absorption costing

Absorption Costing (Definition, Formula) | How to Calculate?

absorption costing

Absorption costing is one of approach which is used for the purpose of valuation of inventory or calculation of the cost of the product in the company where all the expenses incurred by the company are taken into the consideration i.e., it includes all the direct and indirect expenses incurred by the company during the specific period.

In simple terms, “absorption costing” refers to the method of adding up all the costs pertaining to the production process and then allocating them to the products individually. This method of costing is essential as per the accounting standards to produce an inventory valuation which is captured in the balance sheet of an organization.

As per this method, the total product cost is calculated by the addition of variable costs, such as direct labor cost per unit, direct material cost per unit and variable manufacturing overhead per unit, and fixed costs, such as fixed manufacturing overhead per unit.

Absorption Costing Formula

Absorption cost formula = Direct labor cost per unit + Direct material cost per unit + Variable manufacturing overhead cost per unit + Fixed manufacturing overhead per unit

It can also be modified to,

Absorption cost formula = (Direct labor cost + Direct material cost + Variable manufacturing overhead cost + Fixed manufacturing overhead) / No. of units produced

Explanation

The formula for AC can be computed by using the following steps:

Step 1: Firstly, the direct labor cost per unit is directly attributable to the production. The direct labor cost can be determined the labor rate, level of expertise, and the no. of hours put in by the labor for production. However, the labor cost can also be taken from the income statement.

Step 2: Secondly, identify the material type required and then determine the amount of the material required for the production of a unit of product to calculate the direct material cost per unit. However, the direct raw material cost can also be taken from the income statement.

Step 3: Thirdly, determine which part of the manufacturing overhead is variable in nature. The manufacturing overhead is available in the income statement.

Step 4: Next, determine which part of the manufacturing overhead is fixed in nature and then divide the value by the number of units produced to arrive at a per-unit cost.

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Step 5: Finally, the formula for absorption cost is derived by adding up direct labor cost per unit, direct raw material cost per unit, variable manufacturing overhead per unit, and fixed manufacturing overhead per unit, as shown above.

Example #1

Let us take the example of company XYZ Ltd that manufactures clothes for people of the elite class residing in a modern city. Do the calculation of Absorption Costing. The managerial accountant has provided the following information, and the finance director of the company has vetted the same:

It is to be noted that selling and administrative costs (both fixed and variable costs) are periodic costs in nature and, as such, are expensed in the period in which it occurred. However, these costs are not included in the calculation of product cost as per the AC.

Therefore, the calculation of AC is as follows,

Absorption cost Formula = Direct labor cost per unit + Direct material cost per unit + Variable manufacturing overhead cost per unit + Fixed manufacturing overhead per unit

= $20 + $12 + $8 + $200,000 / 50,000

AC will be –

  • Ab cost = $44 per unit of cloth

Example #2

Let us take the example of company ABC Ltd which is a manufacturer of mobile phone covers. Recently, the company has received an order for 2,500,000 mobile covers at a total contract price of $5,000,000.

However, the company is not sure whether the order is a profitable proposition. Do the calculation of Absorption Costing to find the order is profitable or not.

The following are the excerpts from the entity’s income statement for the calendar year ending in December 2017:

Now, the above information, do the calculation

Absorption cost formula = (Direct labor cost + Direct material cost + Variable manufacturing overhead cost + Fixed manufacturing overhead) / No. of units produced

AC = ($1,000,000 + $750,000 + $800,000 + $950,000) ÷ 2,000,000

AC will be –

  • AC = $1.75 per mobile case

As per the contract pricing, the per-unit price = $5,000,000 / 2,500,000 = $2.00 per mobile case

Since this method shows lower product costs than the pricing offered in the contract, the order should be accepted.

Calculator

You can use the following AC Calculator.

Absorption Costing Formula =
Direct Labor Cost + Direct Material Cost + Variable Manufacturing Overhead Cost + Fixed Manufacturing Overhead
No. of Units Produced

Relevance and Use

It is very important to understand the concept of AC formula because it helps a company to determine the contribution margin of a product and that eventually helps in the break-even analysis.

the break-even analysis can decide the number of units required to be produced by the company in order to be able to book a profit.

