Absorption Costing

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Absorption Costing
Absorption costing is a method of costing that assigns a small percentage of production and overheads costs to the price of each product that is going to be sold. It accounts for all costs, direct and indirect, fixed and variable. For example; if 1000 products are made and the total costs are £10000 then each product would cost £10 before making a profit (10000/1000=10). Variable costs are costs that can be controlled by management or a sales worker. Whereas fixed costs are controllable but very rarely controlled. The reasoning for including overheads in the prices of the products is because of the idea that all overheads and costs must be made up before a profit is made rather than a profit just on the production costs. This is beneficial to a business because it enables them to clearly outline sales needed to make a profit, and to also analyse stock value. Breakdown of absorption costs included:

Production costs
Product materials
Overhead costs
Administrative costs
Selling and distribution costs
Direct Materials + Direct Labour + Direct Expenses = Prime Cost Prime Cost + Factory Overheads = Production Cost
Production Cost + Selling and Distribution Costs + Administrative Costs + Finance Costs = Total Cost

Different absorption rates
A percentage of direct materials cost;
A percentage of direct labour cost;
A percentage of prime cost;
A rate per machine hour;
A rate per unit;
A percentage of factory cost (administration overhead)
A percentage of sales or factory cost (for selling and distribution)

Choosing the right absorption rates
The choice of the absorption rate should be based upon what type of overhead costs are incurred by the organisation and if there is a link between the production volume. Variable overheads are usually chosen when an organisation has a variety of labour hours and machine hours. The percentage of materials cost is most commonly used in general stores