"The process of absorption costing (also known as overhead recovery) is highly subjective process which can cause organisations to suffer major problems unless the concept is fully understood by management"
ERNEST MUNOWENYU
P02308522
ACCOUNTING AND FINANCE ACFI 1004
MANAGEMENTACCOUNTING
ASSIGNMENT 2
STEVE DUNGWORTH
"The process of absorption costing (also known as overhead recovery) is highly subjective process which can cause organisations to suffer major problems unless the concept is fully understood by management"
From the above statement it should be noted that it is management's ability to understand and comprehend the workings of absorption costing that is of issue. This paper will attempt to highlight the process itself as well as pointing out the possible areas that could prove problematic in the workings of an organisation. As well as looking at absorption costing in closer detail, this paper will also mention variable costing as measurement milestone for absorption costing. This will be followed by a look at a process of absorption costing, process costing, and how understanding it, along with the whole absorption costing process will enable management to have a clearer picture of the costing processes in their organisations. Numerical examples will be used to further explain all the above processes.
Management accounting systems should provide information for various functions. Internal reporting to managers for cost planning, control and also performance evaluation. Reporting for decisions on how resources should be allocated and priced in relation to product profitability.
The information may also be used by management for strategic and often as a tactical decision making tool. The information especially that found in absorption costing will be used for external reports, such as financial statements.
With this in mind the role of the management accountant will involve allocation of costs between areas such as cost of goods sold and the stock needed for both internal and external profit reporting. Provide relevant information to help managers make better decisions. Provide information for planning, control and performance measurement.
Planning to turn goals and company objectives into actions and resources, while looking at both the long and short term activities of the company. This would be done by controlling activities through setting of targets and standards, comparing performance and controlling costs with the aim of improving the efficiency of the organization.
The information that will be gathered from cost data, will aid in facilitating cost allocation between cost of goods sold and the stock at end of period. Decision making through use of relevant data, will also aid in planning, control and performance measurement
Before looking at the absorption costing system a brief description of costs is needed. This will be helpful as the behavior of these costs affect the costing systems in different ways.
Variable Costs
Vary in direct proportion to the volume of activity
Fixed Costs
Remain constant for specified time, despite any change in activity level
The behavior of costs and overheads needs to be well understood by management for them to produce and understand the full mechanics of the absorption process. In business, overheads are made up of: indirect materials, indirect labour and indirect expenses. Overheads must be shared between all the cost units as they do not relate to any particular unit of output, and are usually classified by function.
The next process after understanding the form of overheads is to allocate them. Allocation of overheads is 'the charging to a cost centre of those overheads that have been directly incurred by that cost centre'.
Apportionment is the next process, and this is where cost centres are charged with a proportion of the overheads.
After the above processes have been carried out the next step then is charge the overheads to the cost units, and this is the where absorption costing starts.
What is absorption costing?
According to Drury (2000) it is "a system ...
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The next process after understanding the form of overheads is to allocate them. Allocation of overheads is 'the charging to a cost centre of those overheads that have been directly incurred by that cost centre'.
Apportionment is the next process, and this is where cost centres are charged with a proportion of the overheads.
After the above processes have been carried out the next step then is charge the overheads to the cost units, and this is the where absorption costing starts.
What is absorption costing?
According to Drury (2000) it is "a system in which all fixed manufacturing overheads are allocated to products" from this simplified definition management needs realise that all manufacturing costs fixed or variable should be treated as product costs.
Full absorption costing is a traditional method where all manufacturing costs are capitalized in the inventory, i.e., charged to the inventory and become assets. This means that these costs do not become expenses until the inventory is sold. In this way, matching is more closely approximated. All selling and administrative costs are charged to expense however. Absorption costing is required for external reporting. The absorption method is also used for internal reporting.
Absorption costing can be defined as "the total amount of resources involved with pursuing a particular objective" (Atrill P and Mclaney 1994).This could be repairing a car, producing a can of baked beans, or building a block of high rise flats. In short the purpose of absorption costing is to answer the question ' how much did it or will it cost ?' the reasons for us wanting to know the answer to that question will be made evident as the mechanics of absorption costing are made clearer. One reason for this would be for the manufacturer or producer to determine what price to charge to their customers to ensure that all costs are covered and that the company makes the required and acceptable level of profit. It is important to know that there is no distinction between fixed and variable cost when you are dealing with absorption costing. All relevant costs used to achieve the particular objective, whether fixed or variable, are taken into account.
Using the information obtained
The information obtained can be used in various areas of accounting. For financial accounting purposes, where identifying the cost of production to find the cost of sales figures, helps in working out the gross profit figure once sales have been taken into account. Over heads are included in the cost of production as standard.
Measuring the profitability of departments or divisions. When comparisons are made between the unit costs of some departmental outputs and the external purchase prices absorption costing information is useful.
Use of absorption costing is also useful for pricing purposes. This is because of the need to use all relevant costs in coming up with the cost per unit and thus setting a profit margin based on those findings. Some businesses base their selling prices on the incurred costs of producing each unit and therefore are called price makers because their prices are based on the costs of production. Most though have their prices set by the market depending on the demand of the products or services they supply and are called price takers. Absorption costing information does not necessarily have to be useless to price takers since knowledge of the full cost will enable them to make a judgment on whether or not to enter or to remain in a particular market given the price dictated by the market. Though the usefulness of absorption costing can be questioned it is probably fair to say that most businesses involved in manufacturing, or in the provision of services, hospitals and universities use absorption costing to determine costs of their output.
