• Absorption costing is a traditional method of costing that allocates all manufacturing costs to the cost of a product, including direct costs such as material, labour, and overhead costs. In this method, fixed overheads are absorbed into the cost of production.

Numerical example:

Let’s assume that a company produces 10,000 units of product A, and its total production costs for the period are $200,000. The company incurs direct material costs of $50,000, direct labour costs of $30,000, variable overheads of $20,000, and fixed overheads of $100,000. The absorption cost per unit would be calculated as follows:

Direct material cost per unit = $50,000 / 10,000 = $5 Direct labor cost per unit = $30,000 / 10,000 = $3 Variable overhead cost per unit = $20,000 / 10,000 = $2 Total variable cost per unit = $5 + $3 + $2 = $10 Absorption cost per unit = Total cost per unit = Total production costs / Number of units produced = $200,000 / 10,000 = $20

Features of absorption costing:

  • All production costs are absorbed into the cost of the product
  • Fixed overhead costs are allocated to the product
  • The cost of a product includes both variable and fixed costs
  • The cost per unit may vary depending on the level of production

Process of absorption costing:

  1. Calculate the direct costs of a product (material and labour costs).
  2. Calculate the variable overhead cost per unit.
  3. Add the direct costs and variable overhead costs per unit to obtain the total variable cost per unit.
  4. Allocate the fixed overhead costs to the product by using a predetermined overhead rate.
  5. Add the total variable cost per unit and allocated fixed overhead cost per unit to obtain the absorption cost per unit.

Advantages of absorption costing:

  • Provides a more accurate cost of a product by including all production costs
  • Helps in setting a profitable selling price by considering all costs
  • Helps in calculating inventory valuation by including fixed overhead costs

Disadvantages of absorption costing:

  • May lead to overproduction as fixed costs are allocated to the product regardless of the actual level of production
  • Can make it difficult to determine the actual profitability of a product
  • Can distort profitability by shifting costs from one product to another if the predetermined overhead rate is not accurate.

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