The absorption cost method calculates the use of total direct costs and overhead costs associated with manufacturing the product as a cost basis. In addition, absorption costs are also governed by generally accepted accounting principles (GAAP).
How To Do Absorption Costing.
Absorption costing is a managerial accounting method that assigns all direct costs and indirect costs to the production cost of goods or services. It is used to determine the cost of production for inventory valuation, as well as for decision-making purposes. Here are the steps to perform absorption costing:
- Identify Direct Costs: Direct costs are the costs that can be easily traced to a specific product, such as raw materials, labor, and direct overhead. Direct costs are usually variable costs, meaning they change in direct proportion to the level of production.
- Determine Indirect Costs: Indirect costs, also known as overhead costs, are the costs that are not directly associated with a specific product or service. These costs include rent, utilities, maintenance, and depreciation. Indirect costs are usually fixed costs, meaning they do not change with the level of production.
- Calculate Overhead Rate: To assign indirect costs to products, you need to calculate an overhead rate. The overhead rate is determined by dividing the total indirect costs by the total direct costs. This will give you a percentage that you can use to allocate indirect costs to each unit of production.
- Allocate Overhead Costs: Using the overhead rate, you can now allocate indirect costs to each unit of production. Multiply the overhead rate by the direct costs of each unit to get the indirect cost per unit.
- Calculate Total Production Cost: To determine the total production cost per unit, add the direct costs and the indirect costs per unit.
- Determine Selling Price: Finally, you can use the total production cost per unit to determine the selling price. Add a markup or profit margin to the total production cost to arrive at the selling price.
By following these steps, you can perform absorption costing to determine the cost of production for inventory valuation and decision-making purposes.
Advantages and disadvantages of Absorption Costing
Advantages
The main Cost advantages include:
- Identify the importance of the fixed costs involved in production.
- The cost absorption method is accepted by the tax office as undervalued inventory.
- The absorption costing method is always used in preparing financial accounts.
- The Absorption Method does not show fluctuations in net income in case of constant production but fluctuates in sales.
- In contrast to marginal posting, which involves fixed costs turning into variable costs, this is a cost in the value of inventory that distorts the valuation of inventories.
Disadvantages
The main drawbacks of Absorption Costing include:
- Because absorption costs emphasize total costs where variable costs are fixed, they are not useful for management to make decisions, control, and planning.
- In addition, because managers emphasize total costs, the cost, volume and profit relationships are neglected. Managers, therefore, need to use intuition for decision making.
