Absorption costing is the conventional way of costing in which inventory is valued at full cost of production. The costs included in the inventory are:
- Direct material cost
- Direct labor cost
- Variable production overheads
- Fixed production overheads
Fixed production overheads are absorbed or applied in the cost of inventory on the basis of a predetermined overhead application/ absorption rate (OAR). OAR is based on fixed overheads budgeted for normal activity or sometimes on the basis of fixed overheads budgeted for budgeted activity.
OAR is used to normalize or average out the fluctuations in fixed production overheads. Certain overheads are not uniform throughout the year. They are incurred at some point of the year whereas benefit is availed by entire production. It is not fair to charge these overheads to such period where benefit is taken by the entire production during the year. Therefore fixed overheads are absorbed in the cost of inventory on the basis of OAR.
The following example will be helpful to understand how absorption costing is applied.
Example: Absorption costing
A company is involved in the production and sale of a single product whose selling price is $ 160. Variable costs per unit consists of material cost of $ 40, labor cost of $ 30 and variable production overheads of $ 15. Fixed production overheads incurred during the month are $ 104,000.
Budgeted fixed production overheads were $100,000 and normal production capacity is 5,000 units per month. Actual production and sales during the month are 5,500 units. Calculate profit for the month under absorption costing system.
|—-Amount in $—-|
|Sales ($160 x 5,500 units)||880,000|
|Cost of goods sold|
|Materials used ($40 x 5,500 units)||220,000|
|Direct labor ($30 x 5,500 units)||165,000|
|Variable production overheads ($15 x 5,500 units)||82,500|
|Fixed production overheads absorbed
(OAR = $100,000/5,000 units = $20 per unit x 5,500 units)
|Over absorbed overheads ($110,000 – $104,000)||(6,000)|
Cost of goods sold
|Profit for the month||308,500|
Under absorption and over absorption
Actual amount of overheads incurred during a period may be higher or lower than the overheads absorbed on the basis of overhead application/ absorption rate (OAR).
If actual overheads incurred are more than the overheads absorbed, it means that overheads are under absorbed.
Difference between actual overheads and absorbed overheads should be added to cost of goods sold.
If actual overheads incurred are less than the overheads absorbed, it means that overheads are over absorbed.
Difference between actual overheads and absorbed overheads should be subtracted from cost of goods sold.
Reasons for under and over absorption
There can be various reasons for under absorption or over absorption of overheads. Some of the reasons are as follows:
- Poor management or control over the overheads expenditure actually incurred during the period resulting in under absorption of overheads.
- Efficient management or control over the overheads expenditure actually incurred during the period resulting in over absorption of overheads.
- An unexpected increase or decrease in overheads occurred during the period which was not accounted for while making the budget.
- Budget made for overheads is unrealistic. Poor budgeting for overheads spending resulting in actual overheads significantly different from the budgeted overheads.