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How Absorption Costing Works
Absorption costing, also known as full absorption costing, or full costing, is a costing method that attempts to allocate all the costs of production, including overhead expenses, to the end product or service. Companies may use absorption costing if they wish to gain a full understanding of the extent to which their costs are covered by their sales income.
The company will therefore take into account not just direct costs, but all overhead costs, in computing the profit on their products, looking at the depreciation of machines involved in production, the salaries of general administrative staff, and overheads such as lighting, heating, power for the machines, and general office expenses such as stationery and telephone expenses. These general expenses will all be allocated to the products in addition to the direct costs, such as the cost of materials and of direct labor. This attempt to take all costs into account in costing the products can, if not done correctly, result in misleading management information, as the following examples of absorption costing calculations illustrate.
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Example of Full Absorption Costing in Manufacturing
Take, for example, a factory that is producing a single end product that sells for $50,000 each. The direct costs in connection with manufacturing each unit of the product may have been $10,000 for materials and $20,000 for direct labor.
If the hours of direct labor relating to each unit of the product are 100 hours, and the capacity of labor for the factory in one year is 100,000 hours, the fraction of 100 divided by 100,000 could be used to allocate general overhead expenses to each product. So if we consider that general overhead expenses in one year are calculated to be $10 million, then the overheads allocated to each product are one-thousandth of this figure which amounts to $10,000.
The total cost allocated to each unit produced, using full absorption costing, is therefore the direct costs of $30,000 plus overhead costs of $10,000, giving a total cost of $40,000 per product. As each product sells for $50,000, the absorption costing system calculates a profit of $10,000 on each unit sold.
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Example of Problems Arising with Full Absorption Costing
The above example assumes that there will be 100,000 labor hours in a year and is allocating the overhead costs to each unit produced, on the basis of that estimate. If that is indeed the case, then 1,000 units of the product can be produced in a year, and at a sale price of $50,000 each, the sales revenue will be $50 million for the year. The direct costs will be $30 million and the overhead costs $10 million as stated above, so the profit would be computed at $10 million for the year. The costing system would be giving a true picture of the profit element earned by each unit.
However if the factory is not operating at full capacity, for example because there is an economic downturn and the orders for the product have fallen, then the number of direct labor hours falls, and the output of units of the product also falls. As the absorption rate of overheads into each unit of product is determined based on estimates at the beginning of the year, the result is that at the end of the year, there is a discrepancy between the actual amount of overhead expense incurred in the year, and the amount of overheads that have been absorbed into the cost of the product for costing purposes.
For example, if the output in a year falls to 800 units, but the costing set up at the beginning of the year has projected an output of 1,000 units, only 80% of the projected overhead costs will have been absorbed into the costing of the products manufactured. Although the reduced output may have resulted in some lower overheads, there are also fixed overhead costs such as salaries of administrative staff that remain the same. This example of an absorption costing calculation, shows that overheads are not being fully absorbed into the cost of the products.
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Where there are multiple cost centres and multiple products, appropriate allocation keys are required for allocating the various costs of the enterprise to the goods and services produced. The example of absorption costing calculation illustrates that this should take into account the relation between the costs incurred and the particular products.
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Multiple Products and Cost Centres
Where a company is producing many different products in a number of factories, there are further complications with allocating overhead expenses to the products. Some of the overhead costs may be variable depending on the level of activity of the factories, while others will be fixed in the short or medium term. Some may relate more to certain products than to others, while some will relate to particular locations and the group of products manufactured there.
Suitable methods must be found to assign overhead costs to products, and this may result in some further estimates and projections needing to be made. Where these projections are inaccurate, this may lead to misleading results as to the profitability of each product. The costing system and the allocation keys used, may not be taking into account excessive use of certain overheads by certain products, so the costing system will suggest that these products are more profitable than is really the case. These products are effectively being subsidised by other products, which are however, shown by the costing system as being less profitable than they are in reality. Such distortions created by the costing system may result in misleading figures being provided to managers who are therefore taking decisions, based on incomplete information, the result being imperfect management decisions.
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Regular Updating of Costing Information
A problem may arise where the costing system is not updated for the current reality on the factory floor. For example, certain allocation keys may be set up at a particular time for the number of labor hours spent on a particular product, or for the amount of machine time required by that product, and these figures used as a basis for allocating overhead expenses. However over time there may be changes to processes on the factory floor that lead to less labor time being required, or product modifications may lead to a different allocation of machine time to each product. If these changes are not taken into account, and the costing system is not updated regularly, this will lead to further distortions over time and the information provided to managers on the costing of products will be misleading.
The costing system would need to be updated each year to take into account such factors as the labor hours per unit produced, total labor costs, material costs, projected number of units to be produced in the year, and projected overhead expenses. In the above manufacturing example of absorption costing calculations, if the output increases to 1,500 units per year, while the costing is done on the same basis as the previous year (1,000 units per year), then the costing system will probably be allocating more overhead costs per units produced, than have actually been incurred. This will show a profit per unit that is much less than the profit that would be shown, if the costing system were updated for the current levels of output. The result of failing to include updated projections into the costing, may be erroneous decisions as to which product lines should be discontinued, and which products are the most profitable.
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Although a typical example of absorption costing calculation may involve a manufacturing enterprise, absorption costing may also be used to cost services using the same principles. Governments often use absorption costing to explain the costs of operating certain services for the public.
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Absorption Costing and Inventory Valuation
Another problem associated with absorption costing, is that the inventory is valued using full absorption costing and the valuation therefore includes overhead costs. This means that the cost of closing stock at the accounting date, which is carried forward to the next accounting period, contains overhead costs that actually relate to the accounting period that has just ended. This is unsatisfactory from an accounting point of view, as such overhead expenses should be charged to the profit and loss account in the period in which they arise.
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Absorption costing and services
Absorption costing is not only used by companies that are manufacturing products, but can also be used to cost services. Absorption costing is often used in costing government services, and the figures quoted in reports and press releases for the cost of certain government services have therefore often been computed on an absorption costing basis. For example, a government agency providing care services in the community, would include in its costing, not just the direct costs, such as salaries of the persons directly providing those services and the costs of the materials used by them. But would also include a proportion of the overhead costs of administrative workers and equipment in the government agency whose work has some relation to that particular care work. In this way the government can account to taxpayers for the way in which their tax dollars have been spent, though the figures produced may not be a suitable basis for government decision-making. Fuel can be added to the fire of political debate, by the use of different costing methods by different participants in the debate.
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Uses of Absorption Costing
As explained above, absorption costing may be useful to a company that is anxious to ensure that all its costs are being taken into account in its costing system. But the above examples of absorption costing calculations, show that problems arise from the distortions that can arise when there are multiple products, or where the actual output varies from the projected output. For this reason, other costing systems such as marginal costing may provide better management information on profitability, to assist decision making on expansion or discontinuance of product lines.
Absorption costing is an attempt to show the real cost of the product or service, and is therefore very suitable for government departments that wish to explain the real cost of their services, either for reasons of correctly funding the services or to explain why certain services need to be cut. The use of different costing systems in decision making can lead to different conclusions, and is one reason why different sides to a dispute can come up with different views of the cost of certain services. The above examples of absorption costing calculations show that absorption costing is only reliable if it is based on reasonable allocation keys and projections of output and costs.
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"Absorption costing" by Angela Newman in Student Accountant Magazine, February 2003, ACCA
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