Chapter Nine
Absorption Cost
Systems
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Outline of Chapter 9
Absorption Cost Systems
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Job Order Costing
Cost Flows through the T-Accounts
Allocating Overhead to Jobs
Permanent versus Temporary Volume
Changes
Plantwide versus Multiple Overhead Rates
Process Costing: The Extent of Averaging
Appendix A: Process Costing
Appendix B: Demand Shifts, Fixed Costs, and
Pricing
9-2
Connection to Other Chapters
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Chapter 9 describes how manufacturing firms use
absorption costing to apply costs to products
manufactured.
Previously, chapters 7 and 8 introduced the topic
of cost allocations and discussed various reasons
why firms allocate costs, including decision
management, decision control, cost-plus pricing
contracts, financial reporting, and taxes.
After chapter 9, chapters 10 and 11 will describe
criticisms of absorption cost systems. Chapter 10
shows how variable costing can mitigate
absorption costing’s incentives to overproduce.
Chapter 11 shows how activity-based costing can
mitigate absorption costing’s tendency to give
inaccurate product costs.
9-3
Manufacturing versus
Nonmanufacturing Settings
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Manufacturing settings
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Product costs: costs of manufacturing goods
Period costs: nonmanufacturing costs
Costs must be allocated between cost of goods sold
(expense or expired costs) and ending inventories
(assets or unexpired costs) Note: Because allocation
involves management’s judgment, it offers discretion in
product costing and income determination.
Nonmanufacturing settings (merchandising and
service firms)
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Product costs: costs of inventory held for resale
Period costs: all other costs
Most product costs for physical goods are directly traced
to external contacts and do not require cost allocation
9-4
Two Types of Absorption Systems
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Absorption cost systems ensure that all
manufacturing costs are assigned to products
either by direct tracing or by cost allocation.
Job order costing is used in departments that
produce output in distinct jobs (job order
production) or batches (batch manufacturing).
Process costing is used in departments that
produce output that is not in distinct batches or
produce continuous flows, such as beverages
and oil refineries.
In practice, many plants use hybrids of job order
and process costing.
9-5
Job Order Costing
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Cost object: Distinct job or batch records are
maintained for each job (see Table 9-1).
Direct traceable costs: Raw materials and direct
labor costs are directly assigned to each job.
Cost allocation: Manufacturing overhead costs
(fixed and variable) that cannot be directly
traced are allocated to jobs
Allocation base: An input measure such as
machine hours or labor hours
Overhead rate: Overhead rate is set at
beginning of year based on estimated total
overhead costs and estimated volume.
9-6
Cost Flow Sequence
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See Figure 9-1 for cost flows in job order cost
system.
1. Costs are accumulated in three major categories:
materials, labor, and overhead.
2. Direct materials, direct labor, and overhead are assigned
to the work-in-process (WIP) inventory account for each
job.
3. When manufacturing is completed, the cost of units
completed is transferred from WIP to the finished goods
inventory.
4. When goods are sold, the costs are transferred from the
finished goods inventory account to the cost of goods
sold expense account.
5. If any amount remains in the overhead account at the
end of the period, it must be allocated to some inventory
or expense account.
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Review Self Study Problem 1.
9-7
Inventory Cost Flow Accounting
Assumptions
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Inventory cost flow assumptions change the amounts
transferred out of an inventory account when input prices
change over time.
External importance: financial statements, taxes, costbased contracts.
Internal importance: decision making and decision control.
1. First In, First Out (FIFO): Oldest items are transferred out
first. When prices are rising, FIFO reports higher net
income than LIFO.
2. Last In, Last Out (LIFO): Newest items are transferred out
first. When prices are rising, LIFO reports lower net income
than FIFO.
3. Specific Identification: Each inventory item is individually
priced.
9-8
Overhead Rate
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Prospective overhead rates are set at the beginning of
the year (also known as predetermined overhead
rates).
Numerator: Estimated annual budgeted overhead
dollars
Denominator: Estimated annual factory volume (input
measure)
Possible input measures: machine hours, direct labor
hours (DLH), direct material dollars, or direct labor
dollars
Incentive effect: Managers reduce whichever input
used to allocate overhead. (Recall Chapter 7).
9-9
Over/Underabsorbed Overhead
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Actual overhead incurred for a year is the
amount of indirect manufacturing costs
incurred during the year.
Absorbed overhead (also known as applied
overhead) is the amount of overhead applied
to work-in-process during they year using the
predetermined overhead rate and the actual
amount of inputs used.
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Underabsorbed overhead exists when actual
> absorbed overhead.
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Overabsorbed overhead exists when actual <
absorbed overhead.
9-10
Disposing of Over/Underabsorbed
Overhead
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Overhead accounts must be cleared of
over/underabsorbed overhead at the end of the
year.
1. Write off all to cost of goods sold expense account.
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Simplest bookkeeping procedure
2. Allocate among WIP and finished goods inventory,
and cost of goods sold expense account.
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Better if ending inventory levels are significant
3. Recalculate job costs with actual overhead rates.
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Most complex data processing
9-11
Flexible Budgets to Estimate
Overhead
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Recall from Chapter 6:
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Static budget estimates do not change with volume.
Flexible budget estimates do change with volume.
Forecast annual budgeted overhead dollars with a
flexible budget:
Budget = Fixed + Variable
= FOH + (VOH X BV)
where, FOH = Fixed overhead estimate
VOH = Variable overhead rate estimate
BV
= Budgeted volume estimate
9-12
Budgeted Volume: Expected versus
Normal
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Expected volume: Volume expected for the coming year.
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Decision control: enhanced because transfer prices are
adjusted for changing volume
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Decision management: impaired because lower volume raises
overhead rate, and encourages profit centers to raise prices
Normal volume: Long-run average volume over economic
cycle.
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Decision control: impaired because managers are not held
responsible for short-run volume fluctuations
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Decision management: better long-run opportunity cost
estimates result in better pricing decisions
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Opportunity to manage earnings: setting normal volume is
more subjective than expected volume
9-13
Permanent versus Temporary Volume
Changes
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How should overhead rate estimates respond
to volume changes?
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Permanent volume changes:
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Write off assets or change estimated useful lives of
assets.
Managers may be reluctant to admit that their prior
projections need to be adjusted.
Temporary volume changes:
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Assumed to average out over economic cycles
No accounting changes should be made.
9-14
Plantwide versus Multiple Overhead
Rates
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Choices of overhead cost allocation disaggregation:
1. Single overhead cost pool for entire plant:
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Easiest to apply, but accounting costs may be very
inaccurate representations of opportunity costs.
2. Many cost pools each with its own cost driver:
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More data processing, but more accurate costing
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3. Two-stage allocation of departmental overhead
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Review Self Study Problem 2.
rates
 Allocate to departments, and then to products.
9-15
Plantwide versus Multiple Overhead
Rates
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If the overhead rates contain large amounts
of fixed historical costs, such as depreciation,
then neither plantwide rates nor individual
department rates accurately reflect the
opportunity cost of capacity.
9-16
Process Costing Overview
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Production process is a continuous flow without
discrete batches or jobs.
Each process is treated as a separate cost
center.
Costs are averaged over large number of
production units that are assumed to be
essentially identical.
Decision making usefulness is reduced because
costs for individual batches are not available.
See Appendix A for process costing details.
9-17
Appendix A: Process Costing Details
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See Table 9-6.
Step 1:
Step 2:
Account for physical flow of units.
Compute number of equivalent physical
units and average cost per equivalent
unit.
Total all the costs to be assigned.
Allocate total costs to WIP inventory
and transfers to Finished Goods
inventory by the number of equivalent
physical units in each category.
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Step 3:
Step 4:
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Refinements: inventory cost flow assumptions
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9-18
Appendix B: Demand Shifts, Fixed
Costs, and Pricing
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Price should be lowered when demand falls
See Figures 9-5 and 9-6
Pricing decision
Shutdown decision
See Table 9-10
9-19