Introduction
“The process which charges fixed
as well as variable overheads to
cost units”
Definitions of Absorption
Costing
• A method of costing that, in addition to direct
•
costs, assigns all, or a proportion of, production
overheads costs to cost units by means of one
or a number of overhead absorption rates
(CIMA)
Absorption costing calculates the unit cost of an
item taking into account all costs, fixed and
variable, direct and indirect. Indirect/fixed costs
are allocated to or absorbed by the products
made
Absorption costing- the essence
• All overheads are included when calculating the
•
•
•
cost of producing particular items
Fixed costs are brought into the calculations on
the assumption that they must be recovered
All overheads are absorbed into cost units but
each aspect of overheads is absorbed separately
by cost centres on an appropriate basis – i.e. not
a blanket approach
Absorption costing is used to calculate profit and
to calculate stock valuation for financial
statements
Classification of costs
• Production costs made up of
– Direct costs for materials, direct labour & other
directly attributable expenses
– Indirect costs (factory overheads) made up of indirect
materials, indirect labour, indirect expenses
• Administrative expenses (indirect costs or
•
overheads
Selling and distribution costs (indirect costs or
overheads)
Total cost statement
Direct materials
+ Direct labour
+ Direct expenses
= Prime Cost
+ Factory overheads
= Production costs
+ Selling and distribution costs
+ Administrative costs
+ Finance costs
= Total costs
Steps in absorption costing
•
•
•
•
•
•
•
Record all costs
Classify all the costs
Direct cost are directly linked to the output
Allocate the indirect costs to the service
departments of a business
Reallocate costs from service support
departments to production departments
Calculate an overhead recovery rate
Absorb both the direct and indirect costs
(overheads) into individual products
The three As
• Allocation: charging to a cost centre those
•
•
overheads which result solely from the existence
of that cost centre
Apportionment: the charging to a cost centre
of a fair share of an overhead on the basis of
the benefit received by the cost centre from the
facilities provided by the overhead
Absorption: when all production overheads
have been allocated and apportioned to a
product cost centre, the total has to be charged
to specific units of production
Key stages
• Allocation of costs directly incurred by
particular cost centres
• Apportion (divide up) all shared
overhead costs between various cost
centres
• Apportion all service cost centre
overheads to the production cost centres
• Absorb the allocated and apportioned
overheads into the costs of production of
cost centres
In plain English
• We own a factory producing widgets and other goods.
•
•
•
•
Widget production is one cost centre
First, all costs directly traceable to widget production are
allocated to this cost centre. This includes overheads
such as the cost of machinery dedicated to the
production of widgets
Second, calculate the cost of service cost centres such
as the HR Department. Apportion these costs to various
production cost centres (including widget production) on
some equitable basis
Third, the apportioned costs are absorbed into each
widget produced
This ensures all costs are recovered
Allocate
• Allocate overhead costs that are directly incurred by
•
•
•
•
particular cost centres. Allocate directly attributable costs
Allocation is the process of charging indirect costs that
are wholly associated with a particular cost centre to
that centre
Examples: machines dedicated to the production of a
particular product, building whose sole use is the
production of a particular product
In both cases there is no need to divide up the costs
between products since the facility is directly linked to
the product
But if an overhead cannot be allocated it must be
apportioned
Apportionment
• Apportionment is the process by which shared
•
•
•
overheads are divided between cost centres on
an equitable basis
Divide all shared overheads between production
and service cost centres
Re-apportion all service cost centre overheads to
the production cost centres
Example: service cost centres include HR
department, maintenance, cleaning. Each
production cost centre will be required to carry
of these overheads
Apportionment should…
• Be related in some way to the manner in
which the cost is incurred by each centre
• Reflect the use made of the resource by
the cost centre
• Be on a basis which is relatively easily
attainable from the records of the
organisation
• Be fair, reasonable and equitable
Bases for apportionment
•
•
•
•
•
•
•
Rent - floor place use by each cost centre
Heating - cubic capacity of each cost centre
Indirect labour - in proportion to direct labour
Supervision/canteen/personnel department - in
proportion to the number of employees in each
cost centre
Depreciation - in proportion to the capital value
of the equipment
Insurance - the book value of assets
Materials handling- weight or size
Absorb
• Overheads are broken down into components
•
•
•
and then absorbed on a pro rata basis using a
variety of yardsticks
Absorb the allocated and apportioned overheads
into the costs of production of each unit
Calculate how much each unit should absorb
The transfer of the department or cost centre
overheads to the product or unit costs by using
cost absorption or recovery rates
Absorption rate
• Definition: A means of attributing overheads to a
•
•
product or service base for example on direct
labour hours, direct labour costs or machine
hours. (CIMA)
Also known as the recovery rate - the rate at
which overheads are charged to cost units
Overhead absorption rates are expressed in
relation to one of: units of output, direct labour
hours, machine hours
A simple example
• Direct costs per unit
• Directly attributable overheads
• Service department overheads
•
•
£5
£200k
£360k
apportionment on the basis of % of employees –
widget production employs 33.3% of employees.
