Introduction
Production of goods and services involves the use of costs which are directly incurred in the production process and production overhead. Direct production costs comprise of labor, hours used in the production process, machining hours, and cost of raw material among others. Production overheads are the indirect costs incurred during a production process.
The production overheads arise from support services offered in the main department. Examples are canteen cost, service bay costs, administration expenses, sales and marketing, and rent among others. The units of output produced should be charged with the total cost of production incurred. There are various approaches that can be used to charge the production costs to units of output produced.
The most common approaches are arbitrage costing, absorption costing and marginal costing (Vanderbeck 2008). This treatise carries out a comprehensive review of absorption costing. It explains the approach, its strengths and weaknesses and finally gives recommendations to the Welsh Government on continuation of the use of the method in the public sector.
Absorption costing and key assumptions
Generally, absorption costing traces both the fixed and variable costs of production of the product. In using this approach, a share of the fixed cost of production is allocated to each product. This share is added together with the direct cost of production for each individual product to obtain the total or the full cost of producing a unit of output.
The fixed costs are assigned using the overhead absorption rates. Absorption costing goes through three key distinct stages these are allocation, apportionment and absorption. There are various types of absorption costing. These are job order costing, process costing and ABC costing. Under job order costing, the cost of production is assigned to products in lots or batches. It is suitable for production processes where goods are produced in lots such as printing and manufacturing of furniture among others.
Under process costing, the cost of production is methodically allocated to the product. Example is the production of soft drinks or oil. Finally, ABC costing is suitable for a firm which produces a number of products with varying volumes. The ultimate aim of absorption costing is to include in the total cost of a product an appropriate share of the company’s total overhead (Tulsian 2007). An appropriate share denotes the average of the amount of time and effort used in producing a unit of output.
One key assumption of the absorption costing approach is that it suppose that consumers and producers are insensitive to price of the product thus pricing of the firm does not affect the decision to purchase. Consumers will purchase the commodities produced at the quoted price. This violates the law of demand and it’s unrealistic because in a competitive market, consumer and producers are sensitive to changes in price (Jawahar-Lal 2009).
Absorption costing as a means of cost control
As mentioned above, absorption costing assign the direct cost of production and production overheads to the cost centers. Therefore, all cost incurred in an organization is accounted for. Assigning of production overhead to each cost center makes managers more accountable and responsible for managing costs in their departments.
Besides, they have to operate within the budgets provided since variations from the budgeted values affect the absorption rates used in allocating the cost. Therefore, absorption costing makes management be more sensitive to spending in their departments (Jawahar-Lal 2009).
Strengths and weaknesses of absorption costing for management
Just like any other process, absorption costing has a number of strengths and weaknesses. One key advantage is that it makes use of fixed cost of production when computing the cost per unit of output. Therefore, the management is able to view the total cost associated with producing a product. Secondly, the method is consistent with the Generally Accepted Accounting Principles therefore, the results of absorption costing helps the management to prepare the financial reports.
Absorption costing helps management in the valuation of stock. The International Accounting Standards (IAS) require that inventory should be valued either at the lower of the costs of the net realizable value. Further, absorption costing is consistent with the accrual and matching concept of accounting. These principles require matching of costs to revenue in a given accounting period. Absorption costing necessitates this.
Results of absorption costing provides the costs required to bring the goods to its useable state. Therefore, once cost is estimated the management will be able to estimate the price of the goods. Absorption costing helps in estimating the total costs incurred in bringing the goods to its use value. Further, results of absorption costing helps in pricing of goods and services.
It is because, most management estimates the prices as a mark up of the costs. The difference between these costs and prices yields profits to the management. Use of absorption costing helps in estimating profit arising from the production of a unit of output. The results of absorption costing does not depend on fluctuation in sales. That is, the results are the same during off peak and peak season.
This helps management maintain a consistent cost schedule throughout the year. Further, absorption costing evades the separation of fixed and variable costs as in the case of variable costing. Finally, the allocation of production overheads to cost centers helps management to control, be informed and in charge of services offered to another department in a company (Drury 2008).
