Absorption Cost

What is absorption cost?

Definition: Absorption cost is both the variable and fixed cost that are consumed to produce a product.

It is also known as full cost for the management considers all the costs whether fixed or variable in production especially when cost manager is reporting to the management using absorption-costing technique.

The process of identifying, assigning and accumulating both fixed and variable cost on a cost object is referred to as absorption costing. Such costs included in a product are;

Fixed costs;

-Insurance

-Rent charges for the machinery

-Leases

Variable costs;

-Raw materials

-Labor

 

Computation of absorption cost in a production context

How do we compute or determine the absorption cost? Unlike in marginal costing technique, in absorption costing, absorption cost per unit incorporates all types of cost elements such as direct labor, direct raw materials, direct expenses, variable overheads and fixed cost. In summary, the formula is as follows;

 

Absorption cost per unit


Example

C-Cubic co ltd is a manufacturing firm. The management provided you with the following production data during production of 10,000 kilogram in one week’s period of animal feed for your aid as cost accounting expert

Is absorption cost the same as marginal or variable cost?

The answer is no, they are not the same in many ways.

 

Computation of Cost per Unit: One way these costs are different is when the production manager wish to simply determine the cost per unit of a product during production process. In the case of marginal cost, the costing technique discriminates the costs in to two such that variable cost and fixed costs are accounted for separately. That is marginal cost is computed separately while the fixed cost is written off. Absorption cost, on the other hand involves a mixture of both variable and fixed costs.

 

Example

Rosy co. ltd produces baby toys and the production data is as provided below;

                                                Amt. $

Salary cost                              50,000

Office rent                               15,000

Packaging materials                12,000

Direct labor                              44,000

Direct materials                        20,000

 

Total units produced was         20,000

 

Required

Determine the absorption cost per unit

NB1: We can conclude that absorption cost is a composite cost which entails mixed cost of variable and fixed cost.

NB2: That the fixed cost is a sunk cost or historical cost which is not very useful in decision making, for it has already occurred.

 

Decision-Making: Another way that makes the two types of cost be different is on decision-making. For marginal cost, it is used for future decision making for it is possible to determine the marginal cost that can be incurred in case one wish to produce an additional unit given that resources being used are limited.

For absorption cost, it is not useful in decision-making for it entails sunk cost or historical cost which is already incurred or paid for.

 

Example

The following production data was extracted from the books of Walter co ltd

                                                                        Amt.$

Raw materials                                                 12,000

Direct expenses                                                8,000

Direct labor                                                       7,000

Fixed cost                                                         60,000

Required;

Determine the total cost necessary for decision making assuming that the monthly production in units associated to the aforementioned costs was 10,000 units of product “W”

 

Solution

In this case, fixed cost is excluded for it is termed as an irrelevant cost for decision-making. You see, decision making is a futuristic activity and it cannot rely on historical views as represented by fixed costs.