# Absorption Costing

Absorption costing is the accounting method that allocates manufacturing costs based on a predetermined rate that is called the absorption rate. It helps company to calculate cost of goods sold and inventory at the end of accounting period.

Absorption costing is an easy and simple way of dealing with fixed overhead production costs. It is assuming that all cost types can allocate base on one overhead absorption rate. The absorption rate is usually calculating in of overhead cost per labor hour or machine hour. The products that consume the same labor/machine hour will have the same cost of overhead.

## Absorption Costing Components

Absorption cost, also known as full costing, allocate all the cost in production into the finished products and only charge to the income statement when they are sold. These costs include:

• Direct material
• Direct labor

## Example

Company ABC produces two main products, Normal and Premium products. Base on company standard costing, the cost of both products includes:

How do we allocate the production cost of \$ 670,000?

Solution

We will use overhead absorption costing, which is absorption by labor hour.

• Labor cost \$ 10 per hour
• Normal product will require: 300,000 (100,000 x 3h) working hour to complete 100,000 units
• Premium product will require: 150,000 (30,000 x 5 h) working hour to complete 30,000 units

Therefore, fixed overhead will be allocated by \$ 1.50 per working hour (\$ 670,000/(300,000h+150,000h)).

Production overhead of Normal product: \$1.50 x 3h = 4.50

Direct Material 15 30
Direct Labor (\$10/h) 30 50
Total production cost 57.5 97.5