ACCT 301 Lecture Notes - Total Absorption Costing, Gestapo, Current Asset
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Overheads and Absorption Costing
In accounting, there are various methods in dealing with direct and indirect costs,
some of which have been explained in previous articles, such as direct/indirect
materials and labor costs. The following series of articles aim to define and explain
the different methods of dealing with overheads.
Overheads are by nature, indirect costs. They are defined as a cost incurred in making
a product or a service, but cannot be traced directly and in full to the product or
Overheads may be classified as manufacturing or non-manufacturing overheads for
the purpose of this article.
Manufacturing overheads being those costs related to the product or service as defined
above, and non-manufacturing overheads are those that cannot be directly allocated to
particular units of output.
In absorption costing, overheads will be added to each unit of output of products
manufactured and sold. It is a method for sharing overheads between different
products on a fair basis.
In other words, it says, look at all those manufacturing overheads incurred, and let’s
add them to the cost of sales!
SSAP 9 recommends this method because cost of all stocks should consist of all costs
incurred in the normal course of business in bringing the product to its ‘present
location and condition.’ Overhead costs are incurred to produce the finished
product(s) including administration and directors’ wages, without them the products
wouldn’t exist! Therefore it is justifiable to charge each unit of output with some of
the overhead costs.
There are also various practical reasons for using absorption costing:
1. Stock Valuations – Closing and Opening Stock would consist of manufacturing
overheads, as such, increasing the value of gross profit, by carrying forward the cost in
the balance sheet as a current asset, rather than writing it off as an expense in the
profit and loss account.
2. Pricing Decisions – If you were to provide a service or a product for a customer, you
would like to know the full cost to be incurred, including no manufacturing costs as
well. This will enable you to determine how much of this cost should be bared by the
3. Profitability of different products – Since overheads are shared on a fair basis and
charged to the cost of sales of each product/department/service, one could ascertain
the profitability of each product/department/service.
The Process of Absorption Costing
Simply, there are three stages:
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