Absorption Costing

Question 1

What is Absorbtion Costing

Answer 1

Absorption costing is used to determine the full production cost per unit

Question 2

How does Absorbtion Costing work

Answer 2

Direct / Production Costs

With absorption costing, production costs are summarised into a cost card which will identify the production cost per unit. It will include all direct costs such as materials, labour and production overheads. An example of production overheads would be supervisor salaries or rent. The production overheads will be allocated to units via a suitable basis such as labour / machine hours.

Fixed Non Production Overheads

For non production overheads such as admin costs or advertising costs, they are allocated using a predetermined absorption rate. This is calculated by dividing the budgeted overhead expenditure by the budgeted volume.

This then provides us with an Overhead Absorption Rate, which we can allocated to each unit.

The benefits of using a predetermined are:

• It is inconvenient to wait until the end of an accounting period to work out what the absorption rate should be.
• A predetermined rate will be required to accurately price the product
• Overhead costs may vary throughout the year and the OAR smooths variations in the overhead

Using an OAR will lead to over and under absorption of overheads when compared to actual expenditure. The under or over absorption can be calculated by the following formula (Budgeted overhead rate per unit x actual units) – Actual overheads incurred.

Question 3

What are the pros and cons of Absorbtion Costing

Answer 3

Advantages of absorption costing are:

• Fixed production costs can be a large proportion of the total production costs incurred. Unless production overheads are allocated to units, a large proportion of costs would be excluded from the measurement of production costs
• Absorption costing follows the matching concept (accruals concept) by carrying forward a proportion of the production cost in the inventory valuation to be matched against the sales value when the items are sold.
• It is necessary to include fixed production overheads in inventory valuers for financial statements. IAS2 requires inventory to include a share of fixed overheads.
• Analysis of under / over absorbed overheads may be useful for identifying inefficient utilisation of production resources.
• It is quite simple when compared to ABC and is therefore cheap to implement and use.

Disadvantages of absorption costing

• The absorption and apportionment of overheads is arbitrary. This means that the allocation of fixed costs may not be accurate and lead to incorrect pricing decisions
• Profits will vary with changes in production volume. If production levels are increased and the additional output is not sold, the carried forward inventory will include fixed overheads and therefore increase profit. It can encourage managers to over produce in order to inflate profits.