Accounting Assignment Help With Understanding Absorption Costing And Direct Costing
5.8 Understanding Absorption Costing and Direct Costing
Absorption costing is a method that charges all costs to products. Under this approach product/service is charged with prime cost and all overheads. Overheads are of two types – fixed and variable. Overheads may be linked to product or they may be fixed in nature within a capacity range. In absorption costing this distinction is ignored. Overheads are analysed and charged to product/service on a suitable basis. This absorption costing is an ‘all-cost’ approach.
Direct costing on the other hand, means costs which are directly related to product/service. Prime cost and variable overheads constitute direct cost.
Let us see an example to explain the distinction between absorption costing and direct costing.
Eg. To produce 1000 units of A and 2000 units of B the following costs have been incurred.
| A $ | B $ | TOTAL $ | |
Direct Materials |
50,000 | 70,000 | 1,20,000 |
Direct Labour |
40,000 | 30,000 | 70,000 |
Production overheads Variable Fixed |
10,000 | 5,000 | 15,000 30,000 |
Administrative overheads Fixed |
40,000 | ||
Selling & Distribution Overheads Variable Fixed |
5,000 | 4,000 | 9,000 20,000 |
Total |
1,05,000 | 1,09,000 | 3,04,000 |
Direct cost of A is $ 105 per unit and of B is $ 54.50 per unit which are directly attributable to the respective product.
For absorption costing, Products A and B have to bear share of fixed cost over and above their respective direct cost. For allocation of fixed overheads you need to choose appropriate bases.
| Overheads | Base | A | B |
Fixed Production overhead |
Production hours |
2000 | 2000 |
Admn. overheads |
Time spent ratio |
3 |
2 |
| S & D OH | Time spent ratio | 1 | 1 |
Accordingly share of overhead of product A & B are as follows.
A $ |
B $ |
|
| Direct Cost | 1,05,000 | 1,09,000 |
| Fixed production overheads (1:1) | 15,000 | 15,000 |
| Fixed Admn OH (3:2) | 24,000 | 16,000 |
| Fixed S & D OH (1:1) | 10,000 | 10,000 |
| Total | 1,54,000 | 1,50,000 |
Cost per unit (absorption costing method) |
154 | 75 |
Cost pr unit (direct costing method) |
105 | 54.50 |
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