Absorption costing is a technique where the goods are valued considering full production cost of the product of the product. When pricing or valuing the stocks goods are values considering only the production cost of the product (I.e. goods are valued considering variable production costs and the fixed production costs. In other words goods are valued based on the full cost of the production.) Absorption cost of a product can be calculated as follows:
Absorption cost per unit = Variable production cost per unit + Overhead Absorption Rate (OAR) per Unit
Absorption cost per unit = (Direct material cost per unit + Direct labour cost per unit + Other variable costs per unit) + Overhead Absorption Rate (OAR) per Unit
Overhead Absorption Rate = Budgeted overheads / Budgeted Activity Level (Labour hours or production Units)
Note: OAR changes from period to another and when valuing the product OAR relevant for the period has to be taken into account.
Gross Profit calculation under marginal costing can be illustrated as follows:
|Sales Revenue (Selling Price X No of units sold)||XXXX|
|(-) Absorption Cost of goods sold|
|Opening stock (Opening stock in units X Absorption cost per unit)||XXX|
|(+) Production (Production level X Absorption cost per unit)||XXXX|
|(-) Closing stock (Closing stock in units X Absorption cost per unit)||(XXX)||(XXXX)|
|Gross Profit for the Period||XXXX|
Illustration of profit calculation will be provided in the article “Comparison of Profit Calculation Under Marginal Costing and Absorption Costing”.
When arriving at the net profit for the period non production costs such as selling and distribution costs and administration cost has to be deducted.
The fundamental of valuing the product based only on PRODUCTION COSTS has to be kept in mind. When calculating the absorption cost only production cost has to be taken into consideration regardless of fixed or variability of the cost. .