A major drawback of this approach is that it does not give accurate results. It is for the reason that allocation, apportionment and absorption of costs using this approach is based on budgeted values. These values are arrived at after taking into account operations of the previous years and future plans of the company. However, business environment does change.
Therefore, there is a tendency that the budgeted values would not be exactly the same as the actual values. This causes variance which calls for adjustments at year end. Further, absorption costing ignores cost volume profit relationship. This relationship is quite significant in decision making. Management has to seek other methods which can be useful in decision making such as marginal costing technique (Debarshi 2011)
Recommendation to Welsh Government
Public sector commonly provides goods and services to the citizens. Most of the public sectors do not directly deal with production of goods or rather are not in the manufacturing sector. It is worth noting that absorption costing is commonly used in the manufacturing sector. However, public sector and other institutions offering services are using the same idea in estimating costs of services.
For instance, in a learning government institution, the costing process entails identifying the resources available in the institution (such as number of employees and assets), identifying the products (such as courses, research papers), identifying the activities (such as library, admission and course activities), assign the resources costs to the activities, link the activities to the products using cost drivers (such as staff, students and space), and finally make a report on the cost per product (Caplan 2012).
Therefore, it is evident that the public sector uses the idea of absorption costing in their pricing decisions. The method is very appropriate for the public sector since it shows the full costs of offering the goods and services to the public. This element is of utmost significance in the public sector because in most cases, government the government is majorly concerned with the cost of provision of the public goods and not the profits that arise from the provision of such goods.
Therefore, a method costing that would provide the full cost of a provide is much important. The full cost of goods and services enables the government to provide adequate funding for the production or provision of the goods and services. The Welsh Government should continue with the use of absorption costing in the public sector organization. This approach facilitates preparation the government budget (Rajasekaran & Lalitha 2011).
A brief presentation on absorption costing outlining the key points
In conclusion, absorption costing is a way of assigning the direct cost of production and overheads to the unit of output produced. The method provides a full cost of the product which is very essential in budgeting. The method assigns costs of production to the units of output produced using three steps these are allocating, apportionment of the costs and absorption of costs.
There are various ways of assigning costs using absorption costing, this depends on the output produced. One key assumption that is implied in the computation of the unit cost of a product is that the consumers and producers are price insensitive that is, they purchase the goods at the prices offered. This assumption is of less significance to the public sector since their main intention is the provision of goods and services and not profit making.
The method would be beneficial to the Welph Government in a number of ways. First, it will enable the government to have the full cost of provision of goods and services to the public. The information is significant in the preparation of the government annual budget.
Secondly, the method is consistent with the government reporting framework. Therefore, there will be no inconsistencies or need for adjustments when using the approach. Finally, the method helps various heads of the public sector to manage the costs in their respective institutions.
It is because they will be allocated funds as per the budget. The method has a number of weaknesses. First, it is not accurate since it uses budgets. These are estimates which arise from previous budgets and future plans. The government of Welph should consider using the approach in the public institutions.
Apart from the use of absorption costing method, the government can also consider using other methods of allocating costs such as direct method, reciprocal approach and step down method. The government can also use marginal costing among others. Therefore, the Welph government should choose the most appropriate method of allocating cost depending on the nature of the services provided by each sector and the aim of the government.
References
Debarshi, B 2011, Management accounting, Dorling Kindersley Pvt. Ltd., South Asia.
Caplan D 2012, Product costing and cost allocation. Web.
Drury, C 2008, Management and cost accounting, South Western Cengage Learning, Canada.
Jawahar-Lal, A 2009, Cost accounting, McGraw-Hill Company Limited, New Delhi.
Rajasekaran, V & Lalitha, R 2011, Cost accounting, Dorling Kindersley Pvt. Ltd., South Asia.
Tulsian, P 2007, Cost accounting, McGraw-Hill Publishing Company Limited, New Delhi.
Vanderbeck, E 2008, Principles of cost accounting, Thomson Learning, Inc., Canada.