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Absorption Cost

Absorption costing is an accounting method that captures all costs associated with manufacturing a product, including direct costs and fixed overhead charges. Semi-variable costs have both fixed and variable components. Step fixed costs remain constant within thresholds but change when thresholds are breached. Sunk costs cannot be recovered, while irrelevant costs do not affect decisions.

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30 views2 pages

Absorption Cost

Absorption costing is an accounting method that captures all costs associated with manufacturing a product, including direct costs and fixed overhead charges. Semi-variable costs have both fixed and variable components. Step fixed costs remain constant within thresholds but change when thresholds are breached. Sunk costs cannot be recovered, while irrelevant costs do not affect decisions.

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Xtreme Fun
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as TXT, PDF, TXT or read online on Scribd
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:::: Absorption cost::::

Absorption costing, sometimes called “full costing,” is a managerial accounting


method for capturing all costs associated with manufacturing a particular product.
The direct and indirect costs, such as direct materials, direct labor, rent, and
insurance, are accounted for by using this method.
Absorption costing includes anything that is a direct cost in producing a good in
its cost base. Absorption costing also includes fixed overhead charges as part of
the product costs.

Example of Absorption cost::


A company produced 60,000 units in the accounting period. It sold 50,000 units
with 10,000 still in inventory. It sold each unit for $100.
Each unit costs $25 in direct materials and $20 in direct labor. Manufacturing
overhead was $10 plus $5 in variable administrative costs. Fixed manufacturing
overhead was $300,000. Fixed administrative costs were $200,000.
The company applied the absorption cost per unit formula:
(Direct Material Costs + Direct Labor Costs + Variable Manufacturing Overhead Costs
+ Fixed Manufacturing Overhead Costs) / Number of units produced. ($25+$20+$10+
$300,000 / $600,000 = $60 per unit product cost.)
The inventory (10,000 units) left in the company’s warehouse is then valued at
$600,000 in absorptive costing.

::::Semi- Variable Cost::::


A semi-variable cost, also known as a semi-fixed cost or a mixed cost, is a cost
composed of a mixture of both fixed and variable components. Costs are fixed for a
set level of production or consumption, and become variable after this production
level is exceeded. If no production occurs, a fixed cost is often still incurred.
The fixed portion of a semi-variable cost is incurred no matter the activity
volume, while the variable portion occurs as a function of the activity volume.
Management may analyze different activity levels by manipulating the activity level
to change the variable costs. A semi-variable cost with lower fixed costs is
favorable for a business because the break-even point is lower.

Examples of Semi-Variable cost

Examples of semi-variable costs include:


(1)Repairs
(2)Monthly telephone charges
(3)Indirect materials
(4)Indirect labor
(5)Fuel
(6)Power
A business experiences semi-variable costs in relation to the operation of fleet
vehicles. Certain costs, such as monthly vehicle loan payments, insurance,
depreciation, and licensing are fixed and independent of usage. Other expenses,
including gasoline and oil, are related to the use of the vehicle and reflect the
variable portion of the cost.

::::Step fixed cost::::


A step fixed cost is a cost that does not change within certain high and low
thresholds of activity, but which will change when these thresholds are breached.
When the cost changes as a result of a threshold breach, a new set of high and low
activity thresholds will then apply, within which the fixed cost will not change
appreciably.Threshold breach can lead to:
(1)Activity increases
Management has the choice of either accepting no additional activity and not
incurring an additional step fixed cost, or of accepting the increase in activity
and incurring the additional cost.
(2)Activity decrease
Management has the option of terminating or reducing the associated step fixed
cost.

Examples of Step fixed cost::


The following are all examples of step fixed costs:
(1)The cost of starting up a new production shift, which includes utilities and the
salaries of shift supervisors.
(2)The cost of a new production facility, which includes depreciation on the
equipment and the salaries of the production line supervisors.s
(3)The cost of rolling out an entirely new sales region, which may include the cost
of a warehouse distribution system.

::::Sunk and irrelevant costs::::


A sunk cost refers to money that has already been spent and cannot be recovered. In
business, the axiom that one has to "spend money to make money" is reflected in the
phenomenon of the sunk cost.
Irrelevant costs are costs, either positive or negative, that would not be affected
by a management decision. Irrelevant costs, such as fixed overhead and sunk costs,
are therefore ignored when that decision is made.

:::Sub heading:::Examples of sunk cost:::


If a sunk cost can be eliminated at some point, it becomes a relevant cost and
should be a part of business decisions about future events.

:::Sub heading:::Examples of irrelevant costs:::


(1)Sunk costs: Expenditures which have already been incurred
(2)Committed costs: Future costs which cannot be altered
(3)Non-cash expenses: Depreciation and amortization
(4)Overheads: General and administrative overheads

::::Production Cost::::
Product cost refers to the costs incurred to create a product. These costs include
direct labor, direct materials, consumable production supplies, and factory
overhead. Product cost can also be considered the cost of the labor required to
deliver a service to a customer.

Example of Production Cost


For example, manufacturers have production costs related to the raw materials and
labor needed to create the product. Service industries incur production costs
related to the labor required to implement the service and any costs of materials
involved in delivering the service.
Examples of product costs are direct materials, direct labor, and allocated factory
overhead.

Another examples if of a manufacturer of pencils. Its product costs may include:


(1)Direct material: The cost of wood used to create the tables.
(2)Direct labor: The cost of wages and benefits for the carpenters to create the
pencils.
(3)Manufacturing overhead (indirect material): The cost of metal used to hold the
rubber together.
(4)Manufacturing overhead (indirect labor): The cost of wages and benefits for the
security guards to overlook the manufacturing facility
(5)Manufacturing overhead (other): The cost of factory utilities.

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