Absorption costing
Absorption costing is a type costing method or rather the approach to costing.
It is sometimes called as full costing method as it values the product (or jobs, batches, processes etc.) by direct costs and allocated, apportioned and absorbed share of production indirect costs (production overheads). This overhead allocation is done by using appropriately chosen absorption (allocation) rate (m2, Kwh, number of employees etc.).
Basic steps used in absorption costing
1. Identify cost centers and products
- production cost centers – to which the costs will finally be allocated and/or apportioned. Cost center may for example be individual production department or production hall
- service cost centers – cost centers providing services to other cost centers, e.g. repairs and maintenance department, canteen, payroll
- general overhead cost center, to which costs not directly identifiable with any cost center above will be allocated
- products within production cost centers
2. Prepare production cost figures, split them according to traceability to product and cost center and:
2.1. Allocate direct costs directly to products / cost unit.
2.2. Prepare a table of production overheads and allocate:
2.2.1. costs directly identifiable with a cost center to that cost center
2.2.2. costs not directly identifiable with a cost center to general overhead cost center
3. Apportion (apportionment is also called departmentalization) general overhead cost center to other cost centers and then service cost centers to production cost centers on a reasonable basis.
3.1. Apportion first general overhead cost center to other cost centers – not only to production cost centers, but also to service cost centers (however, if they consume the apportioned overheads too).
3.2. After that, apportion the costs of service cost centers to production cost centers. Start the apportionment with service centers providing services for the biggest number of other service centers. If service cost centers provide services for each other, the order of cost centers is not important and calculations are to be performed in several iterations unless there is negligible amount left – apportion this amount to production cost centers only.
Basis of apportionment:
It is usual to use a number of apportionment basis for different types of overhead costs. Their choice is a matter of common sense. The most commonly used are direct labor or machine hours consumed by each cost center. Others are:
- Machinery value– for repair and maintenance, depreciation and insurance of machinery
- Floor area – for rent or depreciation of factory
- Number of workers (diners) – for services of canteen
- Kilowatt hours – for power
- Expert surveys
- Direct material costs
- Sales or revenues (usually only if there is no better basis)
ALL COSTS HAVE NOW BEEN ALLOCATED AND APPORTIONED TO PRODUCTION COST CENTERS ONLY. THEY NOW NEED TO BE SPLIT (ABSORBED) INTO PRODUCTS (COST UNITS).
4. Choose and calculate the rate, by which the overheads will be split (absorbed) to products → overhead absorption rate (overhead recovery rate).
Overhead absorption rate = overheads / activity level
It is usually calculated annually for the entire forthcoming year. Overheads and activity level are usually budgeted figures.
Overheads are costs allocated and/or apportioned to the production cost centers. These are the figures you reached within steps 1-3, however, without direct costs.
Activity level is a budgeted activity level of chosen overhead absorption rate, e.g. number of hours worked in the cost center or direct labor or material costs.
Examples of overhead absorption rates:
- Overheads per number of units produced
- Overheads per labor hour worked (for labor-intensive production)
- Overheads per machine hour worked (for machine-intensive production)
- % of overheads on certain direct costs (usually direct labor or material costs)
It is again possible to use several overhead absorption rates and their choice is a matter of common sense. Each department through which the product passes usually has a separate overhead absorption rate as they can have very different character – e.g. one department can be labor intensive, other machine intensive.
5. Absorb the costs in each production cost center to the products by using chosen overhead absorption rate
Actual activity level x overhead absorption rate
For example:
- actual direct labor hours worked on the product x (estimated overheads / estimated direct labor hours)
6. If budgeted (or otherwise estimated) overheads and activity level is used, it will most probably result into unabsorbed overheads. Thus calculate the value of over/under absorbed overheads.
For example, if the used budgeted overhead absorption rate is 10 EUR per machine hour and 50 machine hours were actually worked on the product, then absorbed overheads will be 500 EUR. But actual overheads were 550 EUR. The difference (50 EUR) is under-absorbed overhead.
Unabsorbed overheads
Unabsorbed overheads are over or under absorbed overheads resulting from the fact that the value of actual overheads or actual level of activity (or both) may differ from budgets.
CALCULATION OF UNABSORBED OVERHEADS
(estimated overhead absorption rate x actual activity level) – actual overheads
If > 0 → over-absorbed overheads
If < 0 → under-absorbed overheads
If unabsorbed overheads are material, their cause shall be investigated and ideally corrected. The reasons may be:
- actual overheads differ from those budgeted
- actual level of activity differ from those budgeted:
- wrong estimate of activity level – e.g. different productivity was planned and as the result, more labor hours were actually necessary to produce a unit
- not appropriate overhead absorption rate chosen (e.g. department used to be labor intensive, but the production process was automatized and is currently more machine-intensive)
- level of production is different (e.g. seasonal fluctuations) or production capacity is not fully utilized or is over-utilized
Unabsorbed overheads at the end of the accounting year can be treated as follows:
- if is the value of unabsorbed overhead insignificant and the majority of products causing them have been sold → cost of goods sold (4)
- if the value of unabsorbed overhead is significant and/or the majority of products causing them have not been sold → split the amount between inventory (unsold output) and costs of goods sold (sold output). (4)
Extract from profit and loss under absorption costing system
