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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