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Lecture

Absorption.docx

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Department
Accounting
Course
ACCT 301
Professor
All Professors
Semester
Fall

Description
Absorption 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 In the previous example we assumed that a separate absorption rate is used for each product, and this could be similarly applied to other cost centers and cost units. However, the predetermined absorption rate may not always be distinguishable for each product. Sometimes, a blanket absorption rate is used, in which a single absorption rate is used throughout a factory and for all job units of output irrespective of the department in which they were produced. The result of using a blanket absorption rate may drastically affect the costing of products and units or services manufactured or offered to customers. This can be illustrated by slightly modifying the previous example: Previously we said that the overhead absorption rate of A is $1 per unit, and $2.5 per unit of B. These are separate valuation
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