1. ABSORPTION COSTING OR FULL COSTING
Samir K Mahajan

2. ABSORPTION COSTING/FULL COST METHOD
Absorption costing or full cost method is the traditional method of costing by which all direct and applicable overheads are charged to product or cost centre. According to this method, all costs (fixed and variable cost) are identified with or absorbed into manufactured product.
Here, direct cost and manufacturing overheads (variable and fixed) are treated as product cost . Selling and administrative cost are part of part of period cost.
Absorption cost remain in inventory as an asset until such time as the inventory is sold. They are charged to cost of goods sold. Consequently the cost of goods in inventory or cost of goods sold under this method contain variable costs and fixed overhead cost.

3. ABSORPTION COSTING/FULL COST METHOD

4. Direct Material per unit
Example 1: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows A B C
Direct Material per unit
Rs 3
Rs 4
Rs 5
Direct labour per unit
Rs 2
Selling price per unit
Rs 10
Rs 15
Rs 20
Output
1000 units
The total overhead costs are Rs out of which Rs are fixed and the rests are variable. It is decided to apportion these costs over different products in the ratio of output. Prepare a statement showing the cost and profit of each product according to absorption cost.

5. Statement showing profit and cost Traditional Income Statement
Example 1: solution
Statement showing profit and cost
(Absorption Costing )
Traditional Income Statement
A_____
______B _____
_____C _____
Per unit Rs
Total
Direct material
Direct labour
Overheads:
Fixed
Variable
Total Cost
Profit
Selling price 3 2 1
3000
2000
1000 4
4000 5
5000 9
9000 11
11000 13 7
13000
7000 10
10000 15
15000 20
20000

6. Example 1: solution contd
Total profit under absorption costing is
Total Profit Rs._______
Product A
Product B
Product C

7. ADVANTAGES OF ABSORPTION COSTING SYSTEM
1. Absorption costing recognizes fixed costs in product cost. As it is suitable for determining price of the product. The pricing based on absorption costing ensures that all costs are covered.
2. Absorption costing avoids the separating of costs into fixed and variable elements.
3. Absorption costing has been recognized for the purpose of preparing external reports and for stock valuation purposes.
4. The allocation and apportionment of fixed factory overheads to cost centres makes manager more aware and responsible for the cost and services provided to others.
5. Absorption costing will show correct profit calculation than variable costing in a situation where production is done to have sales in future ( e.g. seasonal production and seasonal sales).

8. DISADVANTAGES OF ABSORPTION COSTING SYSTEM
1. Absorption costing is not useful for decision making. It consider fixed manufacturing overhead as product cost which increase the cost of output. As a result, it does not help in accepting specially offered price for the product. Various types of managerial problems relating to decision making can be solved only with the help of variable costing system( Discussed in Example 2).
2. The technique of absorption cost may lead to rejection of profitable business. A total unit cost will tend to be regarded as the lowest possible selling price. An order at a price which is less than total unit cost may be refused, though the order may be actually profitable ( Discussed in Example 3)
3. Absorption costing is not helpful in control of cost and planning and control functions. It is not useful in fixing the responsibility for incurrence of costs. It is not practical to hold a manager accountable for costs over which he/she has not control.

9. Direct Material per unit
Example 2: Tripura Ltd is manufacturing three product : A, B, C. the cost of manufacture are as follows A B C
Direct Material per unit
Rs 3
Rs 4
Rs 5
Direct labour per unit
Rs 2
Selling price per unit
Rs 10
Rs 15
Rs 20
Output
1000 units
The total overhead costs are Rs out of which Rs are fixed and the rests are variable. It is decided to apportion these costs over different products in the ratio of output. Prepare a statement showing the cost and profit of each product according to absorption cost.
Calculate amount of profit and and loss made by Tripura Ltd in the first two years of its existence, presuming that
In the first year, it manufactures 1000 units of each product A, B, C but fails to effect any sales.
In the second year, it does not produce anything but sells the entire stock carried forward from the first year.
What fallacious conclusions can be drawn from the results.

10. Profit and loss Account of 1st Year
Solution : Example2
Tripura Limited
Profit and loss Account of 1st Year Dr Rs Cr
Direct material A B C
Direct labour
Overhead:
variables A B C
Fixed
3000
4000
5000___
2000
4000___
_12000__
___33000_
Sales
Closing Stock
-----
33000
________

11. Profit and loss Account of 2nd Year
Solution : Example 2 contd.
Tripura Limited
Profit and loss Account of 2nd Year Dr Rs Cr
Opening Stock
Fixed overhead
Profit
33000
9000
3000
_______
45000__
Sales A B C
10000
15000
20000_
______
45000_

12. Solution : Example 2 contd.
The above Profit and Loss accounts shows that in the first year there is no loss in spite of the fact that the company did not make any sales . While in the second year, it makes a profit of Rs As a matter of fact, the company losses Rs.9000 on account of non-recovery of fixed cost in the first year. The profit and loss account does not show any loss because these fixed costs have been included in the closing inventory values and thus carried forward to the next year.
As a result, the profit and loss account for the second year has to bear Rs on account of fixed cost. (i.e. Rs for the first year + Rs.9000 for the second year). The real profit in the second year should be have been Rs and not Rs
Thus, the technique of absorption may lead to rather odd results particularly for seasonal business in which stock levels fluctuate widely form one period to another. Their profits for the two periods will be influenced by the transfer of overheads in and out of stock showing falling profits when the sales are high and increasing profit when sales are low.

13. The cost details of the company are as follows:
Example 3:
Your are the MD of Usha Automobiles Ltd. which has received a special offer for the supply of 200 components at Rs 60 a piece from a motorbike manufacturer. The company has a capacity to produce 1000 components but at present it is utilising 80 percent of its capacity. The present selling price per component is Rs. 100.
The cost details of the company are as follows:
Variable cost per unit Rs 40
Fixed overhead cost per unit Rs 30
(total fixed overheads Rs 24000) ___________
Total cost per unit Rs 70
Your cost accountant advises you to reject the order since the company will be getting less profit than the total cost of the component. How would you react?

14. Solution : Example 3:
Sales Total
Sales in units ___________
Sales in Rs
(800x100) (200x60)_____________________________
Total Cost:
Variable ( Rs 40 per unit)
Fixed cost (Rs) _____
_____
Profit (Rs.)
The advice of the Cost Accountant is not correct. Since he has based his decision on absorption costing, he is advising against accepting the special offer. Thus if the order is accepted the profit will increase from Rs to Rs it is therefore advisable to accept the offer rather than reject.