ABSORPTION COSTING AND MARGINAL COSTING
1 ABSORPTION COSTING IN OUTLINE
• In absorption costing, the cost of a product or service is established by adding a share of fixed production overheads to direct costs. It is consistent with the requirements for stock valuation in financial reporting. It is usual to absorb production overheads only into product costs. Other overheads are written off as an expense when they arise.
• Production overhead costs are first allocated, then apportioned and finally absorbed into production costs (or service costs).
– Overhead allocation. Indirect production costs are allocated to cost centres or codes. Allocation is the process of charging a cost directly to the source of the expenditure.
– Overhead apportionment. The overhead costs that have been allocated to cost centres and codes other than direct production departments are then apportioned to direct production departments. Apportionment is the process of sharing on a fair basis.
– Overhead absorption. An absorption rate is calculated for each production department as follows:
Total overhead costs (allocated and apportioned)
• Where the department produces a single product, production volume can be measured as the number of units produced, and the absorption rate would be a rate per unit produced.
• Where organisations produce different products or carry out non-standard jobs for customers production volume may then be measured as one of the following:
– direct labour hours worked – the absorption rate is a rate per direct labour hour worked
– machine hours worked – the absorption rate is a rate per machine hour operated
– the cost of direct labour – the absorption rate is a percentage of direct labour cost.
• It is possible to calculate absorption rates using actual overhead costs and actual production volume but the normal practice is to absorb based on budgeted overhead expenditure and budgeted production volume.
• An... [continues]
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