- 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.
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:
- Calculate the direct costs of a product (material and labour costs).
- Calculate the variable overhead cost per unit.
- Add the direct costs and variable overhead costs per unit to obtain the total variable cost per unit.
- Allocate the fixed overhead costs to the product by using a predetermined overhead rate.
- 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.