Over Absorption Formula

Over Absorption Formula

Over absorption result because absorption rate used by the organization due to technical reason i.e. actual information about cost is not available at time of production.

The use of predetermined rate may result in over or under absorption. When absorbed overhead are more than actual overheads, this is over absorption situation or case.

Over Absorption = Absorbed overhead – Actual Overheads

Over Absorption Formula Example

A product takes 5000 hr machine hour. The absorption rate was $ 5 per machine hour. Actual production overheads were $ 22,000. Calculate over or under absorption.

Absorbed overhead

(5000 hr x 5 per hour) =     $ 25,000

Less: Actual overheard    = $ 22,000

Over absorbed =                 $ 3,000

Product Absorption Rate Formula

Product Absorption Rate Formula

An absorption rate is calculated on the bases of number of unit produced is known as Product absorption rate or absorption rate based on Product. This absorption rate may be calculated by dividing production overheads with total number of units produced (units of different product).

Absorption Rate (Labour Hr) = Production Overhead/Total Products

Product Absorption Rate Formula Example

Total overhead expenditure is $ 300,000 for two products (A, B). Total production of both products is (50,000 units). Calculate Product Absorption Rate

Solution

Absorption Rate (Labour Hr) = Production overhead/Total units Produced

= $ 300,000 (production overhead)/ 50,000 Total Products

= $ 300,000/ 50,000

= $ 6 (product absorption Rate)

Labour Hour Absorption Rate Formula

Labour Hour Absorption Rate Formula

An absorption rate is calculated on the bases of Labour hour used by the different product is known as Labour hour absorption rate or absorption rate based on Labour hours. This absorption rate may be calculated by dividing production overheads with total number of Labour hours.

Absorption Rate (Labour Hr) = Production Overhead/Total Labour Hours

Labour Hour Absorption Rate Formula Example

Total overhead expenditure is $ 200,000 for two products (A, B). Total production hour is required for production is 10,000 (Hr). Calculate Labour Hour Absorption Rate

Solution

Absorption Rate (Labour Hr) = Production overhead/Total Labour hours

= $ 200,000 (production overhead)/ 10,000 Total Labour Hours

= $ 200,000/ 10,000

= $ 20 (labour hour absorption Rate)

Machine Hour Absorption Rate Formula

Machine Hour Absorption Rate Formula

An absorption rate is calculated on the bases of machine hour used by the different product is known as machine hour absorption rate or absorption rate based on machine hours. Machine hour absorption rate may be calculated by dividing production overheads with total number of machine hours.

Absorption Rate (Machine Hr) = Production Overhead/Total Machine Hours

Machine Hour Absorption Rate Formula Example

Total overhead expenditure is $ 150,000 for two products (A, B). Total production hour is required for production is 10,000 (Hr). Calculate machine Hour Absorption Rate

Absorption Rate (Machine Hr) = Production overhead/Total machine hours

= $ 150,000 (production overhead)/ 10,000 Total Machine Hours

= $ 150,000/ 10,000

= $ 15

Profit Reconciliation Formula

Profit Reconciliation Formula

Absorption and marginal cost profit difference may be reconciled by the following formulas. There are two different formula used i.e. one for stock increase and other for stock level decreased

Absorption Cost profit = Marginal cost profit + stock level increased during year

Absorption Cost profit = Marginal cost profit - stock level Decreased during year

Example (Stock Increased)

Marginal costing profit = 45,000

Opening Stock level = 40,000

Closing Stock Level = 45,000

Calculate absorption costing profit?

Solution

Absorption Cost profit = Marginal cost profit + stock level increased during year

= 45,000 + 5000

= 50,000

Example (Stock Decreased)

Marginal costing profit = 50,000

Opening Stock level = 40,000

Closing Stock Level = 30,000

Calculate absorption costing profit?

Solution

Absorption Cost profit = Marginal cost profit - stock level Decreased during year

=50,000-10,000

=40,000

Disadvantage of Absorption Costing

Disadvantage of Absorption Costing

Disadvantages of absorption costing may be explained in relation to limited use in decision making, profit manipulation, and selection of appropriate absorption rate.

1.    Limited use in Decision making

First disadvantage of absorption costing is its limited role in the decision making process. Absorption costing fails to establish a direct link between sales and profitability. Therefore management prefers to use marginal costing for decision making.

2.    Profit Manipulation

Second disadvantage of absorption costing is its ability to manipulate the profit. In absorption costing profit can be manipulated by changing the stock valuation i.e. by under or over stock. Due to overhead cost in stock valuation, margin of manipulation is high as compared to marginal costing.

3.    Appropriate Absorption rate

Third disadvantage of absorption costing is finding of appropriate absorption rate. In many cased there is no link between absorption rate used and overhead. It means that absorption rate is used are to general in nature. For example factor rent is absorbed by using machine hour make no sense.

Advantages of Absorption Costing

Advantages of Absorption Costing

Advantages of absorption costing can be explained in terms of rational, stock valuation, financial statement preparation, setting price.

1.    Rational & Logical

First advantage of absorption costing is that it is based on a strong logic and rational i.e. all cost should be part of product.

2.    Stock Valuation

Second advantages of absorption costing are its facilitation in stock valuation. At the end of financial year stock value can be easily calculated due to the absorption costing.

3.    Financial Reporting

Third advantage of absorption costing is its support for the preparation of financial statement. Absorption costing provides relevant information i.e. product cost & stock value for the preparation of financial statement.

4.    Setting price

Fourth advantage of absorption costing is its facilitation for price determination. It provides full cost of product, which is one of the key factors in price determination or setting.

5.    Accurate Financial Position & Performance

Absorption costing reflects the accrual financial position and performance of the organization by accurately valuing the stock & product cost. These both are major element of financial statements.

Characteristics of Absorption Costing

Characteristics of Absorption Costing

Characteristics of Absorption costing have been briefly explained below. In absorption cost both direct cost and Factor overheads are taken into account for determining the product cost.

1.    Direct & Indirect Cost

Absorption Costing takes into account both direct & indirect cost. Direct costs vary with level of activity i.e. Production, where indirect cost does not change with level of activity (production). Absorption costing method is also referred as full cost method, because it consider all cost associated with a product.

2.    Direct Costs are Allocated

In absorption costing direct cost are directly allocated to the product (Direct material & Direct Labour). For example for a product A (1000 units), direct material cost is 10,000 and Direct labour cost is 15,000, then direct cost is 25,000 and unit Direct cost is $ 25,000/1000 = $ 25.

3.    Indirect Costs are absorbed

In absorption costing, indirect costs are absorbed. In first place costs are accumulated as overheads cost, and then overheads are charged to different products by using an absorption rate. Absorption rate is used because indirect cost cannot be directly traced & allocated to a product.

4.    Suitable Absorption Rate

In Absorption costing Indirect cost or overhead are absorbed by using a suitable or fair absorption rate. A rate may be based on machine hour, labour hour, or unit produced. For example total overhead is $ 40,000 and machine hour used (expected to use) are 10,000, then absorption rate is $ 4 per machine hour i.e. (40,000/10,000). If a product consumed 5,000 hour, then this product will be charged $ 20,000 for overhead i.e. (5000 hr x $ 4 per hour).

5.    Administration Expense are not absorbed

In absorption costing only the production related expenditure are absorbed. Administration expenditure is not part of production and therefore reported separately in the financial statement. Administrative cost shown as administrative or operating expenditure in the financial statements.