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This article explains Absorption Costing in a practical way. After reading you will understand the basics of this powerful financial management tool.
What is Absorption Costing?
There are several costing methods that can be used with respect to the recognition of product-related costs. In addition to Direct Costing (Variable Costing) Absorption Costing or full costing is one of the best-known methods. This cost calculation method represents the information of all expenses that are associated with the production process of a product or service.
People often quote random numbers however, it is very important to determine what costing method will be used for a correct expense report. Absorption Costing therefore includes much more than the necessary variable (production) costs such as labour and raw material. In addition to the direct material and labour costs, this method also includes the necessary over head costs. For example, the production of a part requires X in raw materials and Y in labour, this part cannot be produced without the overhead such as for example production management and logistics. Absorption Costing can provide a complete picture of the financial cost calculation.
Types of Absorption Costing systems
There are three different types of Absorption Costing systems:
Job Order Costing
The cost calculation is assigned to the product in batches (a non-recurring collection of several production units) and LOTS (production unit, linked to the serial numbers of a product).
The cost calculation is systematically assigned to the product because there are not batches or LOTS.
Activity Based Costing (ABC)
Activity Based Costing (abc): the cost calculation is assigned from cost items to the finished product. The use of Absorption Costing could be particularly critical for small organizations that often lack financial reserves. These companies cannot afford to take losses or to sell products without an insight into the accounting of the overhead.
Example: a clothing manufacturer may not just consider the costs of wool and labour for the manufacturing of a jumper, but he may also consider the costs of the knitting machines, the factory in which the machines are installed, the operating costs of the machines, insurance and other types of overhead costs, etcetera.
Looking at the above mentioned example, Absorption Costing could be required to determine the overhead costs of the enterprise. The more items one plant can produce, the lower the costs will be of these items, especially the overhead costs. If the factory starts producing other items or products, it is possible to spread and reduce the overhead costs even further.
Absorption Costing example
Organization X solely produces and sells product Y. The following financial information about product Y is known:
- Sales price per piece: 50 euro
- Direct material costs per product: 8 euro
- Direct labour costs per product: 5 euro
- Variable production overhead costs per product: 3 euro
Detailed information with respect to the months of March and April
|Production of product Y||500||380|
|Sales of product||300||500|
There was no initial stock in March. The fixed overhead costs are now budgeted at 4,000 euro a month and have been absorbed per production. A regular production is 400 pieces per month.
- Fixed costs for sales: 4,000 euro per month
- Fixed costs for the administration: 2,000 euro per month
- Variable costs for sales (commission): 5% of the sales proceeds
Step 1: Calculation of full production costs per product
|Direct material costs per product||8 euro|
|Direct labour costs per product||5 euro|
|Variable production overhead costs per product||3 euro|
|Fixed production overhead costs (4,000 euro/400 pieces)||10 euro +
|Full production costs per product||26 euro|
Step 2: Calculation of stock value and production
|Month||Initial stock||Production||Closing stock|
|March||0||500 pieces x 26 euro =
|200 pieces x 26 euro =
|April||200 pieces x 26 euro =
|380 pieces x 26 euro =
|80 pieces x 26 euro =
Step 3: uner / over absorbed fixed production overhead costs
|Actual fixed production overhead costs||4.000 euro||4.000 euro|
|Fixed production overhead costs based on >actual production||5.000 euro||3.800 euro|
|under/ over absorbed||1.000 euro over||200 euro under|
Step 4: Absorption costing profit calculation
|Sales||15.000 euro||25.000 euro|
|Less sales costs
– Initial stock
– Closing stockonder/ over absorbed
|8.200 euro||5.200 euro
– Variable costs for sales (commission)
– Fixed administration costs
– Fixed sales costs
– 6.750 euro
– 7.250 euro
|Net profit||1.450 euro||4.550 euro|
It’s Your Turn
What do you think? Is Absorption Costing still applicable in today’s modern financial management? Do you recognize the practical explanation or do you have more suggestions? What are your success factors for good financial management?
Share your experience and knowledge in the comments box below.
- Garrison, R., Noreen, E. and Brewer. P. (2012). Managerial Accounting (14th ed.). McGraw-Hill.
- Kaplan, R. and Bruns, W. (1987). Accounting and Management: A Field Study Perspective. Harvard Business Publishing.
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