Overheads are treated in two ways to get the final figure. Firstly the overheads are taken from the cost centre to the cost unit. The second is the cost of each cost unit forms part of the selling price. This means when management are looking at what to charge the customer all the costs have been taken into account and are passed on to the customer.
The Overhead Absorption Rate OAR can be calculated in three ways; units of output, direct labour hour and machine hour. These are shown below with examples.
Units of Output
Total cost centre overheads total cost units = cost per unit
Total cost centre overheads total cost units = cost per unit
Total cost centre overheads total cost units = cost per unit
Cost units x OAR = overhead absorbed
e.g.
Total cost centre overheads pa £100,000
Expected total output pa 20,000 units
Output in March 1,500 units
£100,000 20,000 units = £5.00 per unit
,500 units x £5 = £7,500 overhead absorbed in March
Direct Labour Hour
Total cost centre overheads total direct labour hours =cost per direct labour hour
Direct labour hours x OAR = overhead absorbed
e.g.
Total cost centre overheads pa £40,000
Expected direct labour pa 5,000 hours
Actual hours in March 450 hours
£40,000 5,000 hours = £8 per labour hour
450 hours x £8 = £3,600 overhead absorbed in March
Machine Hour
Total cost centre overheads total direct machine hours = cost per machine hour
Machine hours x OAR = overhead absorbed
e.g.
Total cost centre overheads pa £216,000
Expected direct labour pa 36,000 hours
Actual hours in March 3,500 hours
£216,000 36,000 hours = £6 per machine hour
3,500 hours x £6 = £21,000 overhead absorbed in March
Process costing
"Appropriate form of costing where the product follows a series of sequential, frequently automatic processes, e.g. paper making, refining, paint manufacture, food processing."(Lucey T 2000) The main focus of process costing is finding the average of the total costs per process and this includes work in progress. It also entails charging the end product of each process as a raw material for the next. Partly completed units at the end of a period are regarded as fractions of the whole process and thus costs allotted to them in the same manner.
It is a straightforward process to determine the full cost per unit of output where a business's products are identical.
This is done by dividing the total costs of production for the period by the number of units of output during that period.
e.g.
Total cost (fixed and variable) for May £1600
Total output for May 200 units
Cost per unit = £1600/200 = £8.00
The length of the period is determined by those requiring the information and preparing the information in this case management. The source of the information is also subjective and up to the user, whether it is historical, i.e. Previous periods figures, is a matter of judgment and depends on the purpose for which the information is required.
In process costing systems, costs are charged directly to the department that incurs them, 1. Material is charged to the department that uses it.
2. Details of direct labour are kept by each department so that the direct labour cost for each department can be calculated.
3. The wages of indirect employees, as foremen, porters, are charged to the department for which they are sent.
All product costs will eventually be charged to some production department. Service activities such as maintenance, and other cost centers like depreciation, must be allocated to the production departments.
Because of the inevitable existence of work in progress at the beginning and end of a given period, that is found in industries that produce one or identical products, the calculation of the cost per unit is made slightly complicated. This is because work in progress from the previous period will be completed in the current period and some of the work that is started in the current period will be incomplete at the end of it, only to be a finished product in the next. To deal with this, process costing systems have adopted a calculation that takes into account the proportion of the incomplete work and makes whole units for the costing process.
e.g.
If, total cost of product c is 25000. And 10000 units were completed, and 1000 partially finished units. The work in progress is 50% complete.
What is the full cost per unit of product c.?
So we say out put is
10000 units + (1/2 x 1000) = 10500
Unit cost was 25000/10500 = £2.38
There are three approaches which could be taken to solving the problem of Work In Progress (WIP) in process costing:
If WIP is insignificant in amount it could be ignored.
2 Where the WIP is similar at the start of the period, it can be ignored because the costs put into the production which is not completed by the end of the period is matched by the production brought forward from the previous period.
3 Where the WIP is significant in value and dissimilar at the start and end of the period, WIP can be converted into an equivalent number of completed units
Supporters of the absorption method of costing argue that it would be prudent to write off fixed production overheads in the period of production without considering the time a sale occurs. This would give a better picture where profits are concerned, seeing as fixed overheads have been apportioned
The Statement of Standard Accounting Practice 9 issued by the accountancy profession and which deals with the accounting treatment of stocks and work in progress supports the absorption costing approach for preparing published accounts for limited companies. Other costing systems such as variable costing may be used for internal reporting and management purposes.
Absorption costing systems have been criticized but are still widely used in business. In recent years there has been a demand from businesses for more accurate identification and control over unit costs as a result of an increasingly competitive environment. Activity based costing ABC has now come to the fore but whether it will be widely accepted and if it will provide benefits to business after all the implementation costs have been accounted for is yet to be seen .
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References
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Lucey, T., Terence, 1934-. - Management accounting. - 4th ed. - London: Continuum, 2000
Atrill, Peter. - Management accounting: an active learning approach / Peter Atrill and Eddie. - Oxford: Blackwell Business, 1994.
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