topic 32 absorption costing

• Uses of absorption costing: calculation of profit when selling prices is fixed and calculation the selling price when a pre-determined level of profit is required
• Stages of absorption costing: allocation, apportionment, transfer of service centre costs, OARs calculation and job costing
• Direct labour hour rate = Overheads divided by Labour hours
• Machine hour rate = Overheads divided by Machine hours
• Advantages of using labour hours as OAR: time based and suitable when production is labour intensive
• Disadvantages of using labour hours as OAR: not suitable for capital intensive production
• Advantages of using machine hours as OAR: time based and suitable for capital intensive production
• Disadvantages of using machine hours as OAR: not suitable for labour intensive production
• Cost centre

  A production or service location, function, activity or item of equipment whose costs may be attributed to cost units
• Cost unit

  A unit of production which absorbs the cost centre's overhead costs
• Absorption costing

  Also known as Total Costing or Full Costing because it includes total/full costs. Absorption costing enables a manufacturer to set the correct selling price which ensures that all costs are covered
• Stage 3 - Transfer of Service Centre Overheads


  Departments that provide services for the production departments are not involved directly in producing the finished products and their costs cannot be directly recovered by including them in the selling price. To recover service centre overheads they are apportioned between production departments
• Reciprocal Services


  When there are reciprocal services, namely when one service centre provides services to another service centre, the treatment is to transfer service centre costs in descending order of the number of cost centres served
• Stage 5 - Job Costing

  Once the overhead absorption rate is added to the prime (marginal) cost of a job it is possible to calculate the total cost of production for that job. If the business is to make a profit on the job, selling and distribution costs and administration expenses need also to be recovered. This is usually done by adding a % mark up to the total production cost to give the total cost of the job plus a profit margin
• Under/Over Absorption of Overheads

  Overhead Absorption Costing is based on pre-determined OARs. If the actual results differ from the estimates the firm may not fully recover overheads (under-absorption) or may have recovered too many (over-absorption)
• Absorption/full costing takes all costs into account. This ensures that the correct selling price is set to cover all costs and make a profit. Absorption costing requires a smaller mark-up than marginal costing. It is suitable for long-term decision making
• Contribution/marginal costing

  Makes a clear distinction between fixed and variable costs and no attempt is made to allocate or apportion fixed costs incurred by cost centres. Marginal costing is useful for short term decisions where fixed costs can be ignored, however there are limitations to the use of marginal costing and basing decision on the notion of contribution
• Marginal costing makes very simplistic assumptions about cost behaviour: costs can be split between fixed and variable. Most costs fall somewhere between. Fixed costs do not change with output. Variable costs are constant per unit. There is a danger in firm's becoming over-reliant on the use of contribution - firms need to cover all costs in order to make a profit
• Marginal costing requires a higher % mark up than full cost pricing. However, Absorption costing also has its complications: it is based on pre-determined figures - actual figures may differ, the basis of apportionment is not precise, it is not appropriate for short-term decision making, under/over-absorption of overheads - if a firm undercharges so that overheads are not recovered it will not make a profit. If it overcharges it may become uncompetitive with competition