Further, the application of AC in the production of additional units eventually adds to the bottom line of the company in terms of profit since the additional units would not cost the company an additional fixed cost. Another advantage of AC is that it is GAAP compliant.

You can download this Excel Template here – Absorption Costing Formula Excel Template

This has been a guide to what is Absorption Costing. Here we discuss how to calculate Absorption Cost and its formula along with the practical examples and downloadable excel sheet. You can learn more about accounting from the following articles –

Источник: https://www.wallstreetmojo.com/absorption-costing/

Absorption Costing Formula | Calculation of Absorption Costing

absorption costing

Let’s take an example to understand the calculation of Absorption Costing in a better manner.

Absorption Costing Formula – Example #1

Let say a company X has produced 50,000 and sold 40,000 units this year and has reported the following costs:

For Absorption costing, we need only material cost, labor cost, and overheads. SG&A is not part of absorption costing

Fixed Overhead Per Unit is calculated using the formula given below

Fixed Overhead Per Unit = Fixed Overhead / Number of Units Produced

  • Fixed Overhead Per Unit = $400,000/ 50,000
  • Fixed Overhead Per Unit = $8 per unit

Unit Cost Under Absorption Cost is calculated using the formula given below

Unit Cost Under Absorption Cost = Direct Material Cost Per Unit + Direct Labor Cost Per Unit + Variable Overhead Per Unit + Fixed Overhead Per Unit

  • Unit Cost Under Absorption Cost = $20 +$15 + $10 + $8
  • Unit Cost Under Absorption Cost = $53

Absorption Costing Formula – Example #2

Now let see another detailed example to see the applicability of absorption costing. Let’s say a company ABC has the following cost and sales element reported for last year:

Total Cost is calculated using the formula given below

Unit Cost Under Absorption Cost = Direct Labor + Variable Overhead + Fixed Overhead + Fixed Selling Cost

  • Unit Cost Under Absorption Cost = $20000 + $8000 + $10000 + $10000
  • Unit Cost Under Absorption Cost = $48000

Cost Per Unit is calculated using the formula given below

Cost Per Unit = Total cost / Unit Produced

  • Cost Per Unit = $48000 / 20000
  • Cost Per Unit = $2.40

Now let’s make Income Statement for 15,000 Units Sold:

Relevance and Uses of Absorption Costing Formula

Absorption costing has various advantages associated with it. First and foremost advantage is that it is GAAP compliant. GAAP is Generally Accepted Accounting Principles which companies used while reporting their financial statements. Since absorption costing is GAAP compliant, many companies use this method of costing for financial statements reporting.

Also, as we have seen above in the examples, in absorption costing method, all the production cost fixed operation cost, rent, utility cost, etc. is taken care of and also all the direct costs associated with production. So in nutshell, although it has some limitations associated with it, it is an important costing tool which is used in the industry by many firms.

Absorption Costing — How to Use the Full Costing Method, Guide

absorption costing

Absorption costing is a costing system that is used in valuing inventoryInventoryInventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a company has accumulated.

It is often deemed the most illiquid of all current assets — thus, it is excluded from the numerator in the quick ratio calculation..

It not only includes the cost of materialsCost of Goods Manufactured (COGM)Cost of Goods Manufactured, also known to as COGM, is a term used in managerial accounting that refers to a schedule or statement that shows the total production costs for a company during a specific period of time.

and labor, but also both variable and fixed manufacturing overhead costs. Absorption costing is also referred to as full costing. This guide will show you what’s included, how to calculate it, and the advantages or disadvantages of using this accounting method.

