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Absorption Costing

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A system of accounting for costs in which both fixed and variable production costs are considered product costs.


Absorption Costing — A method of sharing out overheads incurred amongst units produced.


— Theoretical reasons

—  Practical reasons

–  inventory valuation

–  pricing decision

–  establishing the profitability of different products

—   IAS 2

  1. Absorption costing stages

There are 3 stages when we using absorption costing method for charging production overheads.

   (1) Allocating overhead costs to cost centers directly

   (2) Apportioning common costs to cost centers on a fair basis.

   (3) Absorbing production cost center costs into units of output using an absorption rate.


The process of charging each item of cost directly to a cost center or cost unit.

Direct costs    à    cost units

Overheads     à    cost centers

(2) Apportion

Stage 1: Apportionment of general cost to cost centers using a fair basis of apportionment.

Stage 2: Reapportionment of service department costs to production department

(3) Absorption

The final stage in absorption costing is the absorption into product costs (using overhead absorption rates (OARs)) of the overheads which have been allocated and apportioned to the production cost centers.

  1. Over and under absorption of overheads

Over absorption means that the overheads charged to the cost of  sales are greater than the overheads actually incurred.

Under absorption means that insufficient overheads have been included in the cost of sales.

Reasons of over-/under- absorbed overhead:

— Actual overhead expenditures are different from budgeted overheads.

— Actual volume of activity is different from the budgeted activity level.

— Both


Over-absorbed à addition to profits (expense reduction)

Under-absorbed à charge against profits


  1. Evaluation of Absorption Costing

Fixed production overhead is
treated the same as the other product
costs, direct material and direct labor.

Consistent with long-run
pricing decisions that must
cover full cost.

External reporting
and income tax law
require absorption costing.


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