In absorption costing all manufacturing costs are absorbed by the units produced. This is the costing where full cost of a cost unit is equal to the prime cost plus absorbed overhead cost. Cost of finished goods unit in inventory will include direct materials, direct labor, variable overhead, and fixed manufacturing overhead. Overhead are absorbed into product or service costs using a predetermined overhead absorption rate, usually set annually in the budget. In this costing over or under absorption of overhead arises because the absorption rate is based on estimates. This costing method is also referred to full costing or full absorption method.
Calculation of absorption cost
To calculate the full cost, it is necessary to determine its direct cost or prime cost firstly and, then add a fair share of indirect costs or overhead.
The full of absorption costing can be calculated in the following ways:
| Direct Materials Costs | xxx |
| Direct Labour Cost | xxx |
| Direct Expenses (if any) | xxx |
| Total Direct Costs (Prime Costs) | xxx |
| Share of Indirect Costs/Overhead | xxx |
| Full Costs (Absorption Costs) | xxxx |
Components of Absorption Costing
The main costs assigned to products under an absorption costing system are:
- Direct materials
- Direct labor
- Variable manufacturing overhead
- Fixed manufacturing overhead
Stages of determining absorption costing
There are three stages in determining the share of overhead to be attributed to a cost unit, such as-
- Overhead allocation
- Overhead apportionment
- Overhead absorption
A) Overhead allocation:
The first step of absorption costing is the allocation of overhead. Allocation is the process where cost directly charged to the cost center. A cost center may be one of the following types:
- Production department: Production overheads are charged
- Production service department: Production overheads are charged
- Administrative department: Administration overheads are charged
- Selling or distribution department: Sales and distribution overheads are charged
- Overhead cost center: Overhead costs are shared by a number of departments, such as rent and rates, heat and light and the canteen are charged.
B) Overhead apportionment:
The second step in absorption costing is an overhead apportionment. This involves apportioning general overheads to cost centers (first stage) and then reapportioning the cost of service cost centers to production department (Second Stage).
First Stage: apportioning general overheads:
Overhead costs should be shared out on a fair basis. The bases of apportionment for the most usual cases are given below:
| Overhead to which the basis applies | Basis |
| Rent, rates, heating and light, repairs and Depreciation of building | Floor Area occupied by each cost center |
| Depreciation, Insurance of equipment | Cost or Book value of the Equipment |
| Personnel office, canteen, welfare, wages, first aid | Number of employees or labor hours worked in each cost center |
Second Stage: Service cost center cost apportionment
The second stage of overhead apportionment concern the treatment of service cost centers. For example, a factory is divided into several production departments and also a number of service departments, but only the production departments are directly involved in the manufacture of the units.
Example of possible apportionment bases are as follows:
| Service Cost Center | Basses of Apportionment |
| Store | Number of Materials requisitio |
| Maintenance | Hours of Maintenance for each cost Centre |
| Production Planning | Direct Labour Hours worked in each production cost center |
Service cost center Bases of apportionment
C) Overhead absorption:
Overhead absorption is the indirect costs that is assigned to cost objects. Indirect costs are costs which is not directly linked to a product. On the other hand cost objects are items for which costs are compiled. Both GAAP and IFRS make it mandatory to include overhead costs in the recorded amount of inventory which is presented in company’s financial statements. Overhead absorption is not needed for internal management reporting, this is only for external financial reporting.
Examples of indirect costs are:
- Selling and marketing costs
- Administrative costs
- Production costs
Selling, marketing, and administrative costs are usually charged to expense in the period incurred. However, indirect production costs are classified as overhead and then charged to products through overhead absorption.