Components of Absorption Costing

Under the absorption method of costing (aka “full costing”), the following costs go into the product:

  • Direct material (DM)
  • Direct labor (DL)
  • Variable manufacturing overhead (VMOH)
  • Fixed manufacturing overhead (FMOH)

Under absorption costing, the costs below are considered period costs and do not go into the cost of a product. They are, instead, expensed in the period occurred:

  • Variable selling and administrative
  • Fixed selling and administrative

For your reference, the following diagram gives an overview of costs that go into absorption costing compared to variable costing:

Example of Absorption Costing

Company A is a manufacturer and seller of a single product. In 2016, the company reported the following costs:

Variable costs per unit:

  • Direct materials cost: $25
  • Direct labor cost: $20
  • Variable manufacturing overhead cost: $10
  • Variable selling and administrative cost: $5

Fixed costs:

  • Fixed manufacturing overhead of $300,000
  • Fixed selling and administrative of $200,000

Over the year, the company sold 50,000 units and produced 60,000 units, with a unit selling price of $100 per unit.

Using the absorption method of costing, the unit product costProduct CostsProduct costs are costs that are incurred to create a product that is intended for sale to customers. Product costs include direct material (DM), direct labor (DL) and manufacturing overhead (MOH). is calculated as follows:

Direct materials + Direct labor + Variable overhead + Fixed manufacturing overhead allocated = $25 + $20 + $10 + $300,000 / 60,000 units = $60 unit product cost under absorption costing

Recall that selling and administrative costs (fixed and variable) are considered period costs and are expensed in the period occurred. Those costs are not included in the product costs.

Advantages

There are several advantages to using full costing. Its main advantage is that it is GAAP-compliant. It is required in preparing reports for financial statements and stock valuation purposes.

In addition, absorption costing takes into account all costs of production, such as fixed costs of operation, factory rent, and cost of utilities in the factory. It includes direct costs such as direct materials or direct labor and indirect costs such as plant manager’s salary or property taxes. It can be useful in determining an appropriate selling price for products.

Disadvantages

Since absorption costing includes allocating fixed manufacturing overhead to the product cost, it is not useful for product decision-making. Absorption costing provides a poor valuation of the actual cost of manufacturing a product. Therefore, variable costing is used instead to help management make product decisions.

Absorption costing can skew a company’s profit level due to the fact that all fixed costs are not subtracted from revenue unless the products are sold.

By allocating fixed costs into the cost of producing a product, the costs can be hidden from a company’s income statement in inventory.

Hence, absorption costing can be used as an accounting trick to temporarily increase a company’s profitability by moving fixed manufacturing overhead costs from the income statement to the balance sheet.

For example, recall in the example above that the company incurred fixed manufacturing overhead costs of $300,000.

If a company produces 100,000 units (allocating $3 in FMOH to each unit) and only sells 10,000, a significant portion of manufacturing overhead costs would be hidden in inventory in the balance sheet.

If the manufactured products are not all sold, the income statement would not show the full expenses incurred during the period.

Thank you for reading this guide to calculating the full costing of inventory. Below are additional accounting resources from CFI, the global provider of the Financial Modeling and Valuation Analyst (FMVA)®FMVA® CertificationJoin 350,600+ students who work for companies Amazon, J.P. Morgan, and Ferrari designation.

  • Job Order Costing GuideJob Order Costing GuideJob Order Costing is used to allocate costs a specific job order. This guide will provide the job order costing formula and how to calculate it. As an example, law firms or accounting firms use job order costing because every client is different and unique. Process-costing, on the other hand can be used
  • Activity-based Costing GuideActivity-Based CostingActivity-based costing is a more specific way of allocating overhead costs “activities” that actually contribute to overhead costs. An activity is
  • Cost of Goods Sold (COGS)Cost of Goods Sold (COGS)Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct labor cost, and direct factory overheads, and is directly proportional to revenue. As revenue increases, more resources are required to produce the goods or service. COGS is often
  • Fixed and Variable CostsFixed and Variable CostsCost is something that can be classified in several ways depending on its nature. One of the most popular methods is classification according to fixed costs and variable costs. Fixed costs do not change with increases/decreases in units of production volume, while variable costs are solely dependent

Источник: https://corporatefinanceinstitute.com/resources/knowledge/accounting/absorption-costing-guide/

Absorption Costing

absorption costing

In Absorption Costing, the product, services or activities are charged with a fair share of indirect cost. There are four-step process involved in charging overhead cost to product or services:

  1. Overhead Allocation,
  2. Overhead Apportionment,
  3. Overhead Re-Apportionment and,
  4. Overhead absorption Rate also called Overhead Recovery.

