Absorption Costing

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Absorption Costing

• 1 Definition
• 2 Cost behaviour
• 3 Cost build up
• 4 External vs Internal Reporting
• 5 Treatment of overheads
• 6 Changes in activity levels
• 7 Inventory valuation
• 8 Benefits

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1 - Definition

• Absorption costing is an approach in which a
  share of ALL costs is included in the calculation
  of the cost of each unit of output.
• It is sometimes known as total absorption
  costing or full costing

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2 - Cost behaviour

• Absorption costing does not differentiate
  between fixed and variable costs
• This is logical, as the approach absorbs all
  costs into the cost of output
• Thus, Inventory includes (as per IAS 2) a share
  of fixed costs as well as variable costs
• In marginal costing, fixed costs are treated as
  period costs and are written off

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3 - Cost build up

• Materials estimated
• Labour estimated
• Overheads using OAR
• OAR allocated costs
• apportioned costs

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4 - External Reporting

• IAS 2 cost or NRV
• cost normal course of business
• present location and condition
• at normal level of activity
• includes
• production overheads
• other overheads
• Thus, absorption costing is used for external
  reporting, which assists is achieving the
  objective of comparability

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Internal Reporting

• Beware of the obvious!
• Whether absorption or marginal costing is used
  will depend on
• Managements needs
• How will the information be used?
• What decision must be made?

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5 - Overheads

• Overhead allocation
• Overhead absorption
• Re-apportionment of general cost centres
• Calculate OAR
• Basis of OAR
• Absorb overheads using OAR

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Allocation

• costs are charged directly to a cost unit or cost
  centre
• key questions
• who has responsibility for the cost?
• is responsibility specific?
• Costs may be allocated to general or service cost
  centres

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Apportionment

• the process of sharing costs between cost centres
  on the basis of a proxy measure
• in questions the proxy measure will be clear for
  most costs
• for those which are less clear, consider
• if I had responsibility for a cost centre, would
  I accept a cost on that basis?

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Re-apportionment

• Service / general cost centres need to be
  re-apportioned to production cost centres using
  an appropriate basis
• methods of re-apportionment are
• step (elimination)
• reciprocal (repeated distribution)
• simultaneous equation

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Step (elimination)

• a department which does not receive a major
  benefit from another cost centre can be
  eliminated if re-apportioned first

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Reciprocal

• Where reciprocal services are provided, each
  stage of the re-apportionment process will put
  costs back into a cost centre which had
  previously been re-apportioned
• This process is continued (yawn, yawn) until
  only a small amount is left in a cost centre
• This small amount is finally re-apportioned on
  an arbitrary basis

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Simultaneous equations

• best considered by an example

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Calculate OAR

• Estimate overhead costs for next period
• Allocate, apportion and re-apportion
• Decide on basis of absorption / recovery
• What bases could be used?
• of a specific or total of direct cost
• per direct labour hour / machine hour
• per unit
• OAR Budgeted cost budgeted activity level

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Basis for OAR

• essentially a matter of judgement
• objective is to be as fair as possible
• however it is an approximation
• remember that it is simply dividing the total
  cost over the cost centres
• therefore the basis will have no effect on total
  cost

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Under/over absorption

• Both cost and activity level are estimates
• thus total absorbed
• will not be equal to
• actual cost
• absorbed gt actual costs overabsorption
• absorbed lt actual costs underabsorption

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Reciprocal services

• When service departments do not supply or
  receive services from one another
  re-apportionment of costs is done using the step
  (elimination) method.
• When reciprocal services are provided, we need
  to use either
• repeated distribution or
• simultaneous equations

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Example

• After allocation and apportionment, the costs
  are
• Mach Ass Stores Maint
• Costs 000 100.3 85.6 48.5 54.6
• Maint Hrs 480 340 120
• Requisitions 120 90

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Elimination

• In this case, the logical approach is to
  re-apportion maintenance first, and then stores
• However, if both service cost centres provide
  services to one another, the problem is less
  straightforward.
• So, lets consider a more complex example .

