Absorption costing is a system that helps in the valuation of stock. This method includes labour and material costs and also fixed and variable manufacturing overhead costs. This article will provide you with the absorption costing formula and discuss its advantages and disadvantages and how it is different from variable and marginal costing.
Did you know? Absorption costing includes all direct expenditure/ costs incurred while manufacturing a product.
Absorption Costing Definition
Absorption costing is also known as full costing. It is the method of adding all costs incurred in the process of production and then determining the per unit cost. This method helps businesses to ascertain the value of stock to be mentioned in the balance of the financial year.
The Components of Absorption Costing
The components of absorption costing are given below:
- Direct Materials cost.
- Direct Labour cost.
- Variable Manufacturing Overhead cost.
- Fixed Manufacturing Overhead cost.
The below-mentioned costs are period costs and are not added when calculating the cost of a product.
- Variable selling and administrative cost.
- Fixed selling and administrative cost.
Sales and administrative costs should be put in expense in the period incurred. These costs should not be added to stock since they are not related to goods produced.
Also Read: Cost Accounting vs Management Accounting
Absorption Costing Method
Given below are the steps to calculate the absorption cost:
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Prepare Cost Pools
First, decide on the costs related to the manufacturing of a product. Assign them to different cost pools. A cost pool assigns expenses by activity. You can create different cost pools for activities like marketing, research and development, customer services, and others. As money is spent on the expenses the costs should be assigned to the respective cost pool.
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Fix Usage for Each Cost
Go through the production procedure and decide on the amount spent on each activity during the production. You should decide on usage for activities like hours spent on labour or equipment used during the process of manufacturing, and others.
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Calculation of the Costs
The last step is to calculate the allocation rate. This will tell you the cost per unit.
Also Read: Differences between Financial Accounting and Management Accounting
Absorption Costing Formula
The formula to calculate the absorption costing is mentioned below:
Absorption Cost Per Unit = (Direct Labour Costs + Direct Material Costs + Fixed Manufacturing Overhead Costs + Variable Manufacturing Overhead Costs) / Number of Units Manufactured
For example, a company produces 1,000 units of product in a month. Out of 1,000 units produced, 800 were sold that month with 200 left in stock. Let’s assume the cost of labour and materials come out to ₹500 per unit. The monthly fixed costs are ₹80,000. Using absorption costing the company calculates the fixed overhead costs per unit.
Therefore, fixed overhead costs per unit = total fixed monthly overhead costs/total number of units
ie, fixed overhead costs per unit = ₹80,000/1000 = ₹80 per unit.
Then, absorption cost per unit = fixed overhead costs per unit + variable overhead costs per unit
Ie, absorption cost per unit = ₹80+₹500 = ₹580.
Therefore, cost of goods sold = absorption cost per unit * number of units sold
Ie, cost of goods sold = ₹580*800 = ₹4,64,000
Therefore, the remaining unsold stock of 200 units is valued at ₹1,16,000 in absorption costing.
Also Read: What Is Vouching in Accounting?
The Advantages Of Absorption Costing
The advantages of absorption costing are given below:
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Taking into Account All Costs Related to Production
In absorption costing the smallest cost incurred towards production is taken into account. This proves helpful during the process of product pricing. This helps to ensure that the product is priced appropriately according to the expenses incurred during production. It also ascertains that the products are priced correctly and competitively.
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Tracking Profits
Absorption costing also provides the company with an accurate profitability picture.
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Best Suited for Small Businesses
It helps small businesses to track the cost of products easily as their production is not on a very large scale. The businesses can realise their fixed costs beforehand and correctly price the product for sale.
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Suitable for Changing Demands
Absorption costing provides a systematic costing tool for active businesses while taking into account the fluctuating turnover as costs are already fixed. It is an advantage for businesses that have a constant product demand.
The Disadvantages of Absorption Costing
The disadvantages of absorption costing are mentioned below:
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Over-Assigning Overhead Costs
Under absorption costing the overhead costs which cannot be attributed to the product are assigned to every unit.