Overhead Allocation

Overhead allocation is first of the three stages in establishing a full cost for a product or services. Overhead allocation is the process of charging a whole item of cost to a cost centre.

 Cost Centre is defined as to a unit or organization for which costs are accumulated or computed. In other words, cost centre is area, machine, or person to whom direct and indirect costs are allocated.

 Factory overhead costs are incurred in three main centers:

  • Production centers costs arising in production departments such as the costs of fuel, indirect material, depreciation and supervision
  • Service centers the cost of operating support departments or sections within the factory, for example, the costs of materials handling, production control etc.
  • General costs centers general production overhead such as factory rent/taxes, heating and lighting and canteen

An item of expenses which can be directly related to a cost centre is to be allocation to the cost centre. For example , depreciation of a particular machine should be allocated to a particular cost centre if the machine is directly attached to the cost centre.

 When factory overhead expenses are not identified with a specific product, they are charged to product by a process of overhead allocation. Allocations may be made for each item of expense incurred and the allocations made at the end of the accounting period. The purpose of cost accounting is to provide information to the management.

Management need to know cost per unit as a basis for decision making.

Example 1:

A manufacturing business operates with two production departments P and Q and a department S. It manufactures soup and shampoo. It incurs the following costs in a given period.

Indirect labor cost in department S       Rs. 6,500

Direct labor cost in department P                 4,700

Cost of supervision in department Q            2,100

Direct material cost in department P           10,300

Lighting and heating                                         900

Machine repair cost, department Q               800

Indirect material in department S                1,100

Depreciation of machinery, department S    700

Indirect material consumed by department P          500

Cost of works canteen                             1,500

Requirement: Allocate these costs as overhead cost to the following cost centres:

Production Cost Centre (P), Production Cost Centre (Q), Service Cost Centre (S)  and General Cost Centre (G)

Solution:

>> Practice Multiple-choice Questions: Product Costing Systems MCCQ

 

Overhead Apportionment

Once overhead costs have been allocated to cost centers, general overhead must be shared out or apportioned. This may be to production or services cost centers. Overhead apportionment is the process of sharing out overhead costs on fair basis.

Overheads are to be apportionment to different cost centers following two principle. Cause and Effect: Cause is the process or operation or activity and effect is the incurrence of cost.

 Benefits received: Overheads are to be apportioned to the various cost centres in proportion to the benefits received by them

Example 2:

A general cost in a manufacturing company is factory rental. Annual rental costs are Rs. 80,000.

How this cost should be apportioned between production cost centres and services cost centres? Rental costs are usually apportioned between cost centres on the basis of the floor space taken up by each centre.

Suppose that three cost centres have floor space of 50,000 square meters; Production cost centre (A) has 10,000 square meters, Production cost centre (B) has 15,000 square meters and Service cost centre (C) has 25,000 square meters.

Bases for Overhead Apportionment

  • Basis of apportionment must be rational to distribute overheads
  • Once the base is selected the same is to be followed consistently
  • However, change in basis for apportionment can be adopted only when it is considered necessary due to change in circumstances change in technology, degree of mechanization product mix etc.

Example 3:

An organization has two production department A and B and two services departments, Stores and canteen. The general overhead costs for the organization in total are as follows:

Rent                                                       Rs. 32,000

Building maintenance costs                     5,000

Machinery insurance                                  2,400

Machinery depreciation                            11,000

Machinery running expenses                    6,000

Power                                                             7,000

There are also specific costs that have already been allocated to each cost centre as follows:

Department A               Rs. 5,000

Department B                       4,000

Stores                                    1,000

Canteen                                 2,000

The following information about the various cost centers is also available:

Required: Allocate and apportioned the cost to the four departments by making Overhead Analysis Sheet?

