7/30/2019 Absorption Costing Technique is Also Termed as
Traditional or Full Cost Method
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Absorption Costing technique is also termed as Traditional or
Full Cost Method. According to this
method, the cost of a product is determined after considering
both fixed and variable costs. The
variable costs, such as those of direct materials, direct
labour, etc. are directly charged to the
products, while the fixed costs are apportioned on a suitable
basis over different products
manufactured during a period. Thus, in case of Absorption
Costing all costs are identified with the
manufactured products.
Absorption costing principlesIn product/service costing, an
absorption costing system allocates or apportions a share of
all
costs incurred by a business to each of its products/services.
In this way, it can be established
whether, in the long run, each product/service makes a profit.
This can only be a guide.
Arbitrary assumptions have to be made about the apportionment of
many of the costs which,
given that some costs will tend to remain fixed during a period,
will also be dependent on the
level of activity.
An absorption costing system traditionally classifies costs by
function. Sales less production
costs (of sales) measures the gross profit (manufacturing
profit) earned. Gross profit lesscosts incurred in other business
functions establishes the net profit (operating profit) earned.
Using an absorption costing system, the profit reported for a
manufacturing business for a
period will be influenced by the level of production as well as
by the level of sales. This is
because of the absorption of fixed manufacturing overheads into
the value of work-in-
progress and finished goods stocks. If stocks remain at the end
of an accounting period, then
the fixed manufacturing overhead costs included within the stock
valuation will be
transferred to the following period.
Absorption costing profit statementThe first stage in the
preparation of absorption costing profit statements is the
measurement
of the gross profit (manufacturing profit) earned. This requires
the calculation of unit
production costs, including the establishment of absorption
rates for manufacturing
overheads.
Referring to the example being used for illustration in this
article (see earlier), variable
manufacturing costs per units are given in the question (at 6.40
per unit). Fixed
manufacturing overheads of 92,000 per period are to be absorbed
at a unit rate (based on
normal production activity of 20,000 units per period). The
fixed manufacturing overhead
absorption rate is therefore 4.60 per unit (92,000 20,000 units)
giving a total
manufacturing cost of 11.00 per unit (6.40 + 4.60).
The use of normal activity as the basis for overhead absorption
is similar to the use of
budgeted activity. It is to be expected that actual activity
(and indeed actual expenditure also)
will be different to normal/budget thus giving rise to overhead
over or under absorption. It is
important that this is highlighted in profit statements. The use
of normal (or budgeted)
activity and expenditure to establish the absorption rate not
only helps to focus attention on
overhead recoverybut also has the effect of normalising per unit
product/service costs.
Advantages of Absorption Costing:
It recognizes the importance of fixed costs in production;
7/30/2019 Absorption Costing Technique is Also Termed as
Traditional or Full Cost Method
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This method is accepted by Inland Revenue as stock is not
undervalued; This method is always used to prepare financial
accounts; When production remains constant but sales fluctuate
absorption costing will show
less fluctuation in net profit and
Unlike marginal costing where fixed costs are agreed to change
into variable cost, itis cost into the stock value hence distorting
stock valuation.
Disadvantages of Absorption Costing:
As absorption costing emphasized on total cost namely both
variable and fixed, it isnot so useful for management to use to
make decision, planning and control;
As the managers emphasis is on total cost, the cost volume
profit relationship isignored. The manager needs to use his
intuition to make the decision.
ABSORPTION COSTING PRO-FORMA
Sales Revenue( 2
n) xxxxx
Less Absorption Cost of Sales(no)
Opening Stock (Valued @ absorptioncost)(1
st)
xxxx
Add Production Cost (Valued @ absorption
cost) (1st)
xxxx
Total Production Cost(1st) xxxx
Less Closing Stock (Valued @ absorption
cost) (1st)
(xxx)
Absorption Cost of Production(1st) xxxx
Add Selling, Admin & Distribution Cost(1st) xxxx
Absorption Cost of Sales( 2n
) (xxxx)
Un-Adjusted Profit( 2n
) xxxxx
Fixed Production O/H absorbed(1st) xxxx
Fixed Production O/H incurred(1st) (xxxx)
(Under)/Over Absorption( 2n
) xxxxx
Adjusted Profit( 2n
) xxxxx
