Thursday, 13 April 2017

Absorption Cost

Absorption cost takes account of all costs and allocates them to individual products or cost centers.

Direct or variable costs

Some costs relate directly to a product and this is quite straightforward in principle, although very detailed record-keeping may be necessary.

Among the costs that can be entirely allocated to individual products are

  • direct wages and associated employment costs, 
  • materials and bought-in components.

Indirect costs

Other costs do not relate to just one product and these must be allocated according to a fair formula.  

These indirect costs must be absorbed by each product.

There is not a single correct method of allocating overhead costs to individual products and it is sometimes right to allocate different costs in different ways.

The aim should be to achieve fairness in each individual case.  

Among the costs that cannot be entirely allocated to individual products are

  • indirect wages (cleaners, maintenance staff, etc.), 
  • wages of staff such as salesmen and accountants, and 
  • general overheads such as rent and business rates.

Take care to allocate non-direct costs fairly

Great care must be taken in deciding the best way to allocate the non-direct costs.

There are many different ways.

The following two are common methods:

  1. Production hours
  2. Machine hours

Common Methods for allocating non-direct costs fairly

1.   Production hours

The overhead costs are apportioned according to the direct production hours charged to each product or cost center.

For example:

Consider a company with just two products.

Product A having 5,000 hours charged and Product B having 10,000 hours charged.  

If the overhead is $60,000.  Product A will absorb $20,000 and Product B will absorb $40,000.

2.  Machine hours

The principle is the same bt the overhead is allocated according to the number of hours that the machinery has been running.

For example:  

Consider a company that manufactures three types of jam.

Its overhead costs in January are $18,000 and it allocates them in the proportion of direct labour costs.

January Cost Statement

                                  Strawberry      Raspberry        Apricot         Total
Jars produced              26,000           60,000           87,000           173,000           

                                          $                    $                   $                      $
Direct labour                   2,000            4,000            6,000              12,000
Ingredients                      6,000           11,000          17,000              34,000
Other direct costs            2,000             3,000            6,000              11,000

Total Direct Costs         10,000           18,000         29,000              57,000

Overhead allocation         3,000             6,000           9,000              18,000

Total Cost                      13,000            24,000        38,000              75,000

Cost per jar                    50 sen            40 sen         43.7 sen           43.4 sen  

In the above, the direct labour is smaller than the overhead cost that is being allocated.

The trend in modern manufacturing is for direct costs and particularly direct labour costs, to reduce as a proportion of the total costs.  

If the overheads had been allocated in a different way, perhaps on floor area utilized, then the result would almost certainly not have been the same.

This increases the importance of choosing the fairest method of apportionment

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