An Evaluation of the absorption costing system

Category: Accounting

Job AB was one of the jobs worked on during the period. Direct material costing £35,000 and direct labour hours (800 hours) costing £20,000 were incurred. I. Calculate the production overhead absorption rate predetermined for the period based on: Direct material cost

Direct labour hours

II. Calculate the production overhead cost to be charged to job AB based on the rates calculated in answer to I. above;

III. Assume that the direct labour hour rate of absorption is used. Calculate the under- or over- absorption of production overheads for the period.

IV. In relation to the answer to III. above, state an appropriate treatment in the accounts of the over- or under- absorption and explain the rationale for this treatment.

PART B

Discuss the relative merits of the absorption method of costing and, in particular, comment upon the two methods of overhead absorption used above.

PART A

1.

a) PRODUCTION OVERHEAD / DIRECT MATERIALS = £1,250,000 / £500,000 = £2,5

b) PRODUCTION OVERHEAD / DIRECT LABOUR HOURS = £1,250,000 / 50,000 hr = £25

2. PRODUCTION OVERHEAD

BASED ON DIRECT MATERIAL COSTING

£35,000 x £2,5 = £87500

BASED ON DIRECT LABOUR HOURS

£25 x 800 = £20,000

3. BUDGETED PRODUCTION OVERHEAD £1,250,000

DIRECT LABOUR HOURS £50,000

£1,250,000 : 50,000 = £ 25 PER LABOUR HOUR

ACTUAL OVERHEADS £1,750,000

ACTUAL DIRECT LABOUR HOURS 55,000

ABSORBED £25 x 55,000 = £1,375,000

ACTUAL £1,750,000

UNDER ABSORBED £ 375,000

This is due to direct labour hours worked being more than expected and by actual overheads being £500,000 more than expected.

4. Under-recovery of overheads should be recorded as an expense in the current accounting period and over-recovery of overheads as a reduction in the expenses for the period. In the UK statement of Standard Accounting Practice on Stocks and Work in Progress (SSAP 9) is written that the allocation of overheads in the valuation of inventories and work in progress needs to be based on the company's normal level of activity and that any under- or over-recovery should be written off in the current year (Drury, 2004).

PART B

INTRODUCTION

Cost control is an important activity for all organisations. To increase numbers of items sold and good levels of profit companies have to keep their selling prices competitive. To achieve that, they have to have an accurate measurement of how much the cost is. Without this information determining product cost is impossible, and in consequence they will trade at a loss rather than at a profit.

The fundamental reason for knowing product cost is that they are used to value the cost of sales and stock in the periodic accounts of organisations. The ninth statement of standard accounting practice (SSAP 9) states that production and stock must be valued at the 'absorption' production cost for accounts which are accessible to stakeholders.

MERITS OF THE ABSORPTION METHOD OF COSTING

Absorption costing is the method to evaluate and assess the company's total inventory by including all production costs incurred to produce those goods.

Absorption costing means that all manufacturing costs are absorbed by units produced. In other words, cost of the finisher in inventory includes direct materials, direct labour, and both variable and fixed manufacturing overhead. As the result, absorption costing is also known as full costing or full absorption method (Atrill & McLaney, 2002).

Absorption costing is different from other costing methods, as it takes into account fixed manufacturing overhead costs ( including expenses such as rent of factory, depreciation of the manufacturing equipment and the supervisor's pay). Proportion of these non-measurable expenses has to be included in the total product cost and absorption costing is one way of doing this. For each product, the direct, the direct cost is measured but the indirect cost is estimated. The estimates of indirect costs are usually based on some connection between the cost and a measure such a machine hours used, direct labour hours used, total cost of direct materials used or wages cost. It is very important to use most appropriate overhead absorption rate (OAR). The choice of OAR makes a significant difference to the production cost (OAR/machine hour £25 and OAR/direct labour hour £2,5) and this illustrates the approximate nature of absorption costing.

