Absorption costing also known as full costing is conventional of ascertaining the cost. It is the practice of charging all cost both variable and fixed to operation, processes and products. It is the oldest and widely used technique of ascertaining the cost.
Under this technique of cost, the cost is made up of direct cost plus overhead costs absorbed on some suitable basis. In this technique, cost per unit (CPU) remains the same only when the level of output remains the same. But when the level of output changes the cost per unit also changes in the presence of fixed cost which remains constant.
The change in cost per unit with a change in the level of output in an absorption costing technique poses a problem to the management in taking managerial decisions.
Absorption costing is useful if there is only one product, there is no inventory and overhead recovery rate is based o normal capacity instead of the actual level of activity. Two distinguishing feature absorption costing is that fixed factory expenses are included in the (i) unit cost and (ii) inventory value.
Treatment of Absorption Costing in Books
Absorption costing divides all the costs into 3 parts i.e. manufacturing, administrative and selling & distribution. In the income statement of profit and loss account, all the manufacturing costs are subtracted from the gross sales revenue to arrive at gross margin. From the gross margin, selling and administrative expenses are deducted to find out the net income amount.
It is worth noting that fixed manufacturing overheads are charged to the number of units produced on the basis of per unit fixed manufacturing overhead rate obtained by dividing the standard fixed manufacturing overhead by normal output level as given below:
= Standard Fixed Manufacturing Overhead / Normal Output (normal capacity)
If the actual production is above or below the normal capacity level adjustments need to be made for volume variance.