“The process of absorption costing (also known as overhead recovery) is highly subjective process which can cause organisations to suffer major problems unless the concept is fully understood by management” From the above statement it should be noted that it is management’s ability to understand and comprehend the workings of absorption costing that is of issue. This paper will attempt to highlight the process itself as well as pointing out the possible areas that could prove problematic in the workings of an organisation.
As well as looking at absorption costing in closer detail, this paper will also mention variable costing as measurement milestone for absorption costing. This will be followed by a look at a process of absorption costing, process costing, and how understanding it, along with the whole absorption costing process will enable management to have a clearer picture of the costing processes in their organisations. Numerical examples will be used to further explain all the above processes. Management accounting systems should provide information for various functions.
Internal reporting to managers for cost planning, control and also performance evaluation. Reporting for decisions on how resources should be allocated and priced in relation to product profitability. The information may also be used by management for strategic and often as a tactical decision making tool. The information especially that found in absorption costing will be used for external reports, such as financial statements. With this in mind the role of the management accountant will involve allocation of costs between areas such as cost of goods sold and the stock needed for both internal and external profit reporting.
Provide relevant information to help managers make better decisions. Provide information for planning, control and performance measurement. Planning to turn goals and company objectives into actions and resources, while looking at both the long and short term activities of the company. This would be done by controlling activities through setting of targets and standards, comparing performance and controlling costs with the aim of improving the efficiency of the organization. The information that will be gathered from cost data, will aid in facilitating cost allocation between cost of goods sold and the stock at end of period.
Decision making through use of relevant data, will also aid in planning, control and performance measurement Before looking at the absorption costing system a brief description of costs is needed. This will be helpful as the behavior of these costs affect the costing systems in different ways. The behavior of costs and overheads needs to be well understood by management for them to produce and understand the full mechanics of the absorption process. In business, overheads are made up of: indirect materials, indirect labour and indirect expenses.
Overheads must be shared between all the cost units as they do not relate to any particular unit of output, and are usually classified by function. The next process after understanding the form of overheads is to allocate them. Allocation of overheads is ‘the charging to a cost centre of those overheads that have been directly incurred by that cost centre’. Apportionment is the next process, and this is where cost centres are charged with a proportion of the overheads. After the above processes have been carried out the next step then is charge the overheads to the cost units, and this is the where absorption costing starts.
What is absorption costing? According to Drury (2000) it is “a system in which all fixed manufacturing overheads are allocated to products” from this simplified definition management needs realise that all manufacturing costs fixed or variable should be treated as product costs. Full absorption costing is a traditional method where all manufacturing costs are capitalized in the inventory, i. e. , charged to the inventory and become assets. This means that these costs do not become expenses until the inventory is sold. In this way, matching is more closely approximated.
All selling and administrative costs are charged to expense however. Absorption costing is required for external reporting. The absorption method is also used for internal reporting. Absorption costing can be defined as “the total amount of resources involved with pursuing a particular objective” (Atrill P and Mclaney 1994). This could be repairing a car, producing a can of baked beans, or building a block of high rise flats. In short the purpose of absorption costing is to answer the question ‘ how much did it or will it cost ?
‘ the reasons for us wanting to know the answer to that question will be made evident as the mechanics of absorption costing are made clearer. One reason for this would be for the manufacturer or producer to determine what price to charge to their customers to ensure that all costs are covered and that the company makes the required and acceptable level of profit. It is important to know that there is no distinction between fixed and variable cost when you are dealing with absorption costing. All relevant costs used to achieve the particular objective, whether fixed or variable, are taken into account.
Using the information obtained The information obtained can be used in various areas of accounting. For financial accounting purposes, where identifying the cost of production to find the cost of sales figures, helps in working out the gross profit figure once sales have been taken into account. Over heads are included in the cost of production as standard. Measuring the profitability of departments or divisions. When comparisons are made between the unit costs of some departmental outputs and the external purchase prices absorption costing information is useful.
Use of absorption costing is also useful for pricing purposes. This is because of the need to use all relevant costs in coming up with the cost per unit and thus setting a profit margin based on those findings. Some businesses base their selling prices on the incurred costs of producing each unit and therefore are called price makers because their prices are based on the costs of production. Most though have their prices set by the market depending on the demand of the products or services they supply and are called price takers.
Absorption costing information does not necessarily have to be useless to price takers since knowledge of the full cost will enable them to make a judgment on whether or not to enter or to remain in a particular market given the price dictated by the market. Though the usefulness of absorption costing can be questioned it is probably fair to say that most businesses involved in manufacturing, or in the provision of services, hospitals and universities use absorption costing to determine costs of their output.
Overheads are treated in two ways to get the final figure. Firstly the overheads are taken from the cost centre to the cost unit. The second is the cost of each cost unit forms part of the selling price. This means when management are looking at what to charge the customer all the costs have been taken into account and are passed on to the customer. The Overhead Absorption Rate OAR can be calculated in three ways; units of output, direct labour hour and machine hour. These are shown below with examples.