The absorption rate is a fundamental component of absorption cost accounting, or the inclusion of all costs related to a product being attributed to it. Absorption costing is required for external reporting and applies all of the direct costs and a portion of a companyâ s overhead costs (electricity etc.) to the actual products that are being produced. These costs will then show up in a companyÃƒÂ¢ s cost of sales account and some may be booked into inventory if the products havenÃƒÂ¢ t actually been sold yet.
This is an important concept when it comes to applying the matching concept of accounting, specifically that the expenses related to a sale should only be recognized on the income statement when that sale actually takes place. By applying all of the costs incurred by making products to the actual products themselves this ensures that those costs are only expensed (through the cost of sales) when the sale of those products actually takes place. While the concept is easy enough to grasp the actual mechanics of calculating your absorption rates can be complex and very judgment-driven. Absorption rates refer specifically to the rates at which companies apply certain costs to products being made. In reality, a company can have many different absorption rates depending on the cost they are trying to allocate to their products.
Costs that are typically included in the absorption rate include:
These are all costs that can be included in what a company calls it’s overhead. These indirect costs, while not directly tied to production like direct materials or direct labour, would not be incurred by the company if it werenÃƒÂ¢ t actually in the business of producing goods or services.
Here is a simple example of a company that is attempting to determine its absorption rate. Utility expense: $50K Rent expense: $50K Office & admin expense: $35K Accounting & legal expense: $15K Total units produced: 10,000 With this information the absorption rate would be determined as follows:
= (50,000 + 50,000 + 35,000 + 15,000)
This formula would provide an absorption rate of $15 per expected unit produced. For costing purposes, after applying direct costs like materials and labour, the company would add an additional $15 to the cost of each of these items. When the item is sold the expense would be recognized in the cost of sales as opposed to individual expense line items on the income statement.
The above example is a very simplified version of what takes place in practice. Complexity is added to determining the absorption rate when companies decided to apply more precision to the rate. Typical changes include:
So while it may appear to be a fairly simplistic model it can actually get very complex. Typically a company has to decide if the level of effort applied is worth the value of improved accuracy, as that improved accuracy will come at a cost in more hours spent on costing. Absorption rates are not only for production-based companies, as service-based companies commonly use different absorption rates also. In this case, instead of units produced clients served or hours worked will become the drivers of allocation.
The use of absorption rates, and absorption accounting itself, is criticized in some circles. Many believe that only direct variable costs of production, the more you produce the more you pay, should be included in the cost of products. The desire to apply indirect, or non-variable, costs can end up providing a distorted picture of the actual costs of production, particularly with how discretionary it can be. As with many accounting practices, absorption rates can be a very useful and effective tool when applied correctly and using effective professional judgement.