All other overheads
£400k
apportioned on the basis of % of area occupiedwidget production takes up 25% of floor space
Output of widgets
100k
A simple example
• Allocated overheads
• Apportioned overheads
•
•
•
•
•
£200k
£120k
(33.3% of £360k)
Apportioned overheads
£100k
(25% of £400k).
Total overheads to be absorbed
£420k.
This works out at £420k/100k or £4.2 per unit.
Cost per unit= £5+£4.2= £9.2
Absorption rates
• Calculated by taking the overhead for a
particular cost centre and dividing it by the
number of units of the absorption base
Cost unit absorption rate
= production cost centre overhead
number of cost units
Direct labour hour absorption rate
= production cost centre overheads
number of labour hours
Absorption rates (1)
Machine hour overhead absorption rate
= production cost centre overheads
number of machine hours
Direct wage % overhead absorption rate
= production cost centre overheads x 100
direct wages
Absorption rates (2)
Materials cost % overhead absorption rate
= production cost centre overhead x 100
direct materials
Prime cost % overhead absorption rate
= production cost centre overhead x 100
prime cost
Selling overhead absorption rate
= total selling overheads x100
total factory cost of sales
Over and under absorption
• Absorption rates are based on budgeted
or pre-determined figures
• If output/sales are different from those
budgeted then the result is:
• Over-absorption - absorbed overheads
are greater than actual overheads
• Under-absorption - absorbed overhead
is less than actual overhead
Absorption costing statement
Sales revenue
Less
Direct materials
Direct labour
Production overheads
= Gross profit
Less
Selling overheads
Distribution overheads
Administrative expenses
R and D costs
= Net profit
Advantages of absorption
costing
• Fixed costs are recovered - fixed costs are
•
•
•
•
•
•
incurred in order to make output so it is only fair
to charge all output with a share of these costs
Ensures that costs are fully recovered
Encourages cost consciousness
It is fair in that it uses appropriate methods for
each overhead
Identifies total costs - this is useful where
pricing is on a cost plus basis
Identifies the profitability of different products
and services
Conforms with SSAP9 on the valuing of stocks
Problems of absorption costing
• All methods are arbitrary - no method of diving
•
•
•
•
•
up fixed costs is satisfactory
Absorption cost is true only at the level of
activity at which it was calculated
Danger of under or over absorption of
overheads
Complex, time consuming and expensive
Potentially misleading guide to profitability of
products
The capacity levels chosen for overhead
absorption rates are based on historical
Full costing or absorption
costing?
• The two terms are often but wrongly used
•
interchangeably
It is true that in both cases the indirect costs are
apportioned between various costs centres but…
– In full costing the overheads are apportioned as a
whole and
– Fixed and variable overheads are blanketed and
expressed as some proportion of an easily calculated
costs
• In absorption costing different allocation rules
apply for different types of overhead
Full costing: apportion overheads in
same ratios as direct costs
£
Sales
Direct costs
Indirect costs
Profit
Product A
Product B
Product C
200
100
80
120 (60%)
60 (30%)
20 (10%)
72 (60% of
36 (30% of
12 (10%of
indirect costs) indirect costs) indirect costs)
8
4
48
Full costing
Advantages
• Quick and cheap to
calculate
• Accessible to non
specialists
• Requires only basic
information
• All costs recovered by
cost allocated to each
centre
• A simplified version of
absorption costing
Disadvantages
• Arbitrary and unfair
• Too general to be of great
value for control purposes
• The least accurate
method of allocating
overheads
• Allocation of overheads
gives a distorted view
Key terms
• Absorb – process of charging overhead to cost
•
•
•
units
Absorption rate/recovery rate - the rate at
which overheads are charged to cost units
Allocation - the process of charging indirect
costs that are wholly associated with a particular
cost centre to that cost centre
Apportion – the process by which shared
overheads are divided between cost centres
Cost allocation - a summary
• Full costing - indirect costs are allocated using
•
•
a single arbitrary method. A blanket approach
which may not reflect the true cost of each
product
Absorption costing - this method uses several
criteria for allocation of indirect costs. An
improvement on the blanket method but still
largely subjective
Marginal costing - no attempt is made to
allocate indirect costs. Marginal cost decision
making is based on the value of the contribution
that the product makes to indirect costs