Absorption Costing

ACCA F2 - Management Accounting

Absorption costing determines the full per unit cost of production. It is required for external financial reports and for tax reporting. Under absorption costing costs are divided into production costs (Direct costs - material and labor, Indirect costs - variable, semi fixed and fixed indirect costs e.g. rent, supervisor's salary, depreciation) which are absorbed in determining the unit cost of production and non-production costs (Variable/Fixed selling and administrative costs e.g. advertising, delivery and administrative costs like cleaners and postage) which are treated as period expenses and are excluded for product costs.

Estimating cost per unit of direct material and labour is straightforward and easy. However, calculating per unit of indirect costs is difficult to identify. Therefore, overhead cost per unit is calculated using a suitable basis like units produced, labor hours or machine hours.

Under absorption costing, change in capacity of production can result the change in unit cost of the product. This is because indirect fixed overhead have push and pull effect on unit cost. Let go through capacity concept in brief.

Source: Absorption/Variable costing ….. check link below

Ø  Theoretical capacity is the level of capacity based on producing at full efficiency all the time. This measure of capacity does not allow for plant maintenance, shutdowns, interruptions, or any other factors. It can be achieved for short period but cannot be sustained. This represents ideal goal of capacity utilization.

Ø  Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions - scheduled maintenance or holidays, for example.

Ø  Normal capacity is the level of capacity utilization that satisfies average customer demand over a period of time, frequently one year.

Ø  Master budget capacity utilization is the level of capacity that managers expect for the current time period, frequently one year.

Theoretical and practical capacity measure capacity in terms of what a plant can supply. Normal capacity and master budget utilization measure capacity in terms of demand.

Source: Absorption costing overview …. check link below

Absorption costing can be further classified into three different types. They are:

Ø  Job Order Costing - assigned to product in batches or lots

Ø  Process Costing - cost are systematically assigned to the product - no batches to assign cost (e.g. Oil Distilling and Soda Manufacturing)

Ø  ABC Costing - assigns cost from cost centers to the product best in multi-product environment