ABSORPTION COSTING ('FULL-COSTING') is a costing method in which ALL COSTS, BOTH DIRECT & INDIRECT COSTS ARE USED in determining the AVERAGE FULL COST PER UNIT.
Let's look an example!
This is a straightforward calculation as there is just one product being made. The main problem arises when a business produces two or more products. How should indirect expenses then be divided up between the two (or more) products?
ABSORPTION COSTING ('FULL-COSTING') is a costing method in which ALL COSTS, BOTH DIRECT & INDIRECT COSTS ARE USED in determining the AVERAGE FULL COST PER UNIT.
This is a straightforward calculation as there is just one product being made. The main problem arises when a business produces two or more products. How should indirect expenses then be divided up between the two (or more) products?
The division of indirect costs is called an allocation of indirect costs. The easiest way is to divide total overhead costs by the number of different products being produced.
In Example 2, a manufacturer produces both Product A and Product B. Can you see the problem with this allocation of overhead costs? Example 2 demonstrates the problem
This is an inaccurate division of indirect costs as Product A is obviously much more important to the business and incurs a much higher proportion of direct costs. This way of dividing overheads might lead to some very poor decisions, such as the pricing of Product B. As it has been allocated 50% of indirect costs then the final price, based on average cost, will be high and uncompetitive. Another way of allocating indirect costs must be used. Look at Example 3 (see Table 33.6).
Comment: Now the indirect costs have been allocated differently. They have been allocated between the two
products in the same proportion as they incur direct costs. Product A incurs 90% of direct costs and is allocated 90% of indirect costs. Product B incurs 10% of direct costs so is allocated 10% of indirect costs. More accurate full cost figures are obtained, which will be much more useful for decision- making such as setting prices.
This method is not perfect. One reason is that Product B might take up just as much factory floor space as A or use as much electricity because it is more dependent on machinery than A. An allocation of indirect costs such as rent and electricity based on direct costs might still not be accurate.
.Absorption costing allocates all costs to each product and is sometimes referred to as ‘full costing’. If the business is only producing one type of product, then this is not a problem. In this case, the stages in full costing are:
• identify and add up all of the direct costs
• calculate the total of overheads of the business for a given time period
• add the total direct costs of making the product
• calculate the average cost of producing each product by dividing total costs by output.