Absorption Costing

In absorption costing, all costs are absorbed into production and in this case, there is no distinction
between fixed and variable costs. The stock and work-in-progress contain both fixed and variable
elements. The absorption cost is composed of direct materials, direct wages, direct expenses and
overheads. The absorption costing technique is used mainly in the financial account statements and
cost account statements in some organizations.

The net profit shown in absorption costing statements and marginal cost differs due to the valuation of
stock. In absorption costing the closing stock is valued at total cost of production where as in
marginal costing, statements; it is valued at marginal cost only.
Features of Absorption Costing
1. All manufacturing costs whether fixed or variable are assigned to the products and therefore stocks
are valued at total cost of manufacturer.
2. Non-manufacturing overheads are not allocated to the products but are charged directly to profit
and loss account and therefore excluded from inventory valuation
Merits of Absorption Costing
1. Fixed costs are incurred within the production function and without those facilities, production
would not be possible. Consequently, such costs can be related to production and should be included.

2. Absorption costing follows the matching concept by carrying forward a product of the production
cost in the stock valuation to be matched against the value when the items are sold.

3. It is necessary to include fixed overheads in stock values for financial statements, routine cost
accounting. Using absorption costing procedures, stock values which include fixed overheads.

4. Overhead allotment is the only practicable way of obtaining job costs for estimating prices and
profit resources.

5. Analysis of over or under absorbed overheads is useful to identify inefficient underutilization of

production resources.

Demerits of Absorption Costing

1. The fixed costs do not change as a result of change in the level of activity. Therefore such costs
cannot be related to production and should not be included in stock valuation.

2. The inclusion of fixed costs in the stock valuation conflict with the prudence concept therefore
fixed costs should be written off in the period which they are incurred.
Format of Absorption Costing
 Shs. Shs.
Sales xxx
Less: Cost of Goods Sold
Direct Materials xxx
Direct Labour xxx
Variable Overheads xxx
Fixed Overheads xxx
xxx
Less: Closing Stock of Finished goods (W-I) xxx xxx
Gross Profit xxx
Less: Selling and Admin. Expenses
Sales Commission xxx
General Expenses xxx
Overheads (fixed) xxx xxx
Net Profit xxx

Example
XYZ company limited produces tubes for motor cycles. The following information was provided for
the year 2006.

Shs.
Production 20,000 tubes
Sales 15,000 tubes

Production cost shs

Direct Materials 2,400,000
Direct Labour 600,000
Variable Overheads 500,000
Fixed Overheads 900,000
Selling and Administration
Sales Commission 250,000
General Expenses 160,000
Overhead (Fixed) 240,000

The company sells each tube at a price of Shs. 300

Prepare profit and loss account on the basis of absorption costing.

Solution

Absorption Costing
Profit and Loss Account
For the year ending 31st December 2006
Units S.P (Shs) Value (Shs)
Sales 15,000 300 4,500,000

Less: Cost of goods sold (Shs)

Direct Materials 2,400,000
Direct Labour 600,000
Variable Overheads 500,000
Fixed Overheads 900,000
4,400,000
Less: Closing Stock of finished 1,100,000 3,300,000
Goods (W - I)
Gross Profit 1,200,000
Less: Selling and Admin. Expenses
Sales Commission 250,000
General expenses 160,000
Overheads (fixed) 240,000 650,000
Net Profit 550,000

Working
W-I
Production cost of 20,000 tubes = Shs. 4,400,000
Production cost of 5,000 tubes = 5,000 x 4,400,000
 20,000
= 1,100,000