Definition:

Absorption costing is linking all production costs to the cost unit to calculate a full cost per unit of inventories. This costing method treats all production costs as costs of the product regardless of fixed cost or variance cost. It is sometimes called the full costing method because it includes all costs to get a cost unit. Those costs include direct costs, variable overhead costs, and fixed overhead costs.

This article will discuss not only the definition of absorption costing, but we will also discuss the formula, calculation, example, advantages, and disadvantages.

To get a better understanding, we start with the normal selling price method. To get the selling price, we come up with the formula like:

Cost + Profit = Selling Price

And the cost can be determined in many ways such as:

  • Production cost + Non Production Cost = Total Cost
  • Direct Cost + Indirect Cost = Total Cost
  • Prime Cost + Overhead = Total Cost
  • Fixed Cost + Variable Cost = Total Cost
  • Price ( Rate) * Quantity = Total Cost

Now, let see the formula of absorption costing,

Absorption Costing Formula:

In absorption costing,

Unit Costs of Product = Direct Cost + Production Overhead Cost

  • Direct Cost = Direct Material + Direct Labor
  • Production Overhead Cost = Variable Manufacturing Overhead + Fixed Manufacturing Overhead.

Maybe calculating the Production Overhead Cost is the most difficult part of the absorption costing method. The following is the step-by-step calculation and explanation of absorbed overhead in applying to Absorption Costing.

Here is how Absorbed Overhead calculated,

Step in using absorption costing are:

1) Allocation of Variable Manufacturing Overhead

Variable overhead costs directly relating to individual cost centers such as supervision and indirect materials. You need to allocate all of this variable overhead cost to the cost center that is directly involved.

Related article  Life Cycle Costing: Definition, Processes, Example

This is called Variable Manufacturing Overhead. Once you complete the allocation of these costs, you will know where to put these costs in the Income Statements. See reference to the picture below in this article.

2) Apportionment of Fixed Manufacturing Overhead

General or common overhead costs like rent, heating, electricity are incurred as a whole item by the company are called Fixed Manufacturing Overhead.

Therefore they have to be distributed to cost centers on some sharing basic like floor areas, machine hours, number of staff, etc. This is where Absorption Costing starts.

Overhead Absorption is achieved by means of a predetermined overhead abortion rate.

Overhead Absorption Rate = Budgeted Overheads / Budgeted Activity

Then,

Absorbed Overheads = Overhead Absorption Rate * Actual Activities

Fixed Manufacturing Overhead or Absorbed Overheads

In practice, if your costing method is using Absorption Costing, you are expected to have over and under absorption.

Profit or Loss statement under Absorption Costing will be like this:

profit-or-lost-statement-under-absorption-costing

In case you can’t see the picture above:

Net Sales  $XXX
Less Cost of Sales  
   Opening Inventories$XXX 
   Variable Production Cost$XXX 
   Fixed Overhead Absorbed $XXX 
   Less Closing Inventories ($XX) 
Cost of Sales                                                                       ($XXX)
(under)/over absorption                                                   (X)X
Gross Profit                                                                          $XXX
Less administrative Expenses                                         ($XXX)
Profit or (loss)                                                                       $XXX

Advantages:

Absorption costing is normally used in the production industry here it helps the company to calculate the cost of products so that they could better calculate the price as well as control the costs of products.

Related article  LIFO Reserve: Definition, Formula Example, And How Does it Work

As long as the company could correctly and accurately calculate the cost, there is a high chance that the company could make the correct pricing for its products. This is the best competitive advantage for most of the company.

Here are the key advantages of absorption costing that you should know:

  • Absorption costing is the costing method that allows or compliant with most of the accounting standards. These include US GAAP and IFRS. As we all know, we need to make sure that the costing methods that we are using to calculate or measure the unit cost of inventories are per standards. Otherwise, we will have a problem with the valuation of inventories and subsequently affect the audit report’s opinion on our company’s financial statements.
  • Absorption costing recognizes all of the production-related costs incurred in the productions costs. As you might note above, the fixed overhead costs are also included in calculating absorption costing. This helps the company ensure that all of the production-related costs incurred during the productions process are included in the unit cost of inventories.
  • It also disregards the administrative cost when calculating the unit cost so that any cost incurred during the period. Still, it does not relate to production is not included in the calculation. So the company could avoid costing or overpricing its inventories or products.

Disadvantages:

Besides the advantages that we have discussed above, there is also has a certain drawback of absorption costing that we should be aware of. Now, let discuss the key disadvantages of absorption costing:

  • It might not be the best method when it comes to decision-making if the company use absorption costing. As you might see from the above formula, let us explain fixed manufacturing overhead to calculate the cost per unit of inventories. Certain fixed overhead costs like factory rental are still incurred even though there are no productions and the highest rental costs. There is no production in some cases, but the fixed overhead costs are incurred, then the unit cost could be overstated. This leads to over costing of inventories and overpricing of the products.
  • Following the above point, when fixed overhead costs overstate the unit costs of inventory, It might overstate the Inventories amount that records in the balance sheet at the end of the period or year. Then, the significant adjustment might need to be performed to reduce inventories’ value to their net realizable value. The company’s profit might also be overstated by the amount of fixed overhead costs allocated to inventories, but those inventories are still not selling yet.
Related article  4 Best Account Payable Books of All Time - Recommended

Conclusion:

Unit Cost Per Absorption Costing or Full Costing includes:

  • Direct Material
  • Direct Labor
  • Variable Manufacturing Overhead
  • Fixed Manufacturing Overhead

Fixed manufacturing overhead costs are indirect costs and they are absorbed based on the cost driver.

Written by Sinra