Difference between Cost Allocation and Cost Apportionment

>> Practice Multiple-choice Questions: Product Costing Systems MCCQ

Organizations may have service departments (canteen, maintenance and administration) which cannot be related to any income producing activity.

To find the full cost of a cost unit these department costs should also be absorbed into the unit cost.

Therefore, service departments must be apportioned to the various departments producing the products or services. There are three methods are used for re-apportionment:

  1. Direct Distribution Method
  2. Step-Down Method
  3. Algebraic Distribution Method

Direct Distribution Method

  • In this method services cost centres will be re-apportioned to production cost centre only
  • In this situation where service cost centres do not service each other (Non-Reciprocal Apportionment)

Example 4:

Using the information produced in the previous example, the allocated and apportioned overhead costs are:

The apportionment of the stores cost centre will be on the basis of the value of requisitions by each production cost center. The apportionment of the canteen costs should be on the basis of the number of employees in production dept.  A and B:

Requirement: Show how the service cost centre costs should be re-apportioned and the resulting total overhead costs of each production cost centre assuming that store cost centre does not work for canteen and canteen does not work for store cost centre?

Example 5:

A company has three production departments and two service departments. Distribution summary of overheads is as follows:

The expenses of service departments are charged on a percentage basis which is as follows:

Requirement: Find out the total overheads of production departments by step-down method?

Example 6:

A company has three production departments and two service departments. Distribution summary of overheads is as follows:

The expenses of service departments are charged on a percentage basis which is as follows:

Requirement: Find out the total overheads of production departments by Algebraic Distribution Method?

Overhead absorption RateFormula

Once an Overhead absorption rate has been calculated, the amount of overhead absorption can be calculated as follow:

Overhead absorption = Actual Activity Level * Overhead Absorption Rate

Example 7:

The Company estimated that it would incur Rs. 320,000 in manufacturing overhead costs and would work 40,000 direct labor-hours. What is the company’s Overhead Absorption rate?

Система учета полных затрат

absorption costing

Метод Absorption Costing (Калькулирование себестоимости методом полного поглощения затрат) (также: Full Costing (Калькулирование полной себестоимости)) — модель оценки товарно-материальных запасов и калькулирования себестоимости, которая включает все производственные затраты:

  • Прямые затраты на материалы. Те материалы, которые становятся составляющей частью конечного продукта и которые можно легко отследить в конечном продукте.
  • Прямые затраты на оплату труда. Те затраты на рабочую силу, которые можно легко отследить в отдельных единицах продукции. Также известны как «производственные рабочие».
  • Как переменные, так и постоянные производственные накладные расходы.

в затратах на единицу продукции. В результате, при калькулировании себестоимости методом полного поглощения затрат постоянные накладные расходы относятся на себестоимость произведенной продукции до момента продажи.

Калькулирование себестоимости методом полного поглощения затрат также известно как метод калькулирования полной себестоимости.

Должны постоянные производственные затраты быть включены в товарно-материальные запасы?

Сторонники Absorption Costing (Поглощение издержек) утверждают, что должны, потому что все издержки произведенной продукции необходимы для ее создания . Таким образом, они имеют «будущие хозяйственные преимущества.

» Сторонники Variable Costing (Калькулирование себестоимости по переменным затратам) утверждают, что для того, чтобы постоянные производственные издержки засчитать как актив, они должны удовлетворять критерии «избежания будущих затрат». Так же как, например, предоплаченное страхование.

В случае с постоянными производственными затратами, они не удовлетворяют эти критерии, потому что производятся каждый раз при открытии поточной линии. Таким образом, они должны быть засчитаны как расходы за соостветствующий период, и только изменения в расходах должны быть инвенторизированы.

