The CIMA London, defines Absorption Costing as the “practice of charging all costs both variable and fixed to operations, processes or products.”
Every business has to deal, and effectively manage certain costs (expenses) to successfully streamline the working process. These costs cover each and every aspect while costing from raw materials. labor, to finished goods. Thereby, it leads us to the interesting concept of ‘Absorption Costing.’
We have compiled this detailed guide that will help you to understand Absorption Costing thoroughly. Let’s check what’ll cover:
- What’s Absorption Costing
- Definition of Absorption Costing by CIMA
- Absorption Costing Components
- Objectives of Absorption Costing
- Features of Absorption Costing
- Absorption Costing Calculation
- Absorption Costing Versus Variable Costing
- Advantages of Absorption Costing
- Limitations of Absorption Costing
- Examples of Absorption Costing
What’s Absorption Costing?
Absorption costing (also known as traditional costing, full costing, or conventional costing) is a costing technique that accounts for all manufacturing costs (both fixed and variable) as production cost. It is then utilized to calculate the cost of products produced and inventories.
To put it another way, all manufacturing costs are absorbed into the price of the finished goods.
Furthermore, absorption costing is essential to submit other formal reporting and file taxes. Every production expense is allocated to all items, regardless of whether every made good is sold. To put it another way, the company's products absorb all expenses.
According to the formula, consider the following cost elements in the finished product:
- Direct Labor
- Direct Material
- Fixed Manufacturing Overhead
- Variable Manufacturing Overhead
- The method of absorption costing is defined in generally recognized accounting standards (GAAP) for financial reporting under several regulations.
- Sales and administrative expenses should be recorded as an expense rather than inventory in the period in which they occurred. It's because these expenses aren't related to the goods produced, but rather to the timeframe in which they occurred.
Definition of Absorption Costing by CIMA
According to CIMA (Chartered Institute of Management Accountants):
The CIMA Official Terminology defines absorption costing as “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.”.
Absorption Costing Components
As previously stated; let’s discuss those crucial components associated with absorption costing in detail. Let’s check:
- Direct Labor (DL): the direct labor spent on the unit's production. It is based on the current labor rate;
- Direct Material (DM): the raw materials utilized in the unit's output;
- Fixed Manufacturing Overheads (FMOH): Rent, insurance, and other costs of running the plant that does not alter with production volume.
- Variable Manufacturing Overheads (VMOH): cost of operating a manufacturing plant, which changes with output volume, such as electricity, water, and so on;
Objectives of Absorption Costing
Below we have discussed a few important objectives:
(a) Assess both direct and indirect costs
(b) To determine the cost participation of each department
(c) To determine the product's total cost
(d) Determine the market sale price and fix it
(e) To check resources usage effectiveness, examine production data
Features of Absorption Costing
Following we have listed some of the most important aspects of absorption costing:
- Period Costs:
Period costs include all overheads related to the organization, sales, and distribution. As a result, profits get subtracted from the time in which they take place.
- Treatment as Production Costs:
Product costs include all fixed production overheads as well as variable manufacturing expenses. Therefore charged to operations, processes, or products.
- Categorized according to Function:
Production expenses, administrative costs, selling costs, and distribution costs are all divided into functional categories.
Check the following features points as well:
(a) The finished product absorbs all manufacturing costs, whether direct or indirect.
(b) Each component of the product should bear its own share of the total cost.
(c) There includes no differentiation made between fixed and variable production costs. Both are charged or given the cost unit.
(d) With the help of absorption rate, manufacturing expenditures that aren't related to a single product get distributed. This rate could be the factory's overall recovery rate or departmental recovery rates.
(e) Because product costs comprise both fixed and variable costs, stocks are valued at full cost.
(f) Unsold stock-related fixed costs pass onto the next accounting period in part.
(g) This cost-finding technique results in the under-or over-absorption of industrial overhead.
(h) Profit is defined as the difference between the cost of products sold and sales revenue in this method.
Absorption Costing Calculation
The steps for calculating and allocating absorption costing are as follows:
Generate Cost Pools
Evaluate the price of a product's manufacture first, and then divide them into distinct cost pools. A cost pool is a collection of expenses grouped by activity.
Furthermore, Marketing, customer service, and R&D might be divided into different cost pools. As you spend money, you'll eventually allocate costs to the cost pool that best describes them.
Evaluate Utilizing for each Cost
Examine each action to understand how it ties to the manufacturing process. Throughout the production process, you'll need to calculate usage for activities. It includes time invested in both labor and equipment.
Calculate the Total Cost
Finally, figure out the allocation rate, which is the cost per unit. You can accomplish so by using the following formula:
Absorption Costing Versus Variable Costing
The treatment of Overhead expenses is the fundamental difference between variable and absorption costing.
Absorption costing determines the per-unit cost of fixed overheads. Whereas variable costing does not determine that. Moreover, variable costing results in a single lump-sum spending line item for fixed overhead expenditures for calculating net income on the income statement.
Additionally, there will be two sorts of fixed overhead costs as a result of absorption costing: those pertaining to the cost of products sold and those relevant to inventory.
