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Absorption costing

Absorption Costing Definition

Absorption costing is defined as a method for accumulating the costs associated with a
production process and apportioning them to individual products. This type of costing is
required by the accounting standards to create an inventory valuation that is stated in an
organization's balance sheet.

A product may absorb a broad range of fixed and variable costs. These costs are not
recognized as expenses in the month when an entity pays for them. Instead, they remain in
inventory as an asset until such time as the inventory is sold; at that point, they are charged to
the cost of goods sold.

Absorption Costing Components

The key costs assigned to products under an absorption costing system are:

 Direct materials. Those materials that are included in a finished product.


 Direct labor. The factory labor costs required to construct a product.
 Variable manufacturing overhead. The costs to operate a manufacturing facility, which vary
with production volume. Examples are supplies and electricity for production equipment.
 Fixed manufacturing overhead. The costs to operate a manufacturing facility, which do not
vary with production volume. Examples are rent and insurance.

It is possible to use activity-based costing (ABC) to allocate overhead costs for inventory
valuation purposes under the absorption costing methodology. However, ABC is a time -
consuming and expensive system to implement and maintain, and so is not very cost -
effective when all you want to do is allocate inventory to be in accordance
with GAAP or IFRS.
You should charge sales and administrative costs to expense in the period incurred;
do not assign them to inventory, since these items are not related to goods produced, but
rather to the period in which they were incurred.

Absorption Costing Steps

The steps required to complete a periodic assignment of costs to produced goods is:

1. Assign costs to cost pools. This is comprised of a standard set of accounts that are always
included in cost pools, and which should rarely be changed.
2. Calculate usage. Determine the amount of usage of whatever activity measure is used to assign
overhead costs, such as machine hours or direct labor hours used.
3. Assign costs. Divide the usage measure into the total costs in the cost pools to arrive at
the allocation rate per unit of activity, and assign overhead costs to produced goods based on
this usage rate.

Overhead Absorption

Absorbed overhead is manufacturing overhead that has been applied to products or other
cost objects. Overhead is usually applied based on a predetermined overhead allocation rate.
Overhead is over absorbed when the amount allocated to a product or other cost object is
higher than the actual amount of overhead, while the amount is under absorbed when the
amount allocated is lower than the actual amount of overhead.

For example, Higgins Corporation budgets for a monthly manufacturing overhead cost
of $100,000, which it plans to apply to its planned monthly production volume of
50,000 widgets at the rate of $2 per widget. In January, Higgins only produced 45,000
widgets, so it allocated just $90,000. The actual amount of manufacturing overhead
that the company incurred in that month was $98,000. Therefore, Higgins experienced
$8,000 of underabsorbed overhead.

In February, Higgins produced 60,000 widgets, so it allocated $120,000 of overhead.


The actual amount of manufacturing overhead that the company incurred in that
month was $109,000. Therefore, Higgins experienced $11,000 of overabsorbed
overhead.

Absorption Costing Problems

Since absorption costing requires the allocation of what may be a considerable amount of
overhead costs to products, a large proportion of a product's costs may not be directly
traceable to the product. Direct costing or constraint analysis do not require the allocation of
overhead to a product, and so may be more useful than absorption costing for incremental
pricing decisions where you are more concerned with only the costs required to build the
next incremental unit of product.

It is also possible that an entity could generate extra profits simply by manufacturing
more products that it does not sell. This situation arises because absorption costing
requires fixed manufacturing overhead to be allocated to the total number of units
produced - if some of those units are not subsequently sold, then the fixed overhead
costs assigned to the excess units are never charged to expense, thereby resulting in
increased profits. A manager could falsely authorize excess production to create these
extra profits, but it burdens the entity with potentially obsolete inventory, and also
requires the investment of working capital in the extra inventory.
Process costing

Process Costing Overview

Process costing is used when there is mass production of similar products, where the costs
associated with individual units of output cannot be differentiated from each other. In
other words, the cost of each product produced is assumed to be the same as the cost of
every other product. Under this concept, costs are accumulated over a fixed period of
time, summarized, and then allocated to all of the units produced during that period of
time on a consistent basis. When products are instead being manufactured on an
individual basis, job costing is used to accumulate costs and assign the costs to products.
When a production process contains some mass manufacturing and some customized
elements, then a hybrid costing system is used.

Examples of the industries where this type of production occurs include oil refining, food
production, and chemical processing. For example, how would you determine the precise
cost required to create one gallon of aviation fuel, when thousands of gallons of the same
fuel are gushing out of a refinery every hour? The cost accounting methodology used for
this scenario is process costing.

Process costing is the only reasonable approach to determining product costs in many
industries. It uses most of the same entries found in a job costing environment, so there is
no need to restructure the chart of accounts to any significant degree. This makes it easy
to switch over to a job costing system from a process costing one if the need arises, or to
adopt a hybrid approach that uses portions of both systems.

Example of Process Cost Accounting

As a process costing example, ABC International produces purple widgets, which require
processing through multiple production departments. The first department in the process
is the casting department, where the widgets are initially created. During the month of
March, the casting department incurs $50,000 of direct material costs and $120,000
of conversion costs (comprised of direct labor and factory overhead). The department
processes 10,000 widgets during March, so this means that the per unit cost of the widgets
passing through the casting department during that time period is $5.00 for direct
materials and $12.00 for conversion costs. The widgets then move to the trimming
department for further work, and these per-unit costs will be carried along with the
widgets into that department, where additional costs will be added.

Types of Process Costing

There are three types of process costing, which are:

1. Weighted average costs. This version assumes that all costs, whether from a preceding
period or the current one, are lumped together and assigned to produced units. It is the
simplest version to calculate.
2. Standard costs. This version is based on standard costs. Its calculation is similar to
weighted average costing, but standard costs are assigned to production units, rather than
actual costs; after total costs are accumulated based on standard costs, these totals are
compared to actual accumulated costs, and the difference is charged to a variance
account.
3. First-in first-out costing (FIFO). FIFO is a more complex calculation that creates layers of
costs, one for any units of production that were started in the previous production period
but not completed, and another layer for any production that is started in the current
period.

There is no last in, first out (LIFO) costing method used in process costing, since the
underlying assumption of process costing is that the first unit produced is, in fact, the first
unit used, which is the FIFO concept.

Why have three different cost calculation methods for process costing, and why use one
version instead of another? The different calculations are required for different cost
accounting needs. The weighted average method is used in situations where there is no
standard costing system, or where the fluctuations in costs from period to period are so
slight that the management team has no need for the slight improvement in costing
accuracy that can be obtained with the FIFO costing method. Alternatively, process costing
that is based on standard costs is required for costing systems that use standard costs. It is
also useful in situations where companies manufacture such a broad mix of products that
they have difficulty accurately assigning actual costs to each type of product; under the
other process costing methodologies, which both use actual costs, there is a strong chance
that costs for different products will become mixed together. Finally, FIFO costing is used
when there are ongoing and significant changes in product costs from period to period – to
such an extent that the management team needs to know the new costing levels so that it
can re-price products appropriately, determine if there are internal costing problems
requiring resolution, or perhaps to change manager performance-based compensation. In
general, the simplest costing approach is the weighted average method, with FIFO costing
being the most difficult.

Cost Flow in Process Costing

The typical manner in which costs flow in process costing is that direct material costs are
added at the beginning of the process, while all other costs (both direct labor and
overhead) are gradually added over the course of the production process. For example, in
a food processing operation, the direct material (such as a cow) is added at the beginning
of the operation, and then various rendering operations gradually convert the direct
material into finished products (such as steaks).

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