Absorption Costing

What is Absorption Costing?

Absorption costing is one of approach which is used for the purpose of valuation of inventory or calculation of the cost of the product in the company where all the expenses incurred by the company are taken into the consideration i.e., it includes all the direct and indirect expenses incurred by the company during the specific period.

In simple terms, “absorption costing” refers to the method of adding up all the costs pertaining to the production process and then allocating them to the products individually. This method of costing is essential as per the accounting standards to produce an inventory valuationInventory Valuation Inventory Valuation Methods refers to the methodology (LIFO, FIFO, or a weighted average) used to value the company's inventories, which has an impact on the cost of goods sold as well as ending inventory, and thus has a financial impact on the company's bottom-line numbers and cash flow situation.read more which is captured in the balance sheet of an organizationBalance Sheet Of An OrganizationA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.

As per this method, the total product cost is calculated by the addition of variable costs, such as direct labor cost per unit, direct material cost per unit and variable manufacturing overheadManufacturing OverheadManufacturing Overhead is the total of all the indirect costs involved in manufacturing a product like Property Tax on the production premise, Remunerations of maintenance personnel, Rent of the manufacturing building, etc. read more per unit, and fixed costs, such as fixed manufacturing overhead per unit.

Absorption Costing Formula

Absorption cost formula = Direct labor cost per unit + Direct material cost per unit + Variable manufacturing overhead cost per unit + Fixed manufacturing overhead per unit

It can also be modified to,

Absorption cost formula = (Direct labor cost + Direct material cost + Variable manufacturing overhead cost + Fixed manufacturing overhead) / No. of units produced

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For eg:
Source: Absorption Costing (wallstreetmojo.com)

Explanation

The formula for AC can be computed by using the following steps:

  1. Firstly, the direct labor cost per unit is directly attributable to the production. The direct labor costDirect Labor CostDirect labor costs refer to the total cost incurred by the company for paying the wages and other benefits to its employees against the task performed by them, which are straight away related to the manufacturing of the products or provision of the services.read more can be determined based on the labor rate, level of expertise, and the no. of hours put in by the labor for production. However, the labor cost can also be taken from the income statement.

  2. Secondly, identify the material type required and then determine the amount of the material required for the production of a unit of product to calculate the direct material cost per unit. However, the direct raw material cost can also be taken from the income statement.

  3. Thirdly, determine which part of the manufacturing overhead is variable in nature. The manufacturing overhead is available in the income statement.

  4. Next, determine which part of the manufacturing overhead is fixed in nature and then divide the value by the number of units produced to arrive at a per-unit cost.

  5. Finally, the formula for absorption cost is derived by adding up direct labor cost per unit, direct raw material cost per unit, variable manufacturing overhead per unit, and fixed manufacturing overhead per unit, as shown above.

Examples of Absorption Costing

Example #1

Let us take the example of company XYZ Ltd that manufactures clothes for people of the elite class residing in a modern city. Do the calculation of Absorption Costing. The managerial accountant has provided the following information, and the finance director of the company has vetted the same:

absorption formula example 1.1

It is to be noted that selling and administrative costs (both fixed and variable costs) are periodic costs in nature and, as such, are expensed in the period in which it occurred. However, these costs are not included in the calculation of product cost as per the AC.

Therefore, the calculation of AC is as follows,

absorption formula example 1.2

Absorption cost Formula = Direct labor cost per unit + Direct material cost per unit + Variable manufacturing overhead cost per unit + Fixed manufacturing overhead per unit

= $20 + $12 + $8 + $200,000 / 50,000

AC will be –

absorption formula example 1.3
  • Ab cost = $44 per unit of cloth

Example #2

Let us take the example of company ABC Ltd which is a manufacturer of mobile phone covers. Recently, the company has received an order for 2,500,000 mobile covers at a total contract price of $5,000,000. However, the company is not sure whether the order is a profitable proposition. Do the calculation of Absorption Costing to find the order is profitable or not. The following are the excerpts from the entity’s income statement for the calendar year ending in December 2017:

Example 2.1

Now, based on the above information, do the calculation

Example 2.2

Absorption cost formula = (Direct labor cost + Direct material cost + Variable manufacturing overhead cost + Fixed manufacturing overhead) / No. of units produced

AC = ($1,000,000 + $750,000 + $800,000 + $950,000) ÷ 2,000,000

AC will be –

Example 2.3
  • AC = $1.75 per mobile case

As per the contract pricing, the per-unit price = $5,000,000 / 2,500,000 = $2.00 per mobile case

Since this method shows lower product costs than the pricing offered in the contract, the order should be accepted.

Calculator

You can use the following AC Calculator.

Direct Labor Cost
Direct Material Cost
Variable Manufacturing Overhead Cost
Fixed Manufacturing Overhead
No. of Units Produced
Absorption Costing Formula =
 

Absorption Costing Formula =
Direct Labor Cost + Direct Material Cost + Variable Manufacturing Overhead Cost + Fixed Manufacturing Overhead
No. of Units Produced
0+0+0+0
= 0
0

Relevance and Use

It is very important to understand the concept of AC formula because it helps a company to determine the contribution marginContribution MarginThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution.read more of a product and that eventually helps in the break-even analysisBreak-even AnalysisBreak-even analysis refers to the identifying of the point where the revenue of the company starts exceeding its total cost i.e., the point when the project or company under consideration will start generating the profits by the way of studying the relationship between the revenue of the company, its fixed cost, and the variable cost.read more. Based on the break-even analysis can decide the number of units required to be produced by the company in order to be able to book a profit. Further, the application of AC in the production of additional units eventually adds to the bottom lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. read more of the company in terms of profit since the additional units would not cost the company an additional fixed cost. Another advantage of AC is that it is GAAP compliant.

You can download this Excel Template here – Absorption Costing Formula Excel Template

Recommended Articles

This has been a guide to what is Absorption Costing. Here we discuss how to calculate Absorption Cost and its formula along with the practical examples and downloadable excel sheet. You can learn more about accounting from the following articles –

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