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ACCT 301 Lecture Notes - Total Absorption Costing

Course Code
ACCT 301

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after allocating and apportioning overheads to cost units or cost centers, we need to
add the costs calculated for each cost center to unit, job or batch costs. This is called
overhead absorption or overhead recovery. Therefore, the production overheads
calculated using absorption costing would be included in the following formula:
Direct Materials
Plus: Direct Labor
Plus: Direct Expenses
Plus: Overheads (based on recovery rate)
Equals: Actual Costs of Production
The previous formula is known as normal costing. The actual costs of production are
necessary to calculate the cost of sales, hence, the profits of the organization.
Opening Stock
Plus: Production Costs
Less: Closing Stock
Equals: Cost of Sales
yet, the final process of absorbing the overhead costs into unit and batch costs aren’t
based on actual costs incurred during the course of the business. Absorption costing
is based on a predetermined absorption rate, which is established from a budget for a
forthcoming period.
This could be illustrated using the following example. Suppose that a company makes
two products, A and B, each respectively taking 2 and 5 hours to make. If the total
estimated overheads are $50,000 and the estimated labor hours would be 100,000
hours, what would the absorption rate be?
Calculation Result
Absorption Rate 50/100 $0.5 per labor hour
Overhead absorbed per unit A 2 x 0.5 $1 per unit
Overhead absorbed per unit B 5 x 0.5 $2.50 per unit
The results obtained above mean that whatever the cost of producing one unit of A or
B is, the overhead absorbed per unit should be added to it. Suppose further that the
direct labor, materials and expenses are $12 per unit, and we produce 1000 units of
A and 2000 units of B during the year. We have no opening stock, and no closing
stock, we simply sold all the stock of A and B produced during the year for $30 per
unit. What would the Profit and loss account look like?
Calculation $000 $000
Sales 3000 x 30 90000
Cost of Sales
Opening Stock 0
Closing Stock 0
Production Costs: Direct Overheads 12 x 3000 36000
Overheads ‘A’ 1 x 1000 1000
Overheads ‘B’ 2.5 x 2000 5000 (42000)
Gross Profit 48,000
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