What is absorption costing? (Step by Step guide)

Definition:

Absorption costing is the process of linking all production costs to the cost unit to prepare a full cost per unit. This costing method treats all types of 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 types of cost to get a cost unit.

Those costs include direct costs, variable overhead costs, and fixed overhead costs.

To get a better understanding, we start with the normal selling price method. To get selling price we simply 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 in absorption costing method, and the following is the step by step calculation and explanation of absorbed overhead in applying to Absorption Costing.

Here is how Absorbed Overhead calculated,

Related: Activities Based Costing ( Step by Step)

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 directly involved.

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.

Related:  Predetermined Overhead Rate

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 bases like floor areas, machine hours, number of staff, etc. This is where Absorption Costing starts.

Overhead Absorption is achieved by mean 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)

$XXX

Cost of Sales                                                                      ($XXX)

$XXX

(under)/over absorption                                                 (X)X

Gross Profit                                                                        $XXX

Less Administrative Expenses                                       ($XXX)

Profit or Loss                                                                      $XXX

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

Just In Time: History | Objective | Productions | Purchasing | Example | Manufacturing | Inventories

History of Just In Time (JIT):

Just In Time or sometimes called TOYOTA Manufacturing Production System, it is part of the Lean Manufacturing Production System. There is the long story before becoming the Just – In – Time that we know today.

The Just In Time concept was first initiated by Eli Whitney, in 1799 who has a large contract with U.S. Army at the lowest cost to Frederick W. Taylor, who studies the time manufacturing and the standard of works of manufacturing in the late of 1890s.

In the 1910s, Henry Ford first introduced the new Model T automobile system in The Ford System or Just In Time.

Henry Ford who is said by many as the one whose first implement the Just-In-time System.

Then, not remember the year, Toyota and Ford first were incorporate by  Taichi Ohno, and then Just-In-time System was first introduced in the Toyota System Production System since that time.

The objective of Just In Time (JIT):

Just In Time is the manufacturing production system and its main objectives are listed below:

  • No inventories are stored: so one of just in time objectives is to reduce or eliminate the storage of inventories. In the old manufacturing production system, the raw material is purchased, products or goods are produced, and stores. This concept costs a lot of money to store not only raw material but also store finish goods. Also, the production process is quite slow as the company might not seeking a new way to improve the process. Therefore, JIT tries to overcome this problem. The productions are processed only if there are orders from customers.
  • No material is purchase: In implementing the JIT, the material is not going to purchase if there are no productions. Not like the old system, the raw material is purchase as the result of production forecasting demand and production. The company old the old system normally has the low networking with suppliers and most of the raw material required during the years are purchased in advance and spend a lot of money and space on storing the raw material and taking care of them. Just In Time System is trying to overcome this by making sure that there is a goods relationship with the supplier and the raw materials are purchased only if there is production. However, this meet this objective, the company that implements Just In time need to build the perfect relationship with its suppliers or, in order words, suppliers could access to the company system to understand about the demand. Otherwise, suppliers might not be able to supplies the raw material on time and as required. This is the warning point for the company that wishes to implement this system.
  • Improve the Production System: Another main objective Just In Time Production systems is it is helping the company to improve the production process in the Company. We will look in detail on how the Just In Time could help in the following.

Definition of Just In Time (JIT):

Now let we go to the quick definition of Just In Time,

Just In Time is part of the Lean Manufacturing System that tries to make sure the maximization of the efficiency of the Manufacturing Process, Minimize the wast of Inventories and Reducing the Cost of Storing.

Just In Time Manufacturing System required a deep understanding of the customer’s demand, Perfect Purchasing and Procurement System, and Effective Production System.

Just In Time is the concept, and it is not improving the company directly, yet, it influences another process to improve the company.

We will talk in later in this article,

Just In Time Production:

So what is the Just In Time Production?

The concept of Just In Time Production is that there is no production if there is no purchase order. Just In Time Production requires the perfection of a customers management system that could lead to the production department to get ordering data as quick as possible. The customer order is the driver of production.

Most of the companies fail to implement and miss understand this. Why? Because they just understand that Just In Time System is the method of forecasting how much product is required to produce as the result of current demand by using Just-In-Time formula. This is totally wrong.

