Absorption Costing and Manipulation of Profit

Absorption Costing and Manipulation of Profit

The profit can easily be manipulated in absorption costing by changing the value of closing stock . The stock valuation consist of overhead element which can easily be manipulated by management for the stock valuation purposes.

The overhead absorption rate is very much at the discretion of the management and management can change the absorption rate to get the desired results. Whereas in case of Marginal costing management does not have this opportunity because overheads are charged as period cost.

1.Increase in Stock

If more value of closing stock is increased then it will increase the profit of the entity because some portion of the cost in current period will be stored in closing stock and will be charged next year.

2. Decrease in Stock

Similarly if the closing stock is valued at less amount then maximum expenses are charged in this period and this will reduce the current year profit.

Reasons for under and over absorbed overheads

 Reasons for under and over absorbed overheads

The production overhead are charged on predetermined rate which is based on budgeted overheads and budgeted level of activity. Therefore actual expenditure may differ from that rate. The main reason for that difference due to following reasons.

1. Actual expenditure differ from the budgeted expenditure
2. Budgeted level activity differ from actual level of activity

What is Absorption Rate

What is Absorption Rate

The absorption rate is rate used to charged the overheads to the production . The rate is based on the budgeted level of activity and budgeted overheads. The absorption rate is calculated by dividing the budgeted overheads by the budgeted level of activity.

What is use of Absorption Rate

Absorption rate is basically used to overhead during the year and based on historical data ( i.e budgeted overhead and budged location). The data of the actual overheads are available at the year end therefore predetermined rate is used.

What is under absorption and over absorption

The under absorption is the less amount charged to production than actual amount . The overhead absorption is the more amount charged to the production than actual amount. 

The reason for the under absorption and over absorption is due to use absorption rate for charging the overhead to the production and  which may differ from actual overheads.

Reasons for using absorption Costing

Reasons for using absorption Costing

There are mainly three reasons for using the absorption costing methods

1. Stock Valuation

Accurate Stock valuation is possible under absorption costing.

2. Financial Statements

Accurate financial statement can be prepared under the absorption costing system because under this method stock which is an important part of balance sheet and profit and loss account can only be accurately calculated under this system.

3.Product Pricing

Product pricing decision making can be made with the help of absorption costing.

What are methods of apportionment

What are methods of apportionment

There are basically four methods of apportionment of service department costs.

1.Direct 

If service department do not work for each other then overheads are only charged to production department using appropriate bases. This method of apportionment is called Direct apportionment.

However if it is assumed that service department is providing service to production department and other service department as well then there are three method to deal the situation.

1. Repeated Distribution

under this method cost are distributed among the service department repeadly unless the value of service department becomes negligible.

2. Algebraic method

Algebraic method is used for apportionment.

3.Step-wise Elimination

Under this method firstly one service department is allocated to all departments including serviced department then other service department cost are allocated only to production department.

How Absorption costing Works

How Absorption costing Works

The absorption costing build a product cost by allocation , apportionment and overhead absorption.

1.Direct Allocation

in first place direct expenditure are allocated to appropriate cost center. The examples of direct allocation is direct material and direct labour and direct overheads.

2. Apportionment

Apportionment involves two steps . in first place the general overhead which are charged to production and service department cost centers by using appropriate bases.

in second place the service department general overheads are charged to production department.

3. Absorption

Finally the general heads are charges to production cost by an absorption rate.

What are overheads

What are overheads

Product cost is primarily consist of three element i.e Direct material , Direct Labour and production overheads. Production overheads basically are indirect cost.

What are Examples of Production overheads

The famous examples of Production overheads are factory rent, supervision cost, Depreciation of plant and Machinery , Factory Lightening.

How Factory overhead are Charged 

Factory overheads charged to the product on the bases of absorption rate which is calculated by the management based on the historical data and experience of management.