On the other hand, Variable costing is an accounting method for manufacturing expenses that solely includes variable costs in the product cost.
Also, it includes direct material costs, direct labor expenses, and variable production overheads. Moreover, there is no concept of overhead overabsorption or under-absorption.
Advantages of Absorption Costing
Following we have listed crucial advantages of Absorption Costing. Let’s check:
Assessing all production expenses
Absorption costing considers all costs connected with the production. It further makes it a useful tool for evaluating suitable product pricing.
Furthermore, this information enables businesses to ensure that the price of their product covers the costs of manufacture. It also gives companies the ability to price their items more competitively in their market.
Recognized by Various Bodies
Numerous organizations, including FASB (USA), ASG (UK), and ASB (Australia), have acknowledged it for the purpose of establishing external reporting and inventory value (India).
Accurate Profitability Tracking
Absorption costing provides a more true image of profitability for a company. And, especially if all of its items are not sold at the same time. If a company prepares to ramp up production in preparation for a seasonal sales surge, this is an important factor to consider.
It reveals inefficient or efficient production resource utilization by displaying under- or over-absorption of manufacturing overheads.
Adaptable to changing needs
Companies with a consistent demand for products benefits from absorption costing. It provides a straightforward and rigorous costing tool for active enterprises. It also takes into account fluctuating turnover because costs have been allocated to the items.
Assist in Calculation
It makes computing net profit and gross profit separately in the income statement much easier.
Beneficial for Small Enterprises
Absorption expenses are easy to track because small businesses often do not have a large number of things. Fixed expenses can be absorbed ahead of time. It further allows companies to sell their goods at more realistic pricing and profit margin.
Limitations of Absorption Costing
Check the following limitations of Absorption Costing. Let’s learn:
Hard to Control and Compare of Cost:
Absorption costing is reliant on output level. Moreover, due to the existence of fixed expenses, an increase in output volume usually results in a lower unit cost.
A drop in output, on the other hand, usually means a greater cost per unit. Therefore, cost comparison and control become harder as a result of this.
Ineffective in Managerial Decisions:
When it comes to making managerial decisions, absorption costing is ineffective. It includes whether to buy or produce, choosing an appropriate product mix, whether to accept or reject an export order, the minimum price to be set during a depression, the number of units to be sold to generate the desired profit, and so on.
Inclusion of fixed costs in the cost is not reasonable:
Many accountants claim that administrative, fixed manufacturing, and marketing and distribution overheads are period costs. They have little long-term value and therefore should avoid including in the product's pricing.
Ineffective in the formulation of a flexible budget:
There is no distinction between fixed and variable costs. This distinction should be implemented in order to construct a flexible budget.
Erroneous Product Costs by arbitrary methods:
The accuracy of product costs under this technique is contingent on the proper allocation of overhead costs. Furthermore, certain overhead expenses get apportioned based on arbitrary criteria. It further results in erroneous and unreliable product costs.
Examples of Absorption Costing
Check out the following example, which will help you fully grasp this concept:
A corporation produces 10,000 units of its product. Suppose, 8,000 of the 10,000 units produced were sold that month. And, it further leaves 2,000 in stock.
Now, each unit costs $5 indirect labor and materials. And, a monthly fixed overhead cost of $30,000.
With this approach, you can calculate the fixed overhead expenses per unit. They arrive at the conclusion that each unit costs $3 to manufacture by dividing fixed overhead expenditures by the number of units produced that month ($30,000 / 10,000 units = $3 per unit).
After calculating fixed overhead costs per unit, the corporation can add labor and material costs to arrive at an $8 absorption cost for each unit produced ($3 fixed overhead costs + $5 variable overhead costs = $8).
The total cost of products sold is calculated by multiplying the number of units sold by the absorption cost:
Number of units sold (8,000 units) X $8 per unit cost = $64,000.
Furthermore, that indicates there's $16,000 worth of merchandise left (2,000 units x $8 per unit cost = $16,000).
Company A is a single-product manufacturer and supplier. Following is the recorded data:
Variable Cost per Unit
Fixed Cost per Unit
During the accounting period, a company manufactured 60,000 units. It sold 50,000 units and still has 10,000 left.
Check the following calculation:
The inventory (10,000 pieces) in the company's warehouse is evaluated at $600,000.
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We have reached the end of this informative guide, Let’s take a look at some crucial points for future reference:
- Absorption costing (also known as traditional costing, full costing, or conventional costing) is a costing technique that accounts for all manufacturing costs (both fixed and variable) as production cost.
- Absorption costing is essential to submit other formal reporting and file taxes
- Consider the following cost elements in the finished product:
- Direct Labor
- Direct Material
- Fixed Manufacturing Overhead
- Variable Manufacturing Overhead
- Absorption cost per unit = (Direct Material Costs + Direct Labor Costs + Fixed Manufacturing Overhead Costs + Variable Manufacturing Overhead Costs) / Number of units produced
- Numerous organizations, including FASB (USA), ASG (UK), and ASB (Australia), have acknowledged it for the purpose of establishing external reporting and inventory value (India)
- Absorption expenses are easy to track because small businesses often do not have a large number of things