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 production 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 (Prime Cost): 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 / Canteen: Number of employees
• Depreciation of Machinery: Cost or carrying 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 predetermined 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 predetermined 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:

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

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:

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

2.3. Job and Batch Costing Integration

Once the OAR is established for each production department, it is used directly in Job and Batch Costing to determine selling prices and prepare customer quotations:

• Direct Materials: Traced directly to the specific job or batch.
• Direct Labour: Hours spent on the job multiplied by the direct hourly wage rate.
• Production Overheads: Absorbed by multiplying actual department hours (labour or machine) by the predetermined department OAR.
• Total Production Cost: Direct Materials + Direct Labour + Direct Expenses + Absorbed Overheads.
• Quotation Price: Total Production Cost plus non-production expenses plus profit markup (or profit margin).

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 overhead 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 overhead 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 utility rates) are higher or lower than expected.
2. Actual Activity Level \(\neq\) Budgeted Activity Level: If more or fewer units/hours were worked than originally budgeted.

Memory Aid: If you Under-Absorb, costs charged to production were understated, meaning profit before adjustment is overstated. Therefore, you must deduct the under-absorption from profit in the final statement.

Simple Rule for Adjustment:

• Under-Absorption: You charged too little cost during production. To fix it, ADD to Cost of Sales (meaning, DEDUCT from Gross Profit).
• Over-Absorption: You charged too much cost during production. To fix it, DEDUCT from Cost of Sales (meaning, ADD to Gross Profit).

4. The Absorption Costing Profit Statement and Profit Reconciliation

The main purpose of Absorption Costing is to calculate the full cost of production, which is essential for valuing inventory 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 an absorbed portion of Fixed Production Overheads (in compliance with IAS 2 Inventories).

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

Common Mistake Alert: 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 deduct non-production overheads (e.g., administrative and selling expenses).

4.3. Reconciling Absorption Costing and Marginal Costing Profit

Because absorption costing includes fixed production overheads in inventory while marginal costing treats them as period costs, profits between the two methods will differ whenever inventory levels change:

• If Production > Sales (Inventory Increases): Absorption Costing profit is higher because some fixed overheads are carried forward in closing inventory.
• If Sales > Production (Inventory Decreases): Marginal Costing profit is higher because fixed overheads brought forward in opening inventory are released to cost of sales under absorption costing.
• If Production = Sales (Inventory Unchanged): Both methods report the same profit.

Reconciliation Formula:

\(\text{Difference in Profit} = (\text{Closing Inventory Units} - \text{Opening Inventory Units}) \times \text{Fixed Overhead Absorption Rate per unit}\)

5. Uses, Limitations, and Evaluation

5.1. Uses of Absorption Costing Data

Absorption costing is required for external financial reporting (complying with IAS 2 Inventories) and serves internal management needs:

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

5.2. Limitations of Absorption Costing

While essential for financial statements, it has drawbacks for short-term management decision-making:

• Profit Manipulation Risk: Profit can be artificially increased simply by producing more units than are sold, as fixed overheads become trapped in unsold closing inventory.
• Arbitrary Cost Allocation: The use of apportionment bases (like floor area for rent) means that the full cost assigned to a product may not reflect the exact resources consumed.
• Short-term Decision Making: Because fixed costs are unitised, it can mislead managers when deciding on special orders or shutdown decisions where only marginal costs and contribution matter.

5.3. Non-Financial Factors in Management Decisions

When using absorption cost data for pricing or order acceptance, managers must evaluate non-financial aspects:

• Market Competition: Is the calculated full-cost price competitive in the open market?
• Customer Relationships: Will a lower-priced special order build a valuable long-term customer relationship?
• Employee Morale and Capacity: Will taking additional volume require excessive overtime, stressing production capacity and staff?
• Product Quality: Will price-cutting pressure lead to compromises in quality or brand reputation?

Final Thought: Absorption Costing ensures that all manufacturing overheads are absorbed into product costs for fair inventory valuation and long-term pricing, provided managers understand how inventory changes affect reported profits.