Проблемы с калькулированием себестоимости методом полного поглощения затрат также состоят в потенциальной манипуляции менеджерами на заводах в сторону, например, увеличения производства безотносительно к объемам продаж. Таким образом, издержки могут быть отсрочены до следущего года, и показаны более высокие текущие доходы ради бонусов и продвижения по службе.

Последствия использования Absorption Costing (Калькулирование себестоимости методом полного поглощения затрат) для вычисления прибыли

Разница важна для расчета дохода, когда уровни начальных и конченых запасов различаются:

  • Если уровни начальных и конченых запасов равны: доход при калькулировании себестоимости методом полного поглощения затрат = доход при калькулировании себестоимости по переменным затратам;
  • Если уровень запасов снижается за период: доход при калькулировании себестоимости по переменным затратам будет выше, чем доход при калькулировании себестоимости методом полного поглощения затрат;
  • Если уровень запасов увеличивается за период: доход при калькулировании себестоимости методом полного поглощения затрат будет выше, чем доход при калькулировании себестоимости по переменным затратам.

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Сравните с: Variable Costing (Калькулирование себестоимости по переменным затратам)  |  Activity Based Costing (Учет затрат по видам деятельности)

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Absorption Costing Components

Absorption cost, also known as full costing, allocate all the cost in production into the finished products and only charge to the income statement when they are sold. These costs include:

  • Direct material
  • Direct labor
  • Variable Overhead
  • Fixed Overhead

Example 

Company ABC produces two main products, Normal and Premium products. Base on company standard costing, the cost of both products includes:

Example of absorption costing

How do we allocate the production cost of $ 670,000?

Solution

We will use overhead absorption costing, which is absorption by labor hour.

  • Labor cost $ 10 per hour
  • Normal product will require: 300,000 (100,000 x 3h) working hour to complete 100,000 units
  • Premium product will require: 150,000 (30,000 x 5 h) working hour to complete 30,000 units

Therefore, fixed overhead will be allocated by $ 1.50 per working hour ($ 670,000/(300,000h+150,000h)).

Production overhead of Normal product: $1.50 x 3h = 4.50

Production overhead of Premium product: $1.50 x 5h = 7.50

CostNormalPremium
Direct Material1530
Direct Labor ($10/h)3050
Variable Overhead810
Fixed Overhead4.507.5
Total production cost57.597.5

What are the Advantages of Absorption Costing?

Advantages
Allocate fixed overhead cost into finished product.Besides direct material and direct labor, absorption costing take into account for all fixed cost such as salaries, factory rental, depreciation, utilities, etc. It will help the company to understand more clearly the total product cost.

The company will be able to set a precise selling price.

Simple and easy to calculate the cost of goods soldAbsorption costing simply takes all overhead costs to divide by machine hour or labor hour and allocate it to each product base on the required machine or labor hour. It is very simple and easy for most of the company.

We do not require any complicated accounting software, only normal spreadsheet can get the work done.

Suitable for small SMEs who do not have enough resourcesUn the large company, SMEs only has few products type, absorption costing is a good option for them.

Absorption costing does not require a huge human resource as well as a completed accounting system, so it is the best option for start-ups and SMEs. moreover, the cost is not very expensive to compare to other methods.

Track profit more accuratelyAbsorption costing is not only used variable cost but also allocates fixed cost into the product to ensure a more accurate cost of product. When all costs are included in each product, the company can easily tract its profit by-product as well as the total profit.

What are the Disadvantages of Absorption Costing?

Disadvantage
Mispresented profit during a given period of timeAs the total overhead costs will not deduct during the period unless the products sold, so the income statement may look more favorable than its actual.
Difficult the prepared budgetIt is hard for management to forecast and make a proper business plan due to the allocation of total fixed cost to product.
Wrong cost calculationOverhead costs share with the product base only the labor or machine hour, so it may lead the wrong calculation while some activities are related to different cost drivers. To solve this problem, activities based costing is the best solution.
Cost volume profit analysisIt is hard to calculate cost volume profit analysis (CVP) because there is no separation between the fixed and variable cost of product.

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Источник: https://accountinguide.com/absorption-costing/

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