Absorbed costs

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Absorbed costs
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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[1].

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[2]

Marginal costing[3]:

  • 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[4].

References

Footnotes

  1. Khan M. (ed.)(2010)
  2. Khan M. (ed.)(2010),p.7.4
  3. BPP Learning Media (2011),p.11
  4. Francis J (ed.)(2013)

Author: Sylwia Szrajber