual activity level is lower than budgeted activity level or/and actual overheads incurred is
greater than budgeted overheads
 Other things equal:
Over-absorption Under-absorption
Actual overheads incurred < Budgeted overheads Actual overheads incurred > Budgeted overheads
Actual activity level > Budgeted activity level Actual activity level < Budgeted activity level
When there is under/over-absorption of overheads, the absorption costing profit has to be adjusted to reflect the actual profit.
 Under-absorbed overhead is added to cost of goods sold (i.e. profit decreases).
 Over-absorbed overhead is deducted from cost of goods sold (i.e. profit increases).

N.B. Inventory is NOT adjusted for over- or under-absorption of overheads.

Non-manufacturing overheads
 In financial accounting, only manufacturing costs are allocated to products. Non-manufacturing overheads are
regarded as period costs. For decision-making, non-manufacturing costs should be assigned to products.
e.g. A product may require a significant amount of sales support and administrative costs. If management wants to
determine the profitability of that product, it is necessary to assign non-manufacturing costs to the products to make
sure that the selling price is large enough to cover all the costs and expenses.
 Some non-manufacturing costs may be a direct cost of the product (e.g. delivery and advertising expense for a
particular product). We should select an allocation base or cost driver that corresponds most closely to non-
manufacturing overheads that cannot be allocated directly to the products.

Marginal costing vs absorption costing

In marginal costing (variable costing)
 Closing inventories are valued at marginal (variable) production cost.
 Contribution is arrived at after deducting all (production and non-production) variable costs from sales revenue.
 Fixed costs are charged in full against the profit of the period in which they are incurred.
In absorption costing (full costing)
 Closing inventories are valued at full production cost, and include a share of fixed production costs (absorbed).
 Cost of sales in a period will include some fixed overhead incurred in a previous period (in opening inventory
values) and will exclude some fixed overhead incurred in the current period but carried forward in closing
inventory values as a charge to a subsequent period.

Using absorption costing: Using marginal costing:

To find production cost: To find production cost:
$ $
Direct materials X Direct materials (variable) X
Direct labour X Direct labour (variable) X
Direct expenses X Direct expenses (variable) X
Production overhead absorbed X Variable production overhead X
(Fixed and variable) Production cost X
Production cost X
To find net profit:
To find net profit: Sales X
Sales X Less: Variable production cost X
Less: Production cost X X
Gross profit X Less: Variable non-production cost X
Less: Non-production cost X Contribution margin X
Net profit X Less: Fixed production cost X
Fixed non-production cost X
Net profit X

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Example:
Activity level 50% 100%
Sales and production (units) 400 800
$ $
Sales 8 000 16 000
Production costs: variable 3 200 6 400
fixed 1 600 1 600
Selling and distribution costs:
Semi-variable 4 000 5 600
The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout the year, and actual
fixed costs are the same as budgeted. There is no opening inventory. In the first quarter, 220 units were produced
and 160 units were sold.
Solutions:
Using high-low method, variable selling and distribution cost per unit = (5600 – 4000)/(800 - 400) = $4
Total variable selling and distribution cost = $4 x 800 = $3 200
Total fixed selling and distribution cost = $5600 – $3 200 = $2 400
Using absorption costing, fixed production costs absorbed:
Absorption rate = Budgeted fixed production costs/Budgeted output (normal level of activity)
= $1600/800 = $2 per unit produced
Fixed production costs absorbed = 220 units x $2 = $440
Actual fixed production overhead ($1600/4) $400
Absorbed fixed production overhead $440
Over absorption of overhead $ 40

Profit for the quarter, using absorption costing

Profit for the quarter, using marginal costing
$ $
$ $
Sales (160 x $20) 3 200
Sales (160 x $20) 3 200
Production costs
Variable production costs
Variable (220x$8) 1 760
(220x$8) 1 760
Fixed (absorbed overhead
Less: closing inventory (60x$8) 480
(220x$2)) 440
Variable production cost of sales (1 280)
2 200
1920
Less: closing inventory (60x$10) 600
Variable selling and distribution
Production cost of sales 1 600
costs (160x$4) (640)
Adjustment for over-absorbed
overhead (40) Contribution margin 1 280
Less:
Total production costs (1 560)
Fixed production costs incurred 400
Gross profit 1 640
Fixed selling & distribution
Less: Selling & distribution costs
costs ($2400/4) 600 (1 000)
Variable (160x$4) 640
Net profit 280
Fixed ($2400/4) 600 (1 240)
Net profit 400