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Overproduction to Cut Costs
Under this method, the profitability increases as the products are manufactured in large quantities. The fixed overhead costs remain constant. Hence, with more production, the fixed costs per unit decrease. In case when units are still in stock the fixed overhead costs are not transferred to the expenses report. This increases profitability.
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Incomplete Data
The data available to decide a product’s cost through this method also includes the fixed overhead. This move inflates the actual cost of manufacturing rendering the available data insufficient for a comprehensive analysis.
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Uninformed Profitability
Fixed costs cannot be subtracted from revenue until the units are sold so absorption costing shows incomplete information regarding the profit levels of the company. This may show unaccounted-for costs on the company’s income statement while showing profitability on the balance sheet.
What is Variable Costing?
Variable costing is a concept widely used in managerial and cost accounting. In this case, the fixed manufacturing overhead is excluded from the product cost of the production. This method stands in contrast to absorption costing where the fixed manufacturing overhead is added to the cost of goods produced.
For example, lets refer back to the previous example. The variable cost to produce one unit was ₹500 per unit. So, the variable cost for producing 1,000 units is ₹5,00,000. Here, we have ignored the fixed overhead costs.
Also Read: Matching Concept in Accounting: Benefits and Challenges
Difference Between Absorption Costing and Variable Costing
The table below shows the difference between absorption costing and variable costing.
|
Basis for Comparison |
Absorption Costing |
Variable Costing |
|
Method |
When calculating absorption cost all direct costs, variable manufacturing overhead, and fixed overhead are assigned to the product cost. |
Under variable costing the cost of a product includes only variable costs. |
|
Use |
Calculates per-unit cost of fixed overhead. |
Determines a lump sum for fixed overhead costs. |
|
Stock |
Stock value includes direct labour, direct material, and all overhead. |
Value of stock does not include fixed overhead. |
|
Provides an unclear picture of the profitability of the business as total fixed costs are not subtracted from the revenue. |
Does not match the expenses to revenue in the same accounting period. Since goods in stock do not absorb fixed costs, the result is more accurate. |
|
|
Reporting |
This costing method is acceptable under GAAP. (Generally Accepted Accounting Principles). |
This method of costing is not acceptable under GAAP. |
What is Marginal Costing?
Marginal costing refers to an increase/decrease in the total production cost owing to a change in the output.
For example, making 10 car tires costs ₹10,000. So, the per unit cost is ₹1,000. However, to make 20 tires, it will cost ₹20,200. Now, the per unit cost is ₹1,010. Therefore, this additional cost of ₹10 per unit, incurred to produce 1 more tire is the marginal cost.
Also Read: How do Manual Accounting and Computerised Accounting Differ?
Difference between Marginal Costing and Absorption Costing
The below-given table shows the difference between marginal and absorption costing
|
Basis for Comparison |
Marginal Costing |
Absorption Costing |
|
Meaning |
This technique considers only variable costs as the product costs. |
In absorption costing, both fixed costs and variable costs are taken into account. |
|
About |
Variable cost is assumed as product cost whereas fixed cost is taken as a cost for the period. |
Both variable and fixed costs are considered in the product cost. |
|
Nature of Overheads |
Fixed and variable costs. |
In absorption costing overheads are production, selling, distribution, and administration. |
|
Calculation of Profit |
By using the P/V ratio. |
Fixed costs too are included in product costs. |
|
Determines |
The cost of the next unit. |
The per unit cost. |
|
Opening and Closing Stock |
Change in the opening or closing stock does not affect the per unit cost. |
Change in opening or closing stocks affects the per unit cost. |
|
Important aspect |
Contribution per unit. |
Net profit per unit. |
|
Purpose |
Contribution to the product cost. |
Accuracy of the product cost. |
|
Presentation |
By outlining the total contribution. |
For financial and tax reporting. |
Conclusion:
We hope this article has been of help in providing information about absorption costing. Here at Khatabook, we provide precise and accurate information to our readers. The absorption costing method works by adding all expenses incurred in the production process and then determining the per unit cost. This helps businesses to ascertain the stock value accurately.
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