ABSORPTION COSTING OR FULL COSTING

Samir K Mahajan

ABSORPTION COSTING/FULL COST METHOD

Absorption costing or full cost method is the traditional method of costing by which all direct and applicable overheads

are charged to product or cost centre. According to this method, cost of a product is determined after considering both

fixed and variable cost. That is, all costs are identified with or absorbed into manufactured product. Absorbed cost

include production cost as well as administrative cost and other cost. Thus in case of absorption cost, all costs are

identified with manufactured product.

These costs are not recognized as expenses in the month when an entity pays for them. Instead, they remain in

inventory as an asset until such time as the inventory is sold; at that point, they are charged to cost of goods sold.

Example 1: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided to apportion these costs over different products in the ratio of output. Prepare a statement showing the cost and profit of each product according to absorption cost.

Example 1: solution

Statement showing profit and cost (Absorption Costing )

Traditional Income Statement

A_____ ______B _____ _____C _____

Per unit Rs

TotalRs

Per unit Rs

TotalRs

Per unit Rs

TotalRs

Direct material Direct labour

Overheads: Fixed

Variable

Total CostProfit Selling price

32

31

30002000

30001000

43

31

40003000

30001000

54

31

50004000

30001000

91

90001000

114

110004000

137

130007000

10 10000 15 15000 20 20000

Total Profit Rs 1000 + Rs 4000 + Rs 7000 = Rs 12000

Example 1: solution contd

Total profit under absorption costing is

Total Profit Rs._______

Product A 1000 Product B 4000 Product C 7000 12000

ADVANTAGES OF ABSORPTION COSTING SYSTEM

1. Absorption costing recognizes fixed costs in product cost. As it is suitable for determining price of the product. Thepricing based on absorption costing ensures that all costs are covered.

2. Absorption costing will show correct profit calculation than variable costing in a situation where production is done tohave sales in future ( e.g. seasonal production and seasonal sales).

3. Absorption costing conforms with accrual and matching accounting concepts which requires matching costs withrevenue for a particular accounting period.

4. Absorption costing has been recognized for the purpose of preparing external reports and for stock valuation purposes.

5. Absorption costing avoids the separating of costs into fixed and variable elements.

6. The allocation and apportionment of fixed factory overheads to cost centres makes manager more aware andresponsible for the cost and services provided to others.

DISADVANTAGES OF ABSORPTION COSTING SYSTEM

1. Absorption costing is not useful for decision making. It consider fixed manufacturing overhead as product cost whichincrease the cost of output. As a result, it does not help in accepting specially offered price for the product. Various typesof managerial problems relating to decision making can be solved only with the help of variable costing system.

2. Absorption costing is not helpful in control of cost and planning and control functions. It is not useful in fixing theresponsibility for incurrence of costs. It is not practical to hold a manager accountable for costs over which he/she has notcontrol.

3. Some current product costs can be remove from the income statement by producing for inventory. As such, managerswho are evaluated on the basis of operating income can temporarily improve profitability by increasing production.

4. The technique of absorption cost may lead to rejection of profitable business. A total unit cost will tend to be regardedas the lowest possible selling price. An order at a price which is less than total unit cost may be refused, though the ordermay be actually profitable ( Discussed in Example 3)

Example 2: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided toapportion these costs over different products in the ratio of output. Prepare a statement showing the cost and profit ofeach product according to absorption cost.

Calculate amount of profit and and loss made by Tripura Ltd in the first two years of its existence, presuming thati. In the first year, it manufactures 1000 units of each product A, B, C but fails to effect any sales.ii. In the second year, it does not produce anything but sells the entire stock carried forward from the first year.iii. What fallacious conclusions can be drawn from the results.

Solution : Example2

Tripura Limited Profit and loss Account of 1st Year

Rs Rs

Direct material ABC

Direct labour ABC

Overhead: variables

A 1000B 1000C 1000

Fixed -----

300040005000___ 12000

200030004000___ 9000

30009000 _12000__

___33000_

SalesClosing Stock

-----33000

___________33000_

Solution : Example 2 contd.

Tripura Limited Profit and loss Account of 2nd Year

Rs Rs

Opening Stock Fixed overhead

Profit

3300090003000

_______45000__

SalesA BC

100001500020000_ 45000

______45000_

The above Profit and Loss accounts shows that in the first year there is no loss in spite of the fact that the company did notmake any sales . While in the second year, it makes a profit of Rs.3000. As a matter of fact, the company losses Rs.9000 onaccount of non-recovery of fixed cost in the first year. The profit and loss account does not show any loss because these fixedcosts have been included in the closing inventory values and thus carried forward to the next year.As a result, the profit and loss account for the second year has to bear Rs.18000 on account of fixed cost. (i.e. Rs.9000 for thefirst year + Rs.9000 for the second year). The real profit in the second year should be have been Rs. 12000 and not Rs.3000.Thus, the technique of absorption may lead to rather odd results particularly for seasonal business in which stock levelsfluctuate widely form one period to another. Their profits for the two periods will be influenced by the transfer of overheadsin and out of stock showing falling profits when the sales are high and increasing profit when sales are low.

Example 3: Your are the MD of Usha Automobiles Ltd. which has received a special offer for the supply of 200 components at Rs 60 a piece from a motorbike manufacturer. The company has a capacity to produce 1000 components but at present it is utilising 80 percent of its capacity. The present selling price per component is Rs. 100.

The cost details of the company are as follows:

Variable cost per unit Rs 40Fixed overhead cost per unit Rs 30(total fixed overheads Rs 24000) ___________Total cost per unit Rs 70 Your cost accountant advises you to reject the order since the company will be getting less profit than the total cost of the component. How would you react?

Solution : Example 3:

Sales Total

Sales in units ___________800 200 1000

Sales in Rs. 80000 12000 92000(800x100) (200x60)_____________________________

Total Cost: Variable ( Rs 40 per unit) 32000 8000 40000Fixed cost (Rs) 24000 ---- 24000_____

56000 8000 64000_____Profit (Rs.) 24000 4000 28000

The advice of the Cost Accountant is not correct. Since he has based his decision on absorption costing, he is advising against accepting the special offer. Thus if the order is accepted the profit will increase from Rs. 24000 to Rs.28000. it is therefore advisable to accept the offer rather than reject.