Absorption Costing

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Definition of Absorption Costing (Total Costing or Total Production Cost):

Absorption costing or total costing or total production cost means all costs that are involve in the process of production of a product in any business or industry.

Components:

There are following components of absorption costing or total costing:

(1) Direct production costs or prime costs:

(i) Direct materials, (ii) Direct labor, (iii) Direct expenses.

(2) Indirect production costs/ overheads:

(i) Indirect materials, (ii) Indirect labor, (iii) Factory rent, (iv) Depreciation of plant, (v) Factory cleaning.

(3) Other overheads:

(i) Selling and distribution costs, (ii) Administration costs.

When a factory produces a range of different products, then for costing purposes it needs following information:

(i) What is the cost of operating each cost center or department of the factory?

(ii) What is the cost of producing each of the products manufactured?

(iii) What price should be charged for each product in order to give an adequate profit margin, both for the particular product and overall for the factory?

Production cost may be categorized broadly in two types namely direct (prime) cost and indirect costs (factory overheads). Mostly indirect costs (factory overheads) are incurred for the benefit of the whole factory so it is difficult to identify these overheads with reference to a particular cost center or cost unit, however they can be apportioned to cost centers and then absorbed by cost units.

Explanation:

Overhead absorption signifies the process of including overheads in the total cost of a product. In absorption coasting both variable and fixed production costs are treated as product cost.

Total costs of the products has to be known to the management in order to prepare invoices, send quotations, determine profit, plan for the future and for other costing purposes. Though prime costs can easily be identified with reference to the finished products but it is normally difficult to charge production overheads to the finished items as these costs are normally incurred for the whole factory and so is difficult to charge them to the products or cost units.

The absorption of overheads requires the calculation of an overhead absorption rate (sometimes called recovery rate). This calculation is based on two factors; the total overheads attributable to a given cost center and the absorption base (activity level). Cost allocation and apportionment (discussed below), both are the first steps in absorbing overheads:

cost-allocation-and-apportionment

Calculation Procedure of Absorption Costing or Total Production Cost:

Format:

The cost of production under absorption costing is made as follows:

absorption-costing-calculation-format

Solved Example – Calculation of Absorption Cost Statement and Per Unit Cost:

Mr. A is a manufacturer of soft drinks. Following information relate to his business for the year ended 30 June 2016 for the production of 1125 units.

absorption-cost-statement-example-data

Required:

Draw up an absorption cost statement for the year ended 30 June 2016. Also calculate per unit cost to be used in the valuation of closing inventory (if any).

Solution:

Absorption cost statement

For the year ended 30 June 2016

absorption-cost-statement-example-solution

Features of Absorption Costing:

(i) All overheads (including both fixed and variable) are included to calculate total cost of a product.

(ii) Fixed costs are included in the calculations to recover them from the customers.

(iii) Absorption costing is acceptable under accounting standards to value inventories for financial statements.

(iv) Absorption costing is used in pricing decisions to calculate selling price by adding profit in total cost.