Absorption Costing - Overview

1. Overview of Absorption costing and Variable Costing
2. Review how costs for Manufacturing are transferred to the product
3. Job Order Vs. Process Costing
4. Overhead Application
- Under applied Overhead
- Over applied overhead
5. Problems with Absorption Costing
6. Concluding Comments

Absorption Costing

The focus of this class is on how to allocate manufacturing costs to the product. - Direct Materials

- Direct Labor

- Overhead

Absorption costing is a process of tracing the variable costs of production and the fixed costs of production to the product.
Variable Costing traces only the variable costs of production to the product and the fixed costs of production are treated as period expenses. Absorption Costing

There are three different types of Absorption Costing Systems:
- Job Order Costing
- Process Costing
- ABC Costing
In Job Order Costing costs are assigned to the product in Batches or lots.
- Printing
- Furniture manufacturing
- Bicycle Manufacturing
In Process Costing, costs are systematically assigned to the product, since there are no discreet batches to assign costs.
- Oil Distilling
- Soda Manufacturing
ABC Costing assigns cost from cost centers to the product
- Best in a multi product firm, where there are different volumes

Absorption Costing

A simplified view of Production:

Introduce Raw
Materials

1.
2.

Direct materials are purchased
Direct materials are placed into production Manufacture
Product

1. Direct labor applied to product 2. Overhead costs are incurred

Store finished goods 1. Production process completed 2. Goods are shipped for sale

Sell Finished
Goods

Absorption Costing

How do we account for the production process?
1. Direct materials are purchased and recorded as an asset.
2. As direct materials are placed into production, their cost is transferred from the raw materials account to the Workin-Process account (an asset)
3. As direct labor costs are incurred they are recorded in a labor expense account. Throughout the year they are transferred from the labor expense account to Work-inprocess account (an asset).

Absorption Costing

4. Overhead costs are initially accumulated in expense accounts (electricity, depreciation, etc..). Throughout the year they are transferred to Work-in-process.
5. When goods are completed, their costs (direct materials, direct labor and overhead) are transferred out of Work-inprocess, and into Finished Goods.
6. When foods are sold, their costs are transferred out of finished goods inventory (an asset) and into Cost of goods sold (an expense).

Absorption Costing

Important points to take away from how we account for manufacturing costs:
1. Initial expenditures on raw materials, direct labor, and overhead are
CAPITALIZED (recorded as assets) in Work in process and finished goods inventory. 2. They are transferred to expense accounts when the finished goods are sold
(they go to cost of goods sold).
3. Generally the cost of goods manufactured, (the costs incurred in manufacturing the product) will not equal the cost of goods sold.
- This means that in any year some of the costs associated with manufacturing the product will not flow through the income statement as an expense, they will remain in the inventory accounts as assets!

Absorption Costing

Consider the following example:
A company is formed to manufacture computers. It starts the year with $2000 in cash and equity. During the year the company incurs $500 in payroll costs, $500 in rent for the plant, and $500 in raw materials. During the year he makes 100 computers.
What will his profits (or loss) be if he sells no computers?
What will his profits be if he sells all 100 computers at $20 per computer?

Job Order Costing

Job Order Costing is one method of allocating the costs of manufacturing to the product.
In Job order