Absorption Costing (Copy)

Cost Centre: A department or function within a company that incurs costs (e.g., production or service departments).
Cost Unit: A unit of product or service to which costs are assigned (e.g., per unit of product, per machine hour).

Definition: The rate at which overhead costs are allocated to products or services, based on an appropriate activity base (e.g., machine hours, direct labor hours).

Formula:

Overhead Absorption Rate (OAR) = Total Overhead Costs / Activity Base

Example:
- Total Overhead: $50,000
- Activity Base (Machine Hours): 5,000 hours
- OAR:
```
OAR = 50,000 / 5,000 = 10 per machine hour
```

Allocation: Assigning overheads directly to a specific cost centre (e.g., rent for a specific department).
Apportionment: Dividing overhead costs between different cost centres based on factors like space usage or labor hours.
Common Bases for Apportionment:
- Floor area for rent.
- Number of employees for wages and utilities.
- Machine hours for equipment costs.

Under Absorption: Occurs when the overhead absorbed is less than the actual overhead incurred. It can be caused by lower production or activity than expected.
- Formula:
```
Under Absorption = Actual Overhead - Absorbed Overhead
```
- Example:
  - Actual Overhead: $55,000
  - Absorbed Overhead: $50,000
  - Under Absorption:
```
Under Absorption = 55,000 - 50,000 = 5,000
```
Over Absorption: Occurs when the overhead absorbed is greater than the actual overhead incurred. This can happen when production exceeds expectations.
- Formula:
```
Over Absorption = Absorbed Overhead - Actual Overhead
```
- Example:
  - Actual Overhead: $45,000
  - Absorbed Overhead: $50,000
  - Over Absorption:
```
Over Absorption = 50,000 - 45,000 = 5,000
```

Costing Statement:
- Formula:
```
Total Cost = Direct Materials + Direct Labour + Absorbed Overhead
```
- Example:
  - Direct Materials: $10,000
  - Direct Labour: $5,000
  - Absorbed Overhead: $8,000
  - Total Cost:
```
Total Cost = 10,000 + 5,000 + 8,000 = 23,000
```

Profit Statement:

Formula:

Net Profit = Sales Revenue - (Direct Costs + Absorbed Overhead + Other Expenses)

Example:
- Sales Revenue: $50,000
- Direct Costs: $15,000
- Absorbed Overhead: $8,000
- Other Expenses: $5,000
- Net Profit:
```
Net Profit = 50,000 - (15,000 + 8,000 + 5,000) = 50,000 - 28,000 = 22,000
```

External Reporting: Required for financial accounting under GAAP and IFRS.
Long-term Pricing: Used for setting prices to ensure that both variable and fixed costs are covered.
Profitability Analysis: Helps in determining whether products are priced to cover both fixed and variable costs.

Cost Distortion: Absorption costing can distort product costs when production volumes fluctuate, leading to over- or under-absorption of overhead.
Short-Term Decisions: Not ideal for short-term decision-making (e.g., pricing for special orders) because it includes fixed costs in the cost of the product.
Complexity: Allocating and apportioning fixed overheads can be time-consuming and complicated, especially for businesses with multiple departments.

Quality Control: Ensuring that cost reductions do not compromise the quality of products.
Customer Satisfaction: Pricing decisions should also consider market conditions and customer expectations.
Environmental Factors: Businesses may face environmental regulations that affect production and costs.
Employee Welfare: Wage policies and working conditions are essential to consider when making cost-related decisions.

Absorption Costing includes both fixed and variable overheads in the cost of a product and is used for external financial reporting.
Cost Centre refers to a department that incurs costs, while Cost Unit refers to a specific product or service unit.
Overhead Absorption Rate (OAR) allocates overhead costs based on an activity base.
Under and Over Absorption occurs when the absorbed overhead is different from the actual overhead incurred.
Costing and Profit Statements are prepared using absorbed costs, showing total production costs and profits.
Absorption Costing is useful for long-term pricing decisions and external reporting but has limitations in short-term decision-making.

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