ABSORPTION COSTING OR FULL COSTING

Samir K Mahajan

ABSORPTION COSTING/FULL COST METHOD

Absorption costing or full cost method is the traditional method of costing by which all direct and

applicable overheads are charged to product or cost centre. According to this method, all costs

(fixed and variable cost) are identified with or absorbed into manufactured product.

Here, direct cost and manufacturing overheads (variable and fixed) are treated as product cost . Sellingand administrative cost are part of part of period cost.

Absorption cost remain in inventory as an asset until such time as the inventory is sold. They are

charged to cost of goods sold. Consequently the cost of goods in inventory or cost of goods sold underthis method contain variable costs and fixed overhead cost.

ABSORPTION COSTING/FULL COST METHOD

Example 1: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the restsare variable. It is decided to apportion these costs over different products in theratio of output. Prepare a statement showing the cost and profit of each productaccording to absorption cost.

Example 1: solution

Statement showing profit and cost (Absorption Costing )

Traditional Income Statement

A_____ ______B _____ _____C _____

Per unit Rs

TotalRs

Per unit Rs

TotalRs

Per unit Rs

TotalRs

Direct material Direct labour

Overheads: Fixed

Variable

Total CostProfit Selling price

32

31

30002000

30001000

43

31

40003000

30001000

54

31

50004000

30001000

91

90001000

114

110004000

137

130007000

10 10000 15 15000 20 20000

Example 1: solution contd

Total profit under absorption costing is

Total Profit Rs._______

Product A 1000 Product B 4000 Product C 7000 12000

ADVANTAGES OF ABSORPTION COSTING SYSTEM

1. Absorption costing recognizes fixed costs in product cost. As it is suitable for determining price ofthe product. The pricing based on absorption costing ensures that all costs are covered.

2. Absorption costing avoids the separating of costs into fixed and variable elements.

3. Absorption costing has been recognized for the purpose of preparing external reports and forstock valuation purposes.

4. The allocation and apportionment of fixed factory overheads to cost centres makes managermore aware and responsible for the cost and services provided to others.

5. Absorption costing will show correct profit calculation than variable costing in a situation whereproduction is done to have sales in future ( e.g. seasonal production and seasonal sales).

DISADVANTAGES OF ABSORPTION COSTING SYSTEM

1. Absorption costing is not useful for decision making. It consider fixed manufacturing overhead asproduct cost which increase the cost of output. As a result, it does not help in accepting speciallyoffered price for the product. Various types of managerial problems relating to decision making canbe solved only with the help of variable costing system( Discussed in Example 2).

2. The technique of absorption cost may lead to rejection of profitable business. A total unit costwill tend to be regarded as the lowest possible selling price. An order at a price which is less thantotal unit cost may be refused, though the order may be actually profitable ( Discussed in Example 3)

3. Absorption costing is not helpful in control of cost and planning and control functions. It is notuseful in fixing the responsibility for incurrence of costs. It is not practical to hold a manageraccountable for costs over which he/she has not control.

Example 2: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows

A B C

Direct Material per unit Rs 3 Rs 4 Rs 5

Direct labour per unit Rs 2 Rs 3 Rs 3

Selling price per unit Rs 10 Rs 15 Rs 20

Output 1000 units 1000 units 1000 units

The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable.It is decided to apportion these costs over different products in the ratio of output. Prepare astatement showing the cost and profit of each product according to absorption cost.Calculate amount of profit and and loss made by Tripura Ltd in the first two years of itsexistence, presuming thati. In the first year, it manufactures 1000 units of each product A, B, C but fails to effect any

sales.ii. In the second year, it does not produce anything but sells the entire stock carried forward

from the first year.iii. What fallacious conclusions can be drawn from the results.

Solution : Example2

Tripura Limited Profit and loss Account of 1st Year

Dr Rs Cr Rs

Direct material ABC

Direct labour ABC

Overhead: variables

A 1000B 1000C 1000

Fixed -----

300040005000___ 12000

200030004000___ 9000

30009000 _12000__

___33000_

SalesClosing Stock

-----33000

___________33000_

Solution : Example 2 contd.

Tripura Limited Profit and loss Account of 2nd Year

Dr Rs Cr Rs

Opening Stock Fixed overhead

Profit

3300090003000

_______45000__

SalesA BC

100001500020000_ 45000

______45000_

Solution : Example 2 contd.

The above Profit and Loss accounts shows that in the first year there is no loss in spite ofthe fact that the company did not make any sales . While in the second year, it makes aprofit of Rs.3000. As a matter of fact, the company losses Rs.9000 on account of non-recovery of fixed cost in the first year. The profit and loss account does not show any lossbecause these fixed costs have been included in the closing inventory values and thuscarried forward to the next year.As a result, the profit and loss account for the second year has to bear Rs.18000 onaccount of fixed cost. (i.e. Rs.9000 for the first year + Rs.9000 for the second year). Thereal profit in the second year should be have been Rs. 12000 and not Rs. 3000.

Thus, the technique of absorption may lead to rather odd results particularly forseasonal business in which stock levels fluctuate widely form one period to another.Their profits for the two periods will be influenced by the transfer of overheads in andout of stock showing falling profits when the sales are high and increasing profit whensales are low.

Example 3:

Your are the MD of Usha Automobiles Ltd. which has received a special offer for the supplyof 200 components at Rs 60 a piece from a motorbike manufacturer. The company has acapacity to produce 1000 components but at present it is utilising 80 percent of itscapacity. The present selling price per component is Rs. 100.

The cost details of the company are as follows:

Variable cost per unit Rs 40Fixed overhead cost per unit Rs 30(total fixed overheads Rs 24000) ___________Total cost per unit Rs 70Your cost accountant advises you to reject the order since the company will be getting lessprofit than the total cost of the component. How would you react?

Solution : Example 3:

Sales Total

Sales in units ___________800 200 1000

Sales in Rs. 80000 12000 92000(800x100) (200x60)_____________________________

Total Cost: Variable ( Rs 40 per unit) 32000 8000 40000Fixed cost (Rs) 24000 ---- 24000_____

56000 8000 64000_____Profit (Rs.) 24000 4000 28000

The advice of the Cost Accountant is not correct. Since he has based his decision on absorption costing, he is advising against accepting the special offer. Thus if the order is accepted the profit will increase from Rs. 24000 to Rs.28000. it is therefore advisable to accept the offer rather than reject.