The absorbed cost is also called the absorption cost, it is a method in management accounting that takes into account the general costs of producing a product (variable and fixed). Knowing the total cost of manufacturing the device, the manufacturer can price his products.
Absorbed Costs and unabsorbed cost
The importance of this classification in the income determination process emanates from the fact that variable production cost is not the only true cost. Product costs should include some proportion of fixed costs. This can be understood by an example. Let us assume that the management decides that product manufactured on an operator-controlled machine be henceforth manufactured on an automated process involving high-cost machinery. Assume further, that as a result of the change in the production process, there will be no variation in material costs or variable manufacturing costs per unit. There will be a change indirect labor cost which henceforth will become part of the fixed cost associated with the machine. According to the definitions of product costs ( as per variable costing), the cost of production will be reduced by the direct labor cost, simply because of a change in the method of manufacture. Certainly, this is not a logical viewpoint. Therefore, the argument that the benefits of fixed costs lapse with the passage of time and, hence, must be absorbed by the revenues of that period only to which they relate ignores the point that facilities represented by those cost are value-creating.
From the above, it follows that fixed cost add value to the product and this value is a well-taken account of in determining the selling price. Therefore, such costs must be absorber by revenues of the period in which the products have been sold and not necessarily in the year in which they have been incurred, This fact that good is held as inventories so that can be sold in future further reinforces that above contention. Therefore, fixed costs are relevant and inventoriable. This argument is in line with another cost concept, namely, expired and unexpired cost
- In marginal costing, closing inventories are valued at marginal (variable) production cost whereas, in absorption costing, inventories are valued at their full production cost which includes absorbed fixed production overhead,
- If the opening and closing inventory levels differ, the profit reported for the accounting period under the two methods of cost accumulation will, therefore, be different
- But in the long run, total profit for a company will be the same whichever is used because, in the long run, total costs will be the same either method of accounting. Different accounting conventions merely affect the profit of individual periods
Fully Absorbed Cost vs. Variable Cost (Direct Cost)
Fully absorber cost refers to costs where fixed costs have been allocated to units or departments as required by generally accepted accounting principles. Variable costs, in contrast, may be more relevant for making decisions, such as setting prices.
Fully Absorbed Cost vs. Full Cost
In full costing, all costs, manufacturing cost as well as central corporate expenses (including financing expenses), ale allocated to products or decisions, In full absorption costing, only manufacturing costs are allocated to products. Only in full costing will revenues, expenses, and income summed over all products or divisions equal corporate revenues, expenses, and income.
Examples of Absorbed costs
- Direct Materials: Materials that are included in a product, such as fabric, metal, plastic, or wood, are direct materials. These materials are absorbed into the cost of producing the product.
- Direct Labor: The labor costs associated with producing a product, such as wages and benefits paid to employees, are also absorbed into the cost of producing the product.
- Overhead: Overhead costs are costs associated with running the business, such as rent, utilities, insurance, and other general costs, which also need to be absorbed into the cost of the product.
- Manufacturing Costs: Any costs associated with the manufacturing process, such as machinery, equipment, and supplies, are also absorbed into the cost of producing the product.
- Distribution Costs: Distribution costs, such as the cost of shipping and packaging the product, must also be absorbed in the cost of the product.
Advantages of Absorbed costs
The advantages of absorbed costs include:
- Accurate pricing: This method allows for an accurate assessment of the cost of producing a product, allowing for more accurate pricing decisions.
- Improved accountability: Absorbed costs are also useful for tracking expenses and ensuring that all costs related to the production of a product are accounted for.
- Better visibility: By taking into account all costs associated with a product, absorbed costs can help to improve visibility on the overall cost of production.
- Enhanced efficiency: By accurately tracking all costs related to the production of a product, absorbed costs can help to improve efficiency in production and reduce waste.
Limitations of Absorbed costs
Absorbed costs are a useful tool for understanding the full cost of producing a product, but they also have some limitations. These include:
- They cannot take into account the changing costs of materials, labor, and other inputs. As these costs fluctuate, the cost of production can also change, and this will not be reflected in the absorbed cost.
- Absorbed costs do not account for market forces or customer demand, which can affect pricing.
- They do not take into account the cost of marketing, transportation, distribution, or other external factors that can influence pricing.
- Absorbed costs do not consider the cost of quality control measures and other initiatives that can affect the overall cost of production.
- Absorbed costs can be difficult to calculate accurately, as they require a thorough understanding of the cost of producing a product and its components.
Absorbed cost is an important concept in management accounting that takes into account the total cost of producing a product. There are various approaches related to absorbed costs, including:
- Full absorption costing: This approach considers all of the direct and indirect costs of production when calculating the cost of the product.
- Variable absorption costing: This approach only considers the direct costs of production when calculating the cost of the product.
- Activity-based costing: This approach takes into account the cost of activities related to the production of a product, such as design, development, and marketing.
- Target costing: This approach aims to reduce the cost of production by setting a target cost for each product.
In summary, absorbed cost is an important concept in management accounting, and there are various approaches related to it, such as full absorption costing, variable absorption costing, activity-based costing, and target costing.
- BPP Learning Media (2011), ACCA F5 - Performance Mgt - Study Text 2013, BPP Learning Media, London
- Francis J (ed.)(2013),Financial accounting: an introduction to concepts, methods and uses, Cengage Learning, US
- Khan M. (ed.)(2010),Management Acc, 5E, Tata McGraw-Hill Education, Delhi
Author: Sylwia Szrajber