Absorption Costing: Introduction

• As already said in the introduction to costing for overheads
• Businesses need to know the cost of production for each unit of production
• There are many reasons why a business would need to know this:
  1. To calculate a selling price that recoups all costs of production
  2. To ascertain the value of inventory
  3. So the business may be able to create a quotation for a customer etc
• One traditional method used to ascertain the cost of per unit of production is absorption costing
• Before we explain what Absorption Costing is it is important to note one thing:
• The cost per unit has to and is often be calculated in advance i.e during the period
• The formula for finding cost per unit is:
• \text{Cost Per Unit=}\dfrac{\text{Total Production Cost}}{\text{Total Units Produced}}
• However since this cost per unit is calculated in advance the business would not have the Total Units Produced figure
• The business will have to estimate/forecast this figure based on expectations, experience and other variables
• The formula would thus be:
• \text{Cost Per Unit=}\dfrac{\text{Total Production Cost}}{\text{Budgeted Total Units}}
• Things may become a little more complicated when more than one product is made by the organisation
• In most cases these product may involve slightly different production process
• What would be the cost per unit for each product then?
• Obviously the simple formula shown above would be inadequate at best and even misleading
• This is where absorption costing comes in
• Absorption costing-is a method of costing a product in which all fixed and variable costs are apportioned to cost centres where they are accounted for using absorption rates

• Under absorption costing first the variable costs be unit are determined and added to get the total variable cost per each unit produced
• This is easy to do since most variable costs are usually direct costs that can be easily traced to each product
• Overheads are a different matter
• Each unit of production has to “absorb” a portion of the fixed costs attributable to it
• This allows these costs to be recovered for example when the unit is sold
• The main aim of absorption costing is to make sure that each unit of production absorbs costs a fair portion of overheads that is indicative of the time and effort that went into the production of that unit
• Absorption costing involves the following stages:
  1. The allocation and apportionment of overheads to the different cost centres
  2. The reapportionment of service (non-production) cost centre overheads to the production cost centres
  3. The absorption of overheads into the products
• These steps will be clearly illustrated using examples and further explanations follow the links below to access more notes

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