Posts tagged "total-absorption-costing"

Total Absorption Costing Compared

SEMI-VARIABLE COSTS: as the name implies, semi-variable costs are those costs that are mixed in nature. That is, both elements of fixed and variable costs can be consulted in them. Some techniques like; high-low method, regression analysis, algebraic method, etc can be used in order to separate costs in their various degrees.

FIXED COSTS: fixed costs are those costs that cannot be changed within a range. This is to point out that fixed cost rarely exist in the long run as all costs behaves like variable or at least stepped cost in the long-run.

The assumption is theory is that these expenses are easy to estimate thereby making it an easy task to measure costs.

Talking About Total Absorption Costing..

Note that when there are several product in a production process, it would not be appropriate to use overhead absorption rate per unit. Rather, overhead absorption rate for labour should be determined and then charge each participating unit for fixed overheads according to the number of labour needed for each unit. Fixed overhead absorption costing method is employed to enable the administration of a company determine the total costs of production and subsequently fix the sale price of a product.

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The next absorption cost system method is process costing which is utilized when a manufacturing company makes a large amount of identical products. Each of these units uses the same number of direct labor, direct materials, and overhead costs. Unlike job order costing though. These averages costs across jobs, process costing assigns costs to the product through each process that the product goes through.

Total Absorption Costing???

Finally, activity-based costing (ABC) assigns costs from cost centers to the product. In addition to manufacture, this method is often employed in insurance, marketing departments of companies, and nonprofit organizations. ABC is best utilized in a multi-product firm that has different volumes of products.

Fixed costs are important to production. One of the main advantages of an absorption cost system is that acknowledges the importance of fixed costs by allocating them to cost units produced. Another benefit is that when production remains constant but sales are altered, an absorption cost system will show less fluctuation in net profit. There are some major criticisms of absorption cost systems despite these advantages.

One criticism is that absorption cost systems give rise to an incentive to overproduce. Because fixed costs remain the same irrespective of units produced, the overhead rate is lower when more units are produced. In addition, managers compensated on total profits calculated using absorption cost systems can boost reported profits by increasing production assuming sales are held constant. A variable cost system can reduce the incentive to overproduce by writing off all fixed manufacturing costs as period costs. But variable cost systems aren’t generally observed in practice, mainly as a result of the fact that their total costs generally exceed their total benefits.

Another major criticism of absorption cost systems is that they result in inaccurate product costs due to how the system traditionally allocates costs. Many costs in a plant are driven not so much by the number of units produced only by the number of proceedings such as purchase orders or shipments. Allocating these transaction-based costs using unit volume causes products with greater production volumes to be allotted too large a part of these costs. Having inaccurate product costs means that overhead costs cannot be allocated to the activities causing the costs. Instead, these costs are being combined with other cost pools and these overly aggregated cost pools are then being allocated to products using allocation bases that don’t capture the cause-and-effect relationship driving the particular costs in the overly aggregated cost pool. Activity-based costing, as mentioned above, is one modification that can be taken to traditional absorption based cost systems. ABC recognizes that overhead costs vary not only with volume but also with the order of items manufactured.

So while absorption cost systems are widely used in the manufacturing sector, they come with a range of advantages and disadvantages just like any cost system. The type of industry the company is in and what goods will be produced will determine which cost system will be more conducive to keeping costs low.

Activity based costingis another cost measurement technique that is likely to provide a more reliable account of costs that ate driven by the number of activities that occur in a particular department. Costs in this sense are defined by making reference to the number of cost drivers and do not necessarily reflect the number of hours spent on a draft or department.

The scope of the present article, wouldn’t permit me to demonstrate all that I have said with a numerical example or two but, I encourage you to keep tabs on this blog as there are more to come. In the meantime, keep reading and enjoying other posts in this hub.