Absorption Costing

Introduction

There are two main methods of attributing overheads to products or services, one is by way of establishing average overhead recovery rates (traditional), and one uses a technique called Activity Based Costing (ABC).

The ‘traditional’ way of attributing overheads to products began in the manufacturing industry when most manufacturing businesses had a small and narrow range of products, less reliant on automation, and direct material and labour costs formed a higher proportion of total product costs, support services and attendant overheads being not as significant.

Due to the lack of sophistication of the traditional method of attributing overheads, the growth of marginal costing occurred which diminished the focus on overheads and focused on cost objects as you can see below:

Absorption Costing

Assigning Costs 

When overheads are allocated to cost units it requires an allocation base or cost driver, these can be cause and effect allocations or arbitrary.  The aim is to reflect the burden the product places on the overhead, traditional cost systems often use direct labour hours or machine hours.

The cost allotment – sharing/allotment of indirect cost to cost units procedure can be summarised as:

  1. Collecting production overhead costs by item.
  2. Establishing cost centres.
  3. Allocating and apportion overhead costs to cost centres.
  4. Apportioning service cost centres to production cost centres.
  5. Absorbing production cost centre costs into cost units by using a suitable recovery rate.