See Also:
Semi Variable Costs
Standard Costing System
Variable vs Fixed Cost

Absorption Cost Accounting

Absorption cost accounting (also known as the “Cost-Plus” approach), is a method that is centered upon the allocation of Manufacturing Cost to the product. This method is important for situations when a company needs to decide if it can be competitive in a market, or when the company has control over the pricing in general. This means that Direct Labor, Direct Materials, as well as fixed and variable Overhead Definition are all “absorbed” into product pricing as well as product costing.
[box](NOTE: Want to take your financial leadership to the next level? Download the 7 Habits of Highly Effective CFO’s. It walks you through steps to accelerate your career in becoming a leader in your company. Get it here!)[/box]

Absorption Cost Per Unit

Because absorption cost accounting is a “per-unit” method, it is necessary to understand how to determine the absorption cost per unit. So the fair question remains: What is the absorption cost approach? Ultimately, all of the calculations are done on a Per-Unit basis. For example, Wintax Company creates 5,000 products with Variable Cost per unit being $60 direct materials, $110 direct labor, and $40 variable overhead. In addition to the per-unit costs, the fixed overhead is $100,000. In order to obtain the product cost under absorption costing, first the per-unit costs are added together (direct labor, direct materials, variable overhead). After that, per-unit costs need to be obtained from the fixed overhead so that the per-unit overhead can be applied to the per-unit cost. Adding the overhead to the per-unit costs completes what is absorption costing per unit. See how to work out the problem below.

Solution

Per-Unit Costs Fixed-overhead per-unit
(direct labor + direct materials +variable overhead) + (fixed overhead / number of units)
($210) + ($20)
Absorption cost per unit: $230

Absorption Cost Unit Pricing

In addition to determining the overall cost of a singular product, absorption cost accounting gives one the ability to determine the appropriate selling price of a unit as well. As long as there is a target profit, the absorption costing method can calculate the appropriate price. For example, Bizzo Company desires a profit of $180,000 while producing 10,000 products. In addition, each product costs $150 to produce in total. In order to determine the appropriate selling price, first, divide profit by the number of products. Add that number to the original product cost in order to achieve the correct product price. Check out the solution worked out below.

Solution

((Desired Profit) / (Number of Units)) + (Product Cost Per-Unit)
( $180,000 / 10,000 ) + ( $150 )
Target Product Price= $168

Absorption Costing Formulas

(Absorption Cost per-unit) = (Per-Unit Variable Costs) + (Per-Unit Fixed Overhead)
Sales Price = (Manufacturing Cost Per-Unit) + (Sales and Administrative Cost Per-Unit) + (Profit Markup)
Deciding whether to be competitive in pricing or maintain status in the market is one of the many key decisions a financial leader has to make. Download the free 7 Habits of Highly Effective CFOs to find out how you can become a more valuable financial leader.