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Example

• After allocation and apportionment, the costs
  are
• Mach Ass Stores Maint
• Costs 000 100.3 85.6 48.5 54.6
• Maint Hrs 480 340 120
• Requisitions 120 90 40

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Elimination

• a department which does not receive a major
  benefit from another cost centre can be
  eliminated if re-apportioned first
• in exam, indicate why you have selected a
  particular cost centre for elimination

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Elimination

• Mach Ass Stores
  Maint Total
• Maint Hrs 480 340 120 940
• Requisitions 120 90 40
  250
• Costs 100,300 85,600 48,500 54,600
  289,000
• Maint first 27,881 19,749 6,970 (54,600)
• Then stores 120/210 90/210
• 31,697 23,773 (55,470) NB
• 159,878 129,122 nil
  nil 289,000

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Repeated distribution

• Mach Ass Stores Maint Total
• Maint Hrs 480 340 120 940
• Requisitions 120 90 40
  250
• Costs 100,300 85,600 48,500 54,600
  289,000
• Maint 940ths 27881 19749 6,970 (54,600)
• Stores 250ths 26,626 19,969 (55,470) 8,875
• Maint 940ths 4,532 3,210 1,133
  (8,875)
• Stores 250ths 544 408 (1,133)
  181
• Maint 820ths 106 75 (181)
• Total 159,989 129,011 nil
  nil 289,000

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Simultaneous equations

• If we let S total stores cost and
• If we let M total maintenance cost
• We have two equations
• S 120/940 M 48,500
• M 40/250 S 54,600
• With simultaneous equations, the key is to
  multiply one or both so that one of the unknown
  variables has the same value in both equations.

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Simultaneous equations

• If we multiply the Maintenance equation
• By 250/40 we have
• 250/40 M S 341,250
• This can be re-arranged to express S
• S 250/40 M 341,250

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Simultaneous equations

• Our two equations are now
• S 120/940 M 48,500 or
• 0.1276 M 48,500 and
• S 250/40 M - 341,250 or
• 6.25 M - 341,250
• If we subtract the top from the bottom, we have
  ..

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Simultaneous equations

• S 6.25 M - 341,250 less
• S 0.1276 M 48,500
• 0 6.1224 M - 389,750 or
• 6.1224 M 389,750 thus
• M 389,750/6.1244 63,660
• By substituting this into any of our equations,
  we find that S what?
• Answer 56,627

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Simultaneous equations

• These values can now be substituted
• Mach Ass Stores Maint
  Total
• Costs 100,300 85,600 48,500 54,600
  289,000
• Result (56,627)(63,660)
• and are re-apportioned using the original data
• Maint Hrs 480 340 120 940
• Requisitions 120 90 40
  250
• Maint 32,507 23,026 8,127
• Stores 27,181 20,386 9,060
• Total 159,988 129,012 289,000
• NB same as repeated distribution method

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Absorption Costing Example

• Ray Vaughan has the following budgeted
  information for the next period
• Machining Assembly Canteen Maintenance
  Total
• 
  
• Indirect wages 18,500 19,000
  17,400 20,100 75,000
• Indirect materials 6,200 5,100
  2,300 2,200 15,800
• Rent 17,480
• Insurance of buildings 6,308
• Power 9,700
• Heating oil 5,168
• Electricity 3,002
• Depreciation Machinery 35,500
• Machine value 170,000 114,500
  70,500 355,000
• Floor area m2 1,630 1,100
  350 720 3,800
• Direct labour hours 11,400 27,400
  38,800

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6 - Changes in activity levels

• Impact of fixed costs can distort results
• e.g. company producing a single product
• Selling price 5.00 per unit
• Variable cost 1.75 per unit
• Fixed costs 40,000
• Budgeted volume 20,000 units
• Budgeted profit 25,000

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Profit calculation

• Sales 20,000 x 5 100,000
• Costs
• Variable 20,000 x 1.75 35,000
• Fixed 40,000
• Total cost 75,000
• Profit 25,000
• i.e. 1.25 per unit or

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Profit calculation

• Per unit
• Selling price 5.00
• Variable cost 1.75
• Fixed costs 2.00
• Profit 1.25
• X 20,000 units 25,000

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BUT!!

• if the level of activity changes to say
• 15,000 or 25,000
• the profit is NOT 1.25 x level of activity
• because fixed costs do not change
• So, what is the profit at 15,000 units?
• 8,750
• Here we have used marginal costing

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7 Inventory valuation

• because fixed costs are included in the
  valuation of Inventory
• they are carried forward and written off in a
  future period
• once again this highlights the difference in the
  purposes of external and internal reporting

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8 - Benefits

• Requires fixed costs to be considered
• While fixed costs can be less relevant for
  certain decisions, they are important and must be
  considered in the long run
• Applies the accruals concept by matching fixed
  costs against revenue earned
• Avoids seasonal swings in profitability