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.).
1. Identify cost centers and products
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:
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:
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
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 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:
Unabsorbed overheads at the end of the accounting year can be treated as follows: