Accounting (9706) | Traditional costing methods - Absorption costing

Welcome to Absorption Costing!

Hello future accountants! This chapter introduces you to one of the most fundamental ways businesses calculate the total cost of their products: Absorption Costing.
Don't worry if the name sounds intimidating—it simply means making sure every product "absorbs" its fair share of *all* costs incurred by the factory, including fixed overheads.
Understanding this method is crucial because it affects inventory valuation, profit calculation, and ultimately, important management decisions. Let's dive in!

1. Core Concepts: The Building Blocks

Before we absorb costs, we need to know what we are absorbing them into, and where they are coming from.

1.1 Cost Centre vs. Cost Unit

Cost Centre

This is simply a location, function, or department where costs are incurred and collected.
Think of it as a bucket where you collect specific types of costs.

• Production Cost Centres: Directly involved in making the product (e.g., Assembly Line, Machining Department). These are the departments that will eventually absorb the costs into the final product.
• Service Cost Centres: Provide support to the production centers but do not directly make the product (e.g., Maintenance Department, Canteen, Quality Control).

Cost Unit

This is the final product or service to which costs are attached.
Think of it as the actual thing you are selling.

Examples of Cost Units:

• A single bottle of perfume (in a manufacturing business)
• One hour of a client's time (in a consulting service business)
• One kilometre travelled (in a transportation business)

Quick Analogy: If you run a bakery, the Cost Centres are the kitchen and the packaging area. The Cost Unit is one delicious loaf of bread!

2. The Absorption Costing Principle (The Goal)

Absorption Costing is also known as Full Costing because it includes *all* production costs—both variable and fixed—when calculating the cost of a product.

Product Cost Components under Absorption Costing:

1. Direct Costs: Direct Material + Direct Labour + Direct Expenses
2. Production Overheads: Variable Overheads + Fixed Overheads

The core challenge in Absorption Costing is dealing with the Fixed Production Overheads (like factory rent or supervisor salaries), as these cannot be traced directly to a single product. We need a systematic way to assign them.

2.1. Handling Overheads: The 3-Step Process

This process ensures all factory overheads end up in the production cost centers before being charged to the products.

Step 1: Allocation

Allocation means assigning a specific, identifiable overhead cost entirely to a single cost centre.
If a cost can only belong to one department, you allocate it.

Example: The salary of the Machining Department foreman is allocated only to the Machining Cost Centre.

Step 2: Apportionment

Apportionment means dividing overhead costs that benefit multiple cost centres (production and service) and distributing them based on a fair measure.
If a cost is shared, you apportion it.

Example: Factory rent benefits everyone. It is apportioned based on the floor area occupied by each department.

Common Bases for Apportionment:

• Rent, Rates, Insurance (Building): Floor area (square metres)
• Electricity (Lighting): Number of light fittings or area
• Supervisors’ Salaries: Number of employees
• Depreciation of Machinery: Cost or value of machinery in each department

Did you know? This step is crucial. If you choose an unfair basis for apportionment (e.g., using number of employees to apportion machine depreciation), the resulting product costs will be inaccurate!

Step 3: Reapportionment (The Service Cost Centre Problem)

After Steps 1 and 2, the Service Cost Centres (like Maintenance) still hold overhead costs. Since they don't produce goods, their costs must be transferred (reapportioned) to the Production Cost Centres.

Example: The cost of the Maintenance Department is reapportioned to Production Departments A and B based on the number of maintenance hours used by each.

Once this 3-step process is complete, all factory overheads (both fixed and variable) are collected entirely within the Production Cost Centres.

2.2. Absorption: The Overhead Absorption Rate (OAR)

Now that the Production Cost Centres have all the overhead costs, we need to charge these costs to the individual units produced. This is done using a pre-determined Overhead Absorption Rate (OAR).

Why do we use an OAR?

The OAR is calculated *before* the accounting period begins, using budgeted figures (expected costs and activity levels). We use a pre-determined rate so that we can cost jobs immediately and set selling prices without waiting until the end of the year for actual fixed costs to be known.

Calculating the OAR

The formula for OAR is simple:

$$ \text{OAR} = \frac{\text{Budgeted Total Overhead Costs for the Cost Centre}}{\text{Budgeted Activity Level (Absorption Basis)}} $$

Choosing the Right Absorption Basis:
The basis must reflect what causes the overhead costs to be incurred (the cost driver).

• Direct Labour Hour Rate: Used if the production process is labour-intensive.
• Machine Hour Rate: Used if the production process is machine-intensive (automated).
• Percentage of Direct Labour Cost: Simple to use, but may distort costs if workers have widely differing pay rates.
• Rate per Unit: Only suitable if all products manufactured are identical.

The Absorption Calculation:
Once the OAR is set, the overhead absorbed by a single product (cost unit) is calculated as:

$$ \text{Overhead Absorbed} = \text{Actual Activity Level} \times \text{OAR} $$

3. Calculating Over- and Under-Absorption

Since the OAR uses *budgeted* figures, the amount of overhead charged (absorbed) to the products during the year will almost certainly be different from the *actual* overheads incurred. This difference is called Over- or Under-Absorption.

