ABSORPTION COSTING OR FULL COSTING. Samir K Mahajan

ABSORPTION COSTING OR FULL COSTING Samir K Mahajan

ABSORPTION COSTING/FULL COST METHOD Absorption costing or full cost method is the traditional method of costing by which all direct and applicable overheads are charged to product or cost centre. According to this method, all costs (fixed and variable cost) are identified with or absorbed into manufactured product. Here, direct cost and manufacturing overheads (variable and fixed) are treated as product cost. Selling and administrative cost are part of part of period cost. Absorption cost remain in inventory as an asset until such time as the inventory is sold. They are charged to cost of goods sold. Consequently the cost of goods in inventory or cost of goods sold under this method contain variable costs and fixed overhead cost.

ABSORPTION COSTING/FULL COST METHOD

Example 1: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows A B C Direct Material per unit Rs 3 Rs 4 Rs 5 Direct labour per unit Rs 2 Rs 3 Rs 3 Selling price per unit Rs 10 Rs 15 Rs 20 Output 1000 units 1000 units 1000 units The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided to apportion these costs over different products in the ratio of output. Prepare a statement showing the cost and profit of each product according to absorption cost.

Example 1: solution Statement showing profit and cost (Absorption Costing ) Traditional Income Statement A B C Per unit Rs Total Rs Per unit Rs Total Rs Per unit Rs Total Rs Direct material Direct labour 3 2 2000 4 3 4000 5 4 5000 4000 Overheads: Fixed Variable 3 1 1000 3 1 1000 3 1 1000 Total Cost Profit Selling price 9 1 9000 1000 11 4 11000 4000 13 7 1 7000 10 10000 15 15000 20 20000

Example 1: solution contd Total profit under absorption costing is Total Profit Rs. Product A 1000 Product B 4000 Product C 7000 12000

ADVANTAGES OF ABSORPTION COSTING SYSTEM 1. Absorption costing recognizes fixed costs in product cost. As it is suitable for determining price of the product. The pricing based on absorption costing ensures that all costs are covered. 2. Absorption costing avoids the separating of costs into fixed and variable elements. 3. Absorption costing has been recognized for the purpose of preparing external reports and for stock valuation purposes. 4. The allocation and apportionment of fixed factory overheads to cost centres makes manager more aware and responsible for the cost and services provided to others. 5. Absorption costing will show correct profit calculation than variable costing in a situation where production is done to have sales in future ( e.g. seasonal production and seasonal sales).

DISADVANTAGES OF ABSORPTION COSTING SYSTEM 1. Absorption costing is not useful for decision making. It consider fixed manufacturing overhead as product cost which increase the cost of output. As a result, it does not help in accepting specially offered price for the product. Various types of managerial problems relating to decision making can be solved only with the help of variable costing system( Discussed in Example 2). 2. The technique of absorption cost may lead to rejection of profitable business. A total unit cost will tend to be regarded as the lowest possible selling price. An order at a price which is less than total unit cost may be refused, though the order may be actually profitable ( Discussed in Example 3) 3. Absorption costing is not helpful in control of cost and planning and control functions. It is not useful in fixing the responsibility for incurrence of costs. It is not practical to hold a manager accountable for costs over which he/she has not control.

Example 2: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows A B C Direct Material per unit Rs 3 Rs 4 Rs 5 Direct labour per unit Rs 2 Rs 3 Rs 3 Selling price per unit Rs 10 Rs 15 Rs 20 Output 1000 units 1000 units 1000 units The total overhead costs are Rs.12000 out of which Rs. 9000 are fixed and the rests are variable. It is decided to apportion these costs over different products in the ratio of output. Prepare a statement showing the cost and profit of each product according to absorption cost. Calculate amount of profit and and loss made by Tripura Ltd in the first two years of its existence, presuming that i. In the first year, it manufactures 1000 units of each product A, B, C but fails to effect any sales. ii. In the second year, it does not produce anything but sells the entire stock carried forward from the first year. iii. What fallacious conclusions can be drawn from the results.

Solution : Example2 Tripura Limited Profit and loss Account of 1 st Year Dr Rs Cr Rs Direct material A B C 4000 5000 12000 Sales Closing Stock ----- 3 Direct labour A B C Overhead: variables A 1000 B 1000 C 1000 Fixed ----- 2000 4000 9000 9000 _12000 3 3_

Solution : Example 2 contd. Tripura Limited Profit and loss Account of 2 nd Year Dr Rs Cr Rs Opening Stock Fixed overhead Profit 3 9000 45000 Sales A B C 10000 15000 20000_ 45000 45000_

Solution : Example 2 contd. The above Profit and Loss accounts shows that in the first year there is no loss in spite of the fact that the company did not make any sales. While in the second year, it makes a profit of Rs.. As a matter of fact, the company losses Rs.9000 on account of nonrecovery of fixed cost in the first year. The profit and loss account does not show any loss because these fixed costs have been included in the closing inventory values and thus carried forward to the next year. As a result, the profit and loss account for the second year has to bear Rs.18000 on account of fixed cost. (i.e. Rs.9000 for the first year + Rs.9000 for the second year). The real profit in the second year should be have been Rs. 12000 and not Rs.. Thus, the technique of absorption may lead to rather odd results particularly for seasonal business in which stock levels fluctuate widely form one period to another. Their profits for the two periods will be influenced by the transfer of overheads in and out of stock showing falling profits when the sales are high and increasing profit when sales are low.

Example 3: Your are the MD of Usha Automobiles Ltd. which has received a special offer for the supply of 200 components at Rs 60 a piece from a motorbike manufacturer. The company has a capacity to produce 1000 components but at present it is utilising 80 percent of its capacity. The present selling price per component is Rs. 100. The cost details of the company are as follows: Variable cost per unit Rs 40 Fixed overhead cost per unit Rs 30 (total fixed overheads Rs 24000) Total cost per unit Rs 70 Your cost accountant advises you to reject the order since the company will be getting less profit than the total cost of the component. How would you react?

Solution : Example 3: Sales Total Sales in units 800 200 1000 Sales in Rs. 80000 12000 92000 (800x100) (200x60) Total Cost: Variable ( Rs 40 per unit) 32000 8000 40000 Fixed cost (Rs) 24000 ---- 24000 56000 8000 64000 Profit (Rs.) 24000 4000 28000 The advice of the Cost Accountant is not correct. Since he has based his decision on absorption costing, he is advising against accepting the special offer. Thus if the order is accepted the profit will increase from Rs. 24000 to Rs.28000. it is therefore advisable to accept the offer rather than reject.