Absorption Costing

What is Absorption Costing

Absorption costing takes into account both the direct cost and indirect cost. The direct cost which are directly attributable to the product such as direct labour , direct material and direct over heads. The indirect cost which are not directly attributable to product. The absorption cost also includes the indirect cost in the cost of product by using an appropriate absorption rate.

Typically the indirect costs are apportioned to product cost using appropriate bases like machine hour or labor hour. The great advantage of using absorption costing it is more justified in term of financial reporting. It takes into account the full production cost and therefore inventories are accurately valued at the end of financial year. These inventories values are shown in the financial statement at full cost.

Limitation of Absorption Costing

1.Selection of appropriate absorption rate

it is very difficult to select appropriate absorption rate for consumption of overhead. The using of machine hour or labor hour rate is just a theoretical solution to the problem however in many cases it has no relevance for consumption of overhead.

2.Limited use for Decision Making

The absorption rate is normally decided on the bases of historical information available and therefore it has little role to play in the decision making. And more importantly it takes into cost which is not relevant in many cases and in decision making we only interest in relevant cost. The irrelevant cost has no role to play in decision making process.

Over and under absorbed overheads

As we know that absorption costing use a pre determined rate for absorption therefore the actual amount of expenditure are different from the estimated expenditure. Where the absorbed expenditure using absorption rate is more than actual expenditure it is called over absorbed overhead and where the absorbed overhead are less than actual expenditure it is called under absorbed.

In case of over absorbed expenditure profit is increased or expense is reduced and in case of under absorbed the profit is reduced or expense is increase