The difference in profit is due to the different valuation of closing inventory. In absorption costing, the 60 units of
closing inventory include absorbed fixed overheads of $120 (60x$2), which are costs carried over to the next quarter and
not charged against the profit of the current period. In marginal costing, all fixed costs incurred in the period are charged
against profit.
Reconciliation of profit: Absorption costing profit $400
Fixed production costs carried forward in closing inventory values ($120)
Marginal costing profit $280
N.B. The difference in profit has nothing to do with over/under-absorption of fixed overheads. There is no need to
make any adjustment even though predetermined absorption rate is used in inventory valuation.
How about if there is opening inventory and/or closing inventory?
Comparison on impacts of inventory on net profit
Inventory Impact on profit
Fixed production overheads in opening and closing No difference in profit between absorption
inventories are of same amount costing and marginal costing
(when production volume = sales volume)
Fixed production overheads in closing inventory is greater Profit under absorption costing will be higher
than that in opening inventory than that under marginal costing
(when production volume > sales volume)
Fixed production overheads in closing inventory is smaller Profit under absorption costing will be lower than
than that in opening inventory that under marginal costing
(when production volume < sales volume)

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N.B. Even if production volume is equal to the sales volume, it does not necessarily mean that the profits under
marginal costing and absorption costing are the same. It all depends on how much fixed production overhead is
absorbed in a single unit of opening and closing inventory respectively.
If we assume fixed production overhead absorbed per unit is the same for previous and current year, we may draw
the following conclusions:
If the opening and closing inventory are the same (i.e. production = sales), marginal costing and absorption costing
will give the same profit figure. Otherwise the two costing methods give different results for profit.
 If inventories levels increase (i.e. production > sales), some fixed overheads will be carried forward in
inventory to be matched against the sales revenues of future periods and therefore absorption costing will
report a higher profit.
 If inventories levels decrease (i.e. production < sales), some fixed overheads will be released from
inventory and charged against sales for the period and therefore absorption costing will report a lower
profit.
In the long run, both costing methods will give the same profit because total costs will be the same.

Advantages of absorption costing

 It is consistent with the matching concept in which fixed and variable production costs of sales are matched with
the sales revenue.
 Closing inventory values include a share of fixed production overhead and this is in accordance with financial
accounting standard on valuation of inventory.
 It facilitates cost-plus pricing strategy. In the long run for survival and profitability, prices must cover fixed
costs.
 Analysing under/over absorption of overheads is a useful exercise in controlling costs of an organization.

Disadvantages of absorption costing

 Reported profits can be manipulated by adjusting inventory level in the short run. For example, profit can be
increased by building up inventories (i.e. an increase in production) at the year end and therefore absorption
costing is not a good measure of manager’s performance.
 Absorption of production fixed overheads to product units by means of overhead absorption rate can sometimes
be arbitrary.

Advantages of marginal costing

 It facilitates various short-term decisions making, e,g. breakeven analysis, because variable costs are separated from
fixed costs.
 Marginal costing is a function of sales only and so profit manipulation is impossible.
 It is simple to operate because there is no apportionment of fixed costs and no adjustment of under or over
absorption of overheads.

Disadvantages of marginal costing

 Segregation of production overheads into fixed and variable elements can sometimes be difficult and
impracticable.
 It gives the wrong impression that fixed production overheads have no relationship with the production because it is
excluded from product costs.
Suggested answer to Ex.:
Using absorption costing 15000 units 20000 units
$ $ $ $
Sales (at $10) 150 000 200 000
Less: Cost of sales
Opening inventory 0 0
Production cost ($6x25000+40000) 190 000 160 000
190 000 160 000
Less: closing inventory (10/25)
(at full production cost) 76 000 0
(114 000) (160 000)
Gross profit 36 000 40 000
Less: Variable non-production cost (15 000) (20 000)
Fixed non-production costs (5 000) (5 000)
Profit/(loss) 16 000 15 000
Notes:
1. When sales = production (here = 20000 units), marginal costing and absorption costing will give the same profit figure.
2. Under absorption costing, profit may increase by raising level of production even though sales decrease.