What they first have to do is to make sure that the production department could assess the customer’s orders and also this data link to the purchasing department to make the quick order of material. We will talk later about the concept of Just In Time in Purchasing.

In the production process itself, the production department has to produce the product at the standard requirements, and the wast is minimized by introducing the standardized system and ongoing study of the production process.

The production runs one the demand is the need. Still, after finish goods are done, the customer’s service or selling department could access that information and contact to the customers immediately. In this regards, the company needs to make the selling system that could link and access to the production data.

Just In Time Purchasing

Now we move to JIT in Purchasing,

What is it all about?

JIT in Purchasing is the concept that tries to make sure that there is no raw material are purchases one there is no production. It is hard, right?

If the company does not have the perfect system that links from the production department and customer service department, this perfect purchasing system could not implement.

The important point to implement the Just In Time Purchasing is making the perfect relationship with suppliers.

Why? Because in the  Just In Time Purchasing concept, your company does not have to store the raw materials. You only need the material when there are productions as the results of customers’ orders.

But, what you need to do for this concept,

Well, there are many things you need to do to implement the Just In Time Purchasing, but there are the necessary things,

  • let the Purchasing Department know and access the productions system which could estimate the material that requires and its amounts.
  • Access the supplier’s credit and making the perfect relationship with them.
  • Try to seek an additional source of raw material. If one supplier is dying, then you could have another one instate.
  • If possible, let your customers know about the production departments so that they can be ready for you.
  • Make sure that there is no disruption of your company production because of poor suppliers relationship.

4 Ultimate Purpose of Budgeting

Budgeting is the tool that most of the business entity use to link from the current performance of those business entity to their strategic objective. The entity break its long-term goal, like in ten year or be the market leader, into short-term objective, it called budget.Purpose of Budgeting

In other words, we can say that the budgeting is the short term objective that entity use as part of its long-term goal. The above are not only purpose of budgeting, the following the tops four purpose of it.

About Planning:

Purpose of Budgeting is About Planning

So the business planning is very importance of the successful technique most of the business always do. Planning include Financial and Non-Financial.

For Financial Planning or Budgeting it simply list down how much the company need to generate the sale revenue from its products or services. Revenue budgeting sometime list down by product that need to be sale by the whole entity or list down by division.

Revenue Budgeting are forecast based the the last year experience by taking into account the economic, political, demand, and relevance. Budgeting are also need to be link to the company objective for example, the CEO said the company need to get return on capital for 10% in the next ten years while the current ROC is just 5%. In this case, the Revenue Budget need to be just to this expectation from CEO whether how much revenue need to generate.

Another part that the company need to plan about is expenses that the entity would expected to be incurred like Cost of Sale, Administration, Salaries, Marketing Expenses and Others. These expenses need to be forecast and Budget.

So that is why I said the Purpose of Budgeting is about planning. Planing about the short-term, one year or two years, and planning about long-term, like two years or three years.

Responsibilities

Responsibilities (2)The process of Budgeting could be done by top down approach and bottom up approach; however, with no mater approach use, budgeting always get approval from Board of Directors or at least CEO or Directors.

The purpose of the approval is because of delegating the responsibilities to management at the operational level.

For examples, if the BOD approved the Budget for the company to get at least USD 10,000,000 of Sale revenue per years, then CEO is responsible to make sure that the sale revenue have to be meet.

Integration

This is the very importance one about the budgeting, and make sure you don’t get it wrong. Budget is the short-term objective and most of the business always have its along-term objective along with its vision and mission.

As discuss above, to meet the long term objective, mission and vision, the company need to identify the critical success factors which could make sure that these three things will be meet.

Critical Success Factors are the factors that company need to get done at best to ensure it meet objective, mission and vision.

To make sure that the company get the CFS done at best, the need to find the right KPI, Budget is part of KPI. The company need to set budget or KIP that link or integrate with CFS, then objective, mission and vision could be meet. By contrast, if the company identify the wrong CFS, select the wrong KPI and prepare incorrect budget, the hen objective, mission and vision probably could not be meet.

Motivation:

Why budgeting is importance for motivation? To ensure the success of the company, right team is really need. Staff motivation is part of the management technique to build the right team. Purpose of Budgeting is also help the company to motivate it staff to get all of the KIP set done. For examples, if the company could hit the target set by BOD, then staff will get five months of their salaries or others kind like position or other recognition.