Understanding Absorption Costing And Direct Costing Assignment Help

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.

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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.


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A $B $TOTAL $

Direct Materials

50,00070,0001,20,000

Direct Labour

40,00030,00070,000

Production overheads

Variable

Fixed

10,0005,00015,000 30,000

Administrative overheads

Fixed
40,000

Selling & Distribution Overheads

Variable

Fixed

5,0004,000

9,000

20,000

Total

1,05,0001,09,0003,04,000

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.

OverheadsBaseAB

Fixed Production overhead

Production hours

20002000

Admn. overheads

Time spent ratio

3

2

S & D OHTime spent ratio11

Accordingly share of overhead of product A & B are as follows.

A

$

B

$

Direct Cost1,05,0001,09,000
Fixed production overheads (1:1)15,00015,000
Fixed Admn OH (3:2)24,00016,000
Fixed S & D OH (1:1)10,00010,000
Total1,54,0001,50,000

Cost per unit (absorption costing method)

15475

Cost pr unit (direct costing method)

10554.50

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