This is a method of distributing costs that are not directly connected to the product to reach the total production cost.
Using Absorption Costing
The motive behind absorption costing is that products should report their full cost. Costs like the fixed manufacturing don't vary with the production of an additional unit. This can make them hard to earmark to a particular product.
But it does not imply that these costs are not related to the units produced. An example is the rent cost of the plant. Absorption Costing aims at allocating these costs to find the full production cost per unit. Firms can use several techniques to absorb their overhead costs. Here are the most common methods:
- Direct material cost - These are the materials cost used to produce the product.
- Direct labor cost - Cost of factory labor used to manufacture the product.
- Machine hour - The duration used to manufacture a product.
Absorption Costing principles are used when preparing financial reports for external and for tax compliance purposes. The rationale of absorption is that goods produced must include a share of all production costs and variable and fixed costs incurred. These are the main components of Absorption Costing:
- Direct materials - Materials utilized in production.
- Direct labor - Labour used in production.
- Variable production overheads - The costs that vary with the production of additional components such as electricity cost.
- Fixed production overhead - The costs that do not vary with production, for example, rent.
Example of Absorption Costing Technique
XYZ Breweries produces the following three products:
- Alpha Premium Beer
- Beta Mainstream Beer
- Conc Value Beer
Information relating to the products is listed below:
Alpha Beta Conc
Direct labor cost per unit ($) 0.07 0.14 0.12
Direct material cost per unit ($) 0.17 0.19 0.16
Actual production/Sales units 500,000 150,000 250,000
Direct labor hour per unit 0.001 0.01 0.005
Direct machine hours per unit 0.01 0.04 0.02
Selling price per unit ($) 0.05 0.45 0.43
The annual production overheads are $80,000
Using Absorption Costing, you can calculate the production cost per unit. The first two lines of our calculation are pretty easy to fill as you can be able to find them from the cost card. The difficult part is calculating the overhead absorption rate per unit.
Overhead absorption rate (OAR) = Production overheads/Activity level (To be selected)
The activity level should be appropriate for the business. XYZ Breweries must select the best activity level, for instance, between direct labor hours and machine hours. You can designate the production labor cost based on labor hours or machine hours used to produce one unit.
Take a look at the process. If it leans more towards machine hours than labor hours, more machine hours are used to produce one unit of output. Units produced can also absorb the overhead cost—especially when you're manufacturing more than one type of product. To compute the OAR, you need to divide the total overheads by the total activity level for the period.
- = $80,000/ ((0.01*500,000) +(0.04*150,000) +(0.02*250,000))
- =$80,000/16,000 hours
- =$5 per machine hour
These units can now be absorbed into production.
Alpha Beta Conc
Production overheads ($)
=Machine hours per unit * OAS of $5 0.05 0.02 0.01
Based on that, you can then compute the cost per unit.
Alpha Beta Conc
$ $ $
Direct Material cost per unit 0.17 0.19 0.16
Direct Labor cost per unit 0.07 0.14 0.12
Production overheads per unit 0.05 0.02 0.01
Full production cost per unit 0.29 0.53 0.38
Selling cost per unit 0.50 0.45 0.43
Profit/loss per unit 0.21 (0.08) 0.05
From this example, Alpha and Conc are profitable, while Beta is making losses. Management will have to make decisions if they continue producing Beta. They can look at ways of cutting the production cost or increasing the selling price.
If this isn't feasible, they may alternatively stop manufacturing the product. However, this may not be correct. Activity-Based Costing (ABC) is a more accurate cost allocation technique.
Significance of Absorption Costing
One of the advantages of using Absorption Costing is that it conforms to the accounting concept of accrual. Where you match revenues against cost in an accounting period. It's also useful in pricing decisions when using the cost-plus pricing method. It accounts for all costs when you're pricing a product at a margin and avoid a scenario where some cost is not fully absorbed.
It also gives managers better visibility of costs, driving better operational management decisions. This method, though easy to compute, is not always accurate in apportioning costs. Also, it doesn't capture the behavioral features of costs.