Overheads Absorption3 min read

There are several ways to absorb overheads, including:

  1. Absorption costing: This method involves allocating the cost of overhead expenses to the products or services that are produced. This is done by dividing the overhead costs by the number of units produced and then adding the overhead cost per unit to the direct cost of each product.
  2. Activity-based costing: This method involves assigning overhead costs to specific activities or processes within an organization, rather than simply allocating them to products or services. This allows for a more accurate allocation of overhead costs and can help identify areas where costs can be reduced.
  3. Lean manufacturing: This method focuses on reducing waste and increasing efficiency within an organization. By streamlining processes and eliminating unnecessary activities, overhead costs can be reduced.
  4. Outsourcing: Another way to absorb overheads is to outsource certain activities or processes to external providers. This can help to reduce the overall cost of overhead expenses by allowing the organization to focus on its core competencies.
  5. Cost-cutting measures: Finally, organizations can also absorb overheads by implementing cost-cutting measures, such as reducing staff levels, negotiating better deals with suppliers, or reducing energy costs. These measures can help to reduce the overall amount of overhead expenses that an organization incurs.

Absorption costing

Absorption costing is one method of accounting wherein all the manufacturing costs are assigned to the products. This, apart from direct costs like direct material and direct labor includes a share of indirect costs and factory overheads. It reflects that each product has been charged fully with the cost incurred for it, which is particularly helpful for inventory valuation in financial reporting since it gives confirmation to Generally Accepted Accounting Principles- GAAP.

Example of Absorption Costing

Suppose that the company produces 1,000 units of a product whose costs are as follows:

  1. Direct Material: AED 36,730
  2. Direct Labour: AED 18,365
  3. Variable Manufacturing Overhead: AED 7,346
  4. Fixed Manufacturing Overhead: AED 29,384

Under absorption costing, the products will absorb both variable and fixed manufacturing costs.

  • Total Manufacturing Costs:
  • Direct Materials: AED 36,730
  • Direct Labor: AED 18,365
  • Variable Overheads: 7,346 AED
  • Fixed Overheads: 29,384 AED
  • Total Cost: 91,825 AED
  • Cost per Unit
    AED 91,825 / 1,000 units = AED 91.83 per unit

Under absorption costing each unit made will be added to inventory at AED 91.83 per unit. When these units are sold, the unit cost of goods sold of AED 91.83 will be transferred from inventory to COGS on the income statement.

This way, absorption costing represents the cost of each product more completely. On the other hand, it may lead to higher expenses if not all inventory is sold in the same period since that affects profit calculations.

Activity-based costing

ABC is thus one form of accounting whereby overhead costs and indirect costs get assigned to products or services based on the various activities associated with their production. In contrast with other costing methods whereby costs are based, perhaps, on a single measure, such as labor hours or machine hours, ABC identifies multiple cost drivers, in terms of the number of setups, inspections, or material orders, by which costs can be more accurately assigned.

ABC is particularly applicable to organizations operating in a multi-product environment where different products use various amounts of the organization’s activities and, accordingly, where overhead costs are not assigned accurately using traditional costing methods. The foundation of assigning costs to activities and then from activities to products allows a business to make inferences about product profitability and a source of inefficiency.

Read Also

Marginal Costing

Standard Costing

Overheads absorption costing
Overheads Absorption 2

Refer Materials

https://resource.cdn.icai.org/66529bos53753-cp4.pdf