The aim of absorption costing is to establish the full production cost per unit.
Absorption Costing Steps
Step1: Allocation
This is a process of charging a cost directly to a cost unit or cost centre.
E.g., Maintenance Engineer's Salary can be allocated to the engineering maintenance department.
Step2: Apportion
The idea is to apportion the costs of service centre like the canteen into
production departments in some fair way. For example, the canteen has incurred
$100 costs, then the business can apportion this $100 to the production department
based on their square metres.
Step3: Absorption
If business has only one product, we absorb the costs based on the number of units.
If business has multiple products, we absorb the costs based on labour or machine hours.
Advantages of Absorption Costing
Easy
This method is relatively easy to be implemented with simple calculations which
are easily understood by managers.
IAS2
This is also allowed by International Accounting Standard 2 Inventory when
preparing for financial testaments as this method shows the full production cost of the product.
Problems with Absorption Costing
Guess work
There are choices for the business to use when absorbing the costs into one product:
either it is based on labour or machine hours.
Suitability in current business environment
Companies nowadays will decide to use machines to replace human beings. At the same time,
lots of overhead expenses will be incurred; not just the cost of labour, for example,
quality costs etc. Hence absorption costing may not be suitable in the current business environment.
Dysfunctional behaviour
Gross profit will be calculated by deducting the costs of sales from sales revenue. If
there are stocks which are not sold, they will be deducted from the costs of sales and
increasing up the profit. This means that managers are encouraged to build up stocks
in order to increase up the profits since we charge
fixed overheads into each of unsold/closing stocks.