ABSORPTION COSTING OR FULL COSTING SYSTEM

Absorption costing technique is also termed as Traditional or Full Cost Method. Under this method, the cost of a product is determined, after considering both fixed and variable costs. The variable costs, such as direct materials, direct labour, etc. are, directly, charged to the products. The fixed costs are apportioned on a suitable basis over different products, manufactured during a period.

DEFINITION

Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials, direct labor and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost. Because absorption costing includes all costs of production as product costs, it is frequently referred to as full costing method.

Absorption costing is the method of gathering all of the manufacturing costs and assigning them to the actual individual product. In other words, absorption costing means that all costs associated with production, such as direct materials, direct labor, and all manufacturing overhead costs, are all included in the final cost of the product.

Absorption costing is a method in which cost of units produced is calculated as the sum of both the variable manufacturing costs incurred and the fixed manufacturing costs allocated to those units.

COST UNDER ABSORPTION COSTING 

The following is a list of important costs that are applied using absorption costing:

• Direct labor: This is the labor needed to make the product. For example, to produce a car, direct labor would include all of the employees needed to run the machines to produce the cars.
• Direct materials: This includes all of the materials needed to complete the product. So basically, if a material is used to make the cars, it needs to be included in direct materials.
• Variable manufacturing overhead: These are the costs associated with running a manufacturing facility that vary due to the amount of products produced. Some examples may include the electricity needed to operate the equipment used for production or the supplies used in the facility. Thus, the facility will use more electricity if more machines are running, and they will use more supplies if they produce 15 products instead of 5 products.
• Fixed manufacturing overhead: Like variable manufacturing overhead, fixed manufacturing overhead are the cost that occur when operating a facility. However, these costs do not vary with the amount of products produced. Instead, the costs remain unchanged no matter if the company produced 100 or 150 products. Some examples include insurance and rent for the facility itself.

Difference between Marginal Costing and Absorption Costing:
The difference between marginal costing and absorption costing is as below:

1.   In the marginal costing only variable cost is considered for product costing and inventory valuation, whereas in the absorption costing both fixed cost and variable cost are considered for product costing and inventory valuation.

2.  In the marginal costing, there is a different treatment of fixed overhead. Fixed cost is considered as period cost and by Profit/Volume ratio (P/Vratio), profitability of different products is judged. On the other hand, in absorption costing system, the fixed cost is charged to cost of production. A reasonable share of fixed cost is to be borne by each product and thereby subjective apportionment of fixed overheads influences the profitability of product.

3.     In the marginal costing, the presentation of data is so oriented that the total contribution and contribution from each product gets highlighted. In absorption costing, the presentation of cost data is on conventional pattern. After deducting fixed overhead, the net profit of each product is determined.

4.     In the marginal costing, the unit cost of production does not get affected by the difference in the magnitude of opening stock and closing stock. Whereas, in the absorption costing, due to the impact of the related fixed overheads, the unit cost of production gets affected by the
difference in the magnitude of opening stock and closing stock.

5.     In the marginal costing, classification of expenses is based on nature, i.e. Fixed and Variable whereas, in Absorption Costing, classification of expenses is based on functions, i.e. Production, Administration and Selling & Distribution.

6.      In the marginal costing, fixed overhead Expenditure Variance is to be computed for Variance Reporting. There is no Volume Variance since Fixed Overheads are not absorbed. On the other hand under the Absorption Costing, in Variance Reporting, FOH Expenditure and Volume variances can be computed. Volume Variances can also be sub‐classified into Capacity, Efficiency and Calendar variances.

UNDER-ABSORPTION AND OVER-ABSORPTION OF OVERHEADS

The amount of overhead absorption in costs is the total amount of the overhead costs allotted to individual cost units by application of overhead rate. Overhead costs are fully recovered from production if actual rate method of absorption is adopted as the amount charged to production is equal to the amount of overheads incurred. But when a predetermined rate is used on the basis of budgeted overheads and the rate is applied to the actual base, the actual overhead expenses may be different from the charged or budgeted overhead expenses.

If the amount absorbed is less than the amount incurred which may be due to actual expenses exceeding the estimates and/or the output or hours worked being less than the estimates, the difference is known as under-absorption. Under-absorption of overheads thus means the amount by which the absorbed overheads fall short of the actual amount of overheads incurred. It represents understating the costs as the overhead expenses incurred are not fully recovered in the cost of jobs, processes etc.

On the other hand, if the amount absorbed is more than the expenditure incurred due to expenses being less than the estimates and/or the output or hours worked exceeding the estimates, it would mean over-absorption of overheads and will inflate the costs. Over-absorption of overheads thus means the excess of overheads absorbed over the actual amount of overheads incurred. 

