6 Absorption Costing PDF PDF

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6 Absorption Costing Definition: Adds together all the indirect production overheads and allocates them across products on the basis of labour or machine hours. Purpose • Examines costs incurred by the business. • Assigns costs in a systematic manner to inform and advise management how to optimise business practices based on capacity and cost efficiencies. • Used to forecast, plan, guide and control. • Assist in achieving short and long term goals. • Information is relevant to the organisation so comparability with other firms is not required. Types of Costs Direct: Costs that are directly attributable to each unit of output. Variable: Reflect the additional costs that are incurred by a business in producing one more unit of a product. Marginal: The costs incurred in producing one more unit of a product. Product/Direct Cost Components 1. Direct Materials. 2. Direct Labour - Amount paid to workers for making products. 3. Manufacturing Overhead - Costs (expenses) other than material and labour that can be traced directly to the production of each unit of product - Eg. Electricity required to power machinery to produce one unit of production. Variable Cost Behaviour • Variable costs are assumed to behave in a linear fashion. - The variable costs of production will rise precisely in line with the number of units produced. For marginal cost, the additional cost of producing the additional • unit will be the same for all the previous units of production. Fixed Costs Definition: Costs that do not vary in line with production because for a given period of time they are assumed to remain the same. • Can be direct or indirect costs. Prime = Direct + Direct + Direct Absorption Costing Cost Material Labour Expense Definition: When indirect costs are allocated to each unit of production to give a total cost for each product. Total Production = Prime + Indirect Overhead • Entities will estimate the normal, expected Cost Cost Cost level of production achievable within a period and use the normal level of production as a basis for allocating indirect costs to products. Overhead Absorption = Manufacturing Overhead • The allocation of indirect costs is made to each Rate Cost of Driver unit of production on the basis of this expected production level so indirect costs are Cost of Driver = Labour Hours or Machine Hours recovered with each unit of production sold. Manufacturing = Overhead Absorption x Number of hours required to • Direct costs of Overhead Rate produce the product. production are split into their components.

• Total direct cost production = prime cost. • When both variable and fixed costs are used to calculate the cost of production this is absorption costing. • Where only variable costs are used to calculate the cost of production, this is marginal costing. Inventory Valuation • Valuing unsold inventory at the end of an accounting period. • On an absorption costing basis, inventory is valued based on the direct production costs of a product plus a proportion of the indirect production overheads incurred in each product’s manufacture. • Inventory Valuation = Unsold Inventory x Total Production Cost • This is why it is important for organisations to calculate direct and indirect costs associated with each item in production. Overhead Allocation • Entities will seek to allocate overhead costs to departments then to products on the most appropriate basis. • This will enable organisations to absorb these organisations to absorb these overheads into products to determine a selling price for each product. • Overhead allocation divided according to labour hours in a year where labour is key or machine hours in a year where production is a highly mechanised process. - Calculate total labour/machine hours for the year on the basis of normal operating level. Total Annual Overheads = Operating capacity + Number of hours that production employees/machine work/operate during a year. Service Department Overheads • Service department costs are allocated to production departments on the basis of each department’s usage of each service department. • Service department costs are allocated to products and built into product selling prices to enable all costs incurred to be recovered through sales of products/services. Determining Selling Price Markup Method Selling Price = Product Cost + (Produce Cost x Mark up %) Period Costs Definition: Costs that relate only to the period in which they incurred. • Eg. Administration overheads, finance overheads, marketing overheads. - Marketing activities incur certain costs that vary in line with sales. - Eg. Commission paid to sales teams as rewards. - Costs like advertising, brochures, product catalogues, salaries count as fixed costs. Problems with Absorption Costing • Costs are no longer incurred in a steady, easy to allocate way. - Absorption costing was originally developed when factories would mass produce, when production runs were long and it was easy to spread fixed overheads over many products. - However, today, production runs are short and products are individualised and tailored to customer’s specific requirements. - Costs have been rising due to businesses seeking to fulfil each order’s specific requirements. - As a result, the allocation of costs to particular products on absorption costing basis is no longer appropriate.

• Allocation of costs to products on labour or machine hours basis is too simplistic.

- Does not reflect the actual costs incurred in the provision of specific goods/services. • Absorption costing fails to recognise the demands made by particular products on an entity’s resources. • Overheads arise not in proportion to direct labour and machine hours but as a result of the range and complexity of products/services offered. • Selling prices calculated based on absorption costing may be wrong by overheads being under allocated to products that consume more activities resulting in underpricing or overheads are allocated to products consuming lower levels of activity and so are overpriced. - These misallocations mean products are subsidised by others rather than making a profit by themselves. Activity Based Costing Definition: Costs are allocated to products on the basis of activities consumed. • The more activities that are associated with a particular product, the more overhead is allocated to the product so the higher its cost, the higher the selling price will be. Cost Pools • Rather than putting together all indirect production overheads into departments, activity based costs are allocated into cost pools. • These reflect different activities incurred in the production of goods/services. - Eg. Set up costs, quality control costs, material ordering costs, production monitoring costs. The number of cost pools depends on the complexity/simplicity of an entity’s operations. • • More complex operations = more cost pools. Allocate Costs to Products/Services • Costs are allocated to products/services on the basis of costs drivers. • These reflect the level of activity associated with each cost pool. - Eg. 50 machines set up in a year, cost pool ÷ 50 = cost per machine set up. • Costs in cost pools are allocated to products on the basis of the activities consumed by those products. - Eg. Product used 5 machine set up in a year, the cost for that set up would be allocated to the product. When product costs turn out to be high, management can reduce the activities • consumed by those products to lower costs and improve price competitiveness. Assumptions of Costing • Fixed costs are fixed. - Assumptions are made fixed costs will remain the same level for all levels of production over that period even though this might not be the case. - Once a certain level of production is reach, additional fixed costs have to be incurred to cope with the increase in capacity. - Fixed costs may then behave in a stepped fashion so costs remain tied for a given range of production and then rise to a new level once the original range of product is exceeded. • Variable costs remain the same for all units of production.

- Increased purchases of materials from suppliers with earn quantity/bulk discounts from those suppliers.

- The higher the level of direct material purchases, the bigger the discounts so the lower the average price of the materials.

- Each unit cost of labour doesn’t remain constant as increased productivity will earn -

productivity bonuses for employees, pushing up the average cost of each unit of production. Production facilities can use materials that fluctuate in price (metals and oil). The price of these direct materials can rise and fall during an accounting period so shows that variable costs do not remain the same for all units of production and so do not behave in a linear fashion.

• Costs can be determined with the a degree of accuracy in order to produce accurate selling prices. - This is highly unlikely due to under/over estimations of the time it will take to complete a given task, the cost of materials used in the production of goods and the amount of direct expenses used to make products. - Materials costs vary in line with market prices so become cheaper/expensive depending on the current supply of materials in the market. - Labour may become more expensive if the required skills are in short supply which pushes up the direct labour cost of production. - Therefore, absolute accuracy of estimation is not going to be achieved so the best that is done is a reasonably close estimate....