Updated July 5, 2023
Definition of Absorption Costing
A management costing technique called absorption allocates variable and fixed costs to the product cost for inventory valuation. Because it takes both variable and fixed costs into consideration when estimating the cost of producing a good, the method is also known as the whole costing method.
Explanation
The variable costing method differs from the absorption costing, also known as the full costing method, as it only assigns variable costs to each unit of the manufactured product, excluding fixed costs. The fixed cost allocation to each produced crew is based on an absorption rate derived from the budgeted fixed overheads and production. This leads to over and under-absorption of fixed costs because the actual output may vary from the budgeted production.
When calculating we include a few examples of direct and indirect costs, such as natural material, direct labor, variable manufacturing overheads, and fixed manufacturing overheads.
Formula
The formula for calculating product manufacturing cost under the absorption costing method is as follows:
Wherein,
Total Direct Cost = Direct Labor Cost + Direct Material Cost
Total Manufacturing Overhead = Fixed Manufacturing Overhead + Variable Manufacturing Overheads
Example of Absorption Costing
We have the following information relating to ABC Ltd, and we need to calculate the product cost using the absorption costing method:
- Manufactured Units – 4000
- Units Sold – 3000
- Direct Labor Cost – $6000
- Direct Material Cost- $8000
- Fixed Overhead – $7000
- Variable Overheads – $1000
Solution:
Total Product Cost = Total Direct Cost + Total Manufacturing Overheads
- Total Product Cost = (direct Labor Cost + Direct Material Cost + Variable Overhead + Fixed Overhead)
- Total Product Cost = $6000+$8000 + $1000 + $ 7000
- Total Product Cost = $22,000
Components of Absorption Costing
- Direct Material Cost: The production of the finished goods inventory utilizes materials.
- Direct Labor Cost: Factory labor cost involved in the manufacturing of the product.
- Variable Manufacturing Overhead: The cost of operating the manufacturing unit or facility, such as electricity for manufacturing machinery, supplies, etc. The cost varies according to the volume of production.
- Fixed Manufacturing Overhead: The cost involved in operating the manufacturing unit that does vary with the production volume like rent of the premises, insurance premium, etc.
Uses of Absorption Costing
The uses are as follows:
- It is employed to ascertain the profitable selling price of products since it encompasses all costs associated with product manufacturing.
- Additionally, it is utilized for the purpose of inventory or stock valuation.
Advantages
- It allocates fixed overheads as well to each unit of product manufactured, therefore, giving a fair presentation of the total manufacturing cost of the products.
- It helps in determining the appropriate selling price of manufactured products.
- It helps set the recovery rate for fixed overheads as it involves fixed overheads as part of the product cost.
Disadvantages
- As the method includes fixed overheads, therefore it does not help much in decisions regarding product mix or making or buying of products.
- It is not helpful for cost control purposes as fixed overheads cannot be curbed or curtailed; they will always remain the same.
- Accountants can potentially manipulate profits using absorption costing because it allocates fixed costs per unit of manufactured products, resulting in the fixed costs not being expensed in the income statement.
Conclusion
From the above discussion, it is evident that absorption costing holds significant importance in calculating product costs. The main difference between absorption costing and variable costing is regarding the recognition of fixed costs.
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