REASONS FOR OVER OR UNDER RECOVERY:

The reasons for over or under recovery of overheads are as follows:

1.      The actual hours worked may be more or less than the estimated hours.

2.      The actual overhead costs are different from budgeted overheads.

3.      Both actual overhead costs and actual activity level are different from the budgeted costs and levels.

4.      The absorption method used may not be correct.

5.      Extraordinary expenses might have been incurred during the accounting period.

6.      Major changes might have taken place for example replacement of manual labour with machines, replacement of general purpose machine with automatic high speed machine, increase in level of capacity etc.

TREATMENT OF UNDER/OVER ABSORPTION OF OVERHEADS:

The methods used in treating the under or over absorbed overheads are given below:

Application of Supplementary Rates:

The under or over recovered overhead is adjusted by application of supplementary rates. This method is used to adjust the difference between overheads absorbed and overheads actually incurred by computing supplementary overhead rates.

Such rates may be either positive or negative. A positive rate is used to add the unabsorbed overheads to cost of production. A negative rate is used to correct the cost of production by deducting the amount of over absorbed overheads. The supplementary rate is calculated by dividing the under or over absorbed amount by the actual base.

Write off to Costing Profit and Loss Account:

If the under or over absorbed overhead is small and negligible, then it will be written off by transferring it to the Costing Profit and Loss Account without using the supplementary rates. In case of under absorption of overheads arises due to factors like idle capacity, defective planning etc. it may also be transferred to Costing Profit and Loss Account.

Carry Forward to Subsequent Year:

Treating the under or over absorbed overheads as seasonal fluctuations, may be carried forward to the subsequent accounting year. This may be transferred to Overhead Suspense Account or Overhead Reserve Account.

This method is not considered desirable as it allows costs of one period to affect costs of another period, which renders the comparison of financial results difficult. This method may be used in the initial years of business since the operations will be low in the starting period.

ADVANTAGES OF ABSORPTION COSTING:

The following are the advantages of absorption costing:

1. Consideration of Fixed Costs: Absorption costing rightly recognises the importance of including fixed production costs in product cost determination and in determining a suitable pricing policy. Supporters of absorption costing argue that fixed production costs are just as much used in the production of goods and services as the variable production costs.
2. Seasonal Sales: In a situation where production is done to have sales in future (e.g., seasonal sales), absorption costing will show correct profit calculation than the variable costing. In such a case, under variable costing, sales will be zero but all fixed costs will be shown as an expense in the same accounting period. The result is that losses will be reported during out of season periods and large profits will be reported in the periods when the goods are sold.
3. Conformity with Accrual and Matching Concepts: Absorption costing conforms with accrual and matching accounting concepts which requires matching costs with revenue for a particular accounting period.
4. No Need to Separate Costs as Fixed and Variable: Absorption costing avoids the separation of costs into fixed and variable elements which cannot be easily and accurately done.
5. Relevance of Under-absorption and Over-absorption: The presentation of under- absorption and over-absorption of factory overheads in absorption costing discloses inefficient or efficient utilisation of production resources which is not possible in variable costing.
6. Accountability of Departmental Managers: the allocation and apportionment of fixed factory overheads to cost centers or departments makes managers more aware and responsible for the costs and services provided to their centers/departments.

 DISADVANTAGES

The following are the contentions against absorption costing:

1. It is observed that in the absorption costing, a portion of fixed cost is carried over to the subsequent accounting period as part of the closing stock. This is an unsound practice because costs pertaining to a period should not be allowed to be vitiated by the inclusion of costs pertaining to the previous period and vice versa.
2. Further, absorption costing is dependent on the levels of output which may vary from period to period, and consequently cost per unit changes due to the existence of fixed overhead. Unless the fixed overhead rate is based on normal capacity, such changed costs are not helpful for the purposes of comparison and control.
3.  Cost Data not Useful for Control Purpose: Fixed costs are apportioned on an arbitrary basis. This reduces the practical utility for the purpose of control.
4. Fixed Costs: Fixed costs are included in the valuation of closing stock and carried forward to the next year. In other words, though the fixed costs relate to the current year, they are not charged to the current year. They are carried forward to the next year to the extent they relate to closing stock. In a similar manner, opening stock contains fixed costs of the previous year and they were not charged during the previous year. Normally, costs are to be charged in the year in which they incur. As, that practice is not followed, it is an unsound practice.
5. Presentation of Data: As fixed costs are apportioned to the products, presentation of data is not useful for decision-making as overheads obscure cost-profit-volume relationship.
6. Opportunities Get Unnoticed: The behavioural pattern of costs is not highlighted. So, opportunities, otherwise, available may get unnoticed. An export order may not be considered worthy for acceptance as its unit cost may not cover the total cost. If accepted, the order may cover variable costs and leave something towards contribution to boost up profits. Marginal costing provides the opportunity for acceptance, while Absorption costing ignores the same.