3.1. Definitions and Calculation

• Under-Absorption: This occurs when the amount of overhead absorbed is less than the actual overheads incurred. (The business did not charge enough fixed cost to its products).
• Over-Absorption: This occurs when the amount of overhead absorbed is more than the actual overheads incurred. (The business charged too much fixed cost to its products).

$$ \text{Over/Under Absorption} = \text{Total Overhead Absorbed} - \text{Actual Total Overhead Incurred} $$

If the result is positive, it is Over-Absorption.
If the result is negative, it is Under-Absorption.

3.2. Causes of Over/Under Absorption

The variance is caused by differences between budgeted and actual figures used in the OAR calculation:

1. Actual Overhead Costs $\neq$ Budgeted Overhead Costs: If actual costs (e.g., factory rent or insurance) are higher or lower than expected.
2. Actual Activity Level $\neq$ Budgeted Activity Level: If more or fewer units were produced/hours worked than expected.

Memory Aid: If you Under-Absorb, your profit is currently Understated because you haven't charged enough cost. You must add the under-absorption back to the profit in the final statement. (Wait, that's tricky!)

Simple Rule for Adjustment:

• Under-Absorption: You charged too little cost. To fix it, you must ADD the cost (meaning, DEDUCT from profit).
• Over-Absorption: You charged too much cost. To fix it, you must DEDUCT the cost (meaning, ADD back to profit).

4. The Absorption Costing Profit Statement

The main purpose of Absorption Costing is to calculate the full cost of production, which is essential for valuing inventory (stock) for the Statement of Financial Position and the Statement of Profit or Loss.

4.1. Key Feature: Inventory Valuation

Under Absorption Costing, the value of finished goods inventory (both opening and closing stock) includes Direct Costs PLUS Variable Production Overheads PLUS a portion of Fixed Production Overheads.

This is the primary distinction between Absorption Costing and Marginal Costing (which only includes variable costs in inventory valuation).

4.2. Format of the Statement of Profit or Loss (Absorption Costing)

The structure is similar to a standard manufacturing account and income statement:

Total Cost of Production (Direct Costs + All Overheads Absorbed)
Add: Opening Inventory (Valued at full Absorption Cost)
Less: Closing Inventory (Valued at full Absorption Cost)
= Cost of Goods Sold

Step-by-Step Profit Calculation:

1. Calculate Full Production Cost: Sum of Direct Materials, Direct Labour, Direct Expenses, and Absorbed Production Overheads.
2. Calculate Cost of Goods Sold (COGS): Adjust Full Production Cost for Opening and Closing Inventories.
3. Calculate Gross Profit: Sales Revenue minus COGS.
4. Adjust for Over/Under Absorption: The variance is treated as an adjustment to the Gross Profit/COGS to reflect the actual overhead incurred during the period.
5. Calculate Net Profit: Adjust Gross Profit (after variance correction) for Non-Production Overheads (Administration, Selling, Distribution).

Example Structure:

Common Mistake Alert: Students often forget that under Absorption Costing, all fixed production overheads are already included in the Cost of Goods Sold figure through the absorption rate. Therefore, when listing expenses after Gross Profit, you only include non-production overheads (e.g., selling and admin costs).

5. Uses, Limitations, and Evaluation

5.1. Uses of Absorption Costing Data

Absorption costing is generally required for external reporting (Financial Accounting), as required by accounting standards (like IAS 2 Inventories), but it also serves internal management needs:

• Inventory Valuation: It ensures inventory is valued according to the full cost principle for the Statement of Financial Position, giving a truer representation of asset value.
• Pricing Decisions (Long-term): To ensure the company covers *all* costs (fixed and variable) in the long run, setting the selling price based on the full cost provides a sustainable profit baseline.
• Comparison: It allows managers to compare actual performance against budgeted full costs.

5.2. Limitations of Absorption Costing

While useful for financial statements, it has drawbacks for management decision-making:

• Profit Manipulation Risk: Profit can be increased simply by producing more units than are sold. Why? Because the fixed overheads are "stuck" in the unsold closing inventory. If production > sales, less fixed overhead hits the Statement of Profit or Loss.
• Misleading Costs: The use of arbitrary bases (like floor area for rent) means that the "full cost" assigned to a product may not truly reflect the resources it consumed.
• Decision Making: Because fixed costs are included, the cost per unit appears fixed, which can lead to poor decisions about marginal or special orders. For these short-term decisions, marginal costing is often more appropriate.

5.3. Non-Financial Factors and Management Decisions

When management uses absorption cost data for pricing or deciding to take a special order, they must also consider factors that aren't measured in dollars:

• Market Competition: Is the calculated full cost too high to compete with rivals?
• Customer Relationships: If a special order is low-profit but secures a long-term, loyal customer, it might be worthwhile.
• Employee Morale: Will accepting a special, high-volume order require extreme overtime and reduce staff satisfaction?
• Product Quality/Reputation: Reducing costs to meet a target price might compromise quality, damaging the brand in the long run.

Final Thought: Absorption Costing gives us the "safest" cost estimate for mandatory reporting, ensuring all overheads are accounted for. Just remember that it can distort unit costs and profit results when inventory levels fluctuate dramatically!