Some of most common benefits of absorption costing are:

This method is accepted by tax and securities as stock is not undervalued;

This method is always used to prepare financial accounts;

When production remains constant, but sales fluctuate absorption costing will show less fluctuation in net profit and

Unlike marginal costs where fixed costs are agreed to change in variable cost, which is cost in value of shares thus stock valuation of distortion;

Disadvantages of full costing method are:

As absorption costing not so useful for management to use to make decision, planning and control;

Data collection process for this system is very time consuming;

As the manager's emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision;

Technical limitation. Absorption costing is approximately one hundred years old. It was created for a manufacturing era whose products relied upon direct labour more than they do today. Volume production in the twenty-first century is based on computer controlled automatic machinery.

Absorption costing is often contrasted with variable costing or direct costing. Under variable or direct costing, fixed manufacturing costs are not allocated above or assigned to (not absorbed by) manufactured products. Variable costing is often useful for management decision making. However, absorption costing is required for external financial reporting and reporting on income (Horngren et al, 2002).

Direct materials, direct labour and direct expenses that are part of prime cost are all direct costs. They can be assigned (attributed) to manufacture of the product directly. Costs beyond cost of production are called overhead. These costs are not directly attributable to products or services or cost centres. They are given by mapping process and apportioning overhead costs, distribution is based on the rational rationale.

In calculating cost of product or service, the technique considers marginal cost of behavioural costs (segregation of costs into fixed and variable elements) as the variable unit cost is fixed and total costs are variable in nature, where total fixed costs are fixed and fixed cost per unit is variable in nature and, in addition, variable costs are controllable in nature, while total fixed costs are uncontrollable in nature.

Marginal costs is useful for short-term planning, control and decision making, especially in the business where many products are produced.

In context of calculating cost of the product or service, absorption costing considered the part of any expenses incurred by the company for each of the products or services. In absorption costing technique, costs are classified according to their functions.

Absorption costing gives the better product information and pricing, which includes both variable and fixed costs.

Over / under absorption of overheads

Overhead is defined as sum of costs of indirect materials, indirect labour and other costs, including services that can not be loaded appropriately direct to specific cost units. Thus, overhead costs are all other costs of direct expenditure. Overall, operating expenses include all expenses incurred by or in connection with general organization of all or part of company (cost of operating supplies and services used by company, which includes maintenance capital goods).

Overhead is generally applied to production, based on predetermined rates. Default rate may have actual or estimated cost. Actual overhead cost incurred and overhead applied to production is rarely same. But due to certain reasons for difference between two may arise.

Over absorption: If amount requested exceeds actual cost is said to absorb excess overhead.

Under absorption: If amount requested is fall short of real head of production is said to be under absorption of overheads. Varying absorption of overheads may be referred to as changes in indirect costs. Under or over absorption of overheads may occur for following reasons:

Errors in estimation of overheads;

Overhead costs may change due to change in method of production;

Seasonal fluctuation of overall expenditure in certain industries;

Use of available capacity, sudden change in volume of output;

When expected level of activity and actual activity are not same, there is always over or under absorption situation. This is because rate of absorption of overhead costs is set at beginning of period based on an expected level of production and that during period, level of production and / or expenses will differ from projected costs and / or output.

Increased absorption occurs when total overhead recovered or absorbed is greater than actual level of overhead for period.

Under-absorption occurs when total costs recovered or absorbed is less than actual overhead costs incurred during period.

In product / service costing, absorption costing system allocates or distributes the portion of any expenses incurred by the company for each of products / services. In this way, we can establish whether, in long run, each product / service makes the profit. This can only be the guide. Arbitrary assumptions must be made on distribution of many of costs because some costs tend to remain fixed for the period, also depend on level of activity.

An absorption costing system traditionally classifies costs by function. Sales and production costs (sales) measures gross profit (manufacturing profit) of job. Gross profit less costs incurred in other business functions provides net profit (operating profit) of work.

Use of absorption costing system, profit reported for the manufacturing business for the period will be influenced by level of production and level of sales. This is due to absorption of fixed manufacturing overhead in value of work in process and finished goods inventories. If stock remain at end of an accounting period, then fixed indirect production costs included in valuation of inventories are carried forward.