Absorption Costing: Meaning and Criteria | Cost Accounting

In this article we will discuss about:- 1. Meaning of Absorption Costing 2. Growing Importance of Overheads 3. Criteria for Absorption of Overheads 4. Advantages and Limitations of Absorption Costing.

Meaning of Absorption Costing:

Absorption costing is a principle whereby fixed as well as variable costs are allocated to cost units and total overheads are absorbed according to activity level.

The term may be applied where:

(a) Production cost only, or

(b) Costs of all functions.

It is the practice of charging all costs, both variable and fixed, and both direct and indirect to operations, products or processes. Conceptually, absorption costing is a simple and fundamental method of ascertaining the cost of a product or service.

Absorption costing is familiar, since many firms still follow the approach for pricing decisions in terms of adding something on a total cost. It is the oldest and widely used system of cost accounting in operation. Considerable problems are inherent in application of absorption costing, yet it is widely used in business decisions.

The assigning of a fair share of indirect costs, along with direct costs, to cost units is the main principle of absorption costing. Absorption costing is also termed as ‘cost plus’ costing where a fixed percentage is added to total cost, to cover profit. Absorbed cost is made up of direct costs plus overhead costs, the latter having been allotted to cost units by means of overhead absorption rates.

Absorption costing is still in practice, in fact, that the accounting standards on stocks and work-in-progress recommends that they be valued at that cost which includes production overheads.

In absorption costing the difference in the magnitude of opening and closing stock affects the unit cost of production due to the impact of related fixed overheads. Figure 18.1 shows the apportionment and absorption of overhead to product cost.

Growing Importance of Overheads:

The control of overheads is an increasingly important function of the Management accountant for the following reasons:

(a) Inflation, under which most expenses, like salaries, energy costs, rates etc. have risen rapidly and considerably.

(b) Improvements in control techniques where the direct cost of materials and material holding have been reduced.

(c) Automation and mechanization, where labour costs have been reduced but where increased installation, maintenance and operation costs have been increased.

(d) Specialist services, where industrial and commercial enterprises have increasingly resorted to outside specialists such as market researchers, behavioural scientists, taxation advisers, technical consultants etc.

(e) Advertising and promotional costs and practices, which most enterprises being forced to undertake to meet increasing competition by more extensive and more frequent advertising and promotion.

(f) Business size, where increase in the size and structural complexity of business enterprises have necessitated the installation and operation of effective and costly control systems.

Criteria for Absorption of Overheads:

A variety of criteria have been used to decide a rate for the absorption of overheads.

The most common are:

(a) Percentage of Direct material cost

(b) Percentage of Direct labour cost,

(c) Percentage of Prime cost,

(d) Rate per Unit produced,

(e) Rate per Labour hour, and 

(f) Rate per Machine hour.

The circumstances of a particular situation must be considered before a choice is made. The fifth and sixth methods seem preferable to the others in most cases. The overheads incurred in running a business is known with certainty, but whereas the amount of overhead absorbed is based on prior estimates of the levels of production and overheads likely to be incurred during the period.

The explanations behind the major causes of over and under recovery of overheads are price fluctuations, change in level of general economic activity, poor marketing and so on.

Advantages and Limitations of Absorption Costing:

Advantages:

The advantages from adoption of absorption costing method are as follows:

(a) Absorption costing conforms with the accrual concept by matching costs with revenue for a particular accounting period.

(b) Stock valuation complies with the accounting standards, and fixed production costs are absorbed into stocks.

(c) It avoids separation of costs into fixed and variable elements, which is not easily and accurately achieved.

(d) The analysis of under/over absorbed overheads reveals any inefficient utilization of production resources.

(e) The apportionment and allocation of fixed production overheads to cost centres (e.g., departments), makes managers more aware of the costs and services provided.

(f) Cost plus pricing under absorption costing ensures that all costs are covered. Pricing at the margin may, in the long-run, result in contribution failing to cover the fixed costs. It is important in absorption costing that sales are equal to or exceed the budgeted level of activity otherwise fixed costs will be under-absorbed.

Limitations:

Absorption costing suffers from following limitations:

(a) This method employs highly arbitrary way of apportionment of overheads which reduces the practical utility of cost data for control purposes. Neither the actual nor the predeter­mined method of absorption distinguishes clearly the extent to which total unit costs are affected by volume changes and other causes respectively. Thus, there is no one unit cost that may be used as a guide to decision-making when the decision involves a change in volume.

(b) In this method all fixed costs are not charged against the revenue of the year in which they are incurred. It is an unsound practice.

(c) Assigning product cost with a reasonable share of fixed overhead obscures cost-volume- profit relationship. When there are different types of cost units, the attribution of overheads to them is bound to be arbitrary to some extent. If sales pricing decisions are based on total unit costs there is a danger that some products will be overpriced and others underpriced, and total revenue and/or profit will not be maximized.

(d) Behavioural pattern of costs is not given importance.

(e) In reporting enterprise results, the profit of a particular period will be affected by the amount of overheads absorbed into closing inventories or work-in-progress or finished stock or charged against the period when opening inventories are sold.

(f) Absorption costing produces a means of determining selling prices, but in most cases accuracy cannot be achieved due to the nature of overheads included in the calculations.

(g) The complaint is sometimes made that absorption costing often deals only with production costs and ignores selling and administration costs.

(h) The decision-maker needs to know the costs that will vary as a result of his decision, and the costs that will remain unchanged. Absorption costing does not provide a convenient basis for making such calculations. Its main purpose is to provide cost information for stock valuation and the measurement of reported profits.