The Management Accountant’s Profit Statement – Absorption Costing
Under absorption costing every unit carries a share of the fixed production overheads, absorbed at a rate fixed in advance from the budget. Because actual production (or actual hours) and actual overheads rarely match the budget, the overheads absorbed are almost never exactly the overheads incurred. The difference is the over- or under-absorbed overhead.
This chapter shows how the management accountant’s profit statement is built under absorption costing, how closing inventory is valued, and the rule for calculating the over- or under-absorption and adjusting the profit for it – whether overheads are absorbed per unit or per hour.
1 Introduction
In the previous chapter we stated that the cost per unit is normally calculated in advance using estimated or budgeted figures. This is for several reasons. For instance, we need an estimate of the cost before we can fix a selling price. In addition, the estimated cost per unit provides a benchmark for control purposes. The Management Accountant can check regularly whether or not units are costing more or less than estimated and attempt to take corrective action if necessary.
As a result, the Management Accountant’s Profit Statement (or Operating Statement) takes a different form than that of the Financial Accountant’s statement of profit or loss (income statement).
The statement is usually prepared monthly, and its objective is to show whether the profit is higher or lower than that expected, and to list the reasons for any differences.
The statement starts with the profit that should have been made if all the costs had been the same as on the standard cost card.
It then lists all the reasons for any differences in profit (or variances) to end with the actual profit.
2 Product costs and period costs
Under absorption costing, the cost of a unit is its full production cost: direct materials, direct labour, variable production overheads and a share of the fixed production overheads, absorbed using the overhead absorption rate (chapter 4).
Treatment under absorption costing | |
Direct materials, direct labour, variable production overheads | Product costs – included in the cost per unit and in the value of inventory |
Fixed production overheads | Product costs – absorbed into each unit at the overhead absorption rate, so inventory carries a share of them |
Selling, distribution and administration costs (fixed or variable) | Period costs – never absorbed into units; charged in full against the profit of the period in which they are incurred |
So closing inventory is valued at full production cost per unit, and is carried forward to be charged against the profit of the period in which it is sold. Selling costs cause no difficulty: the variable selling cost is charged per unit sold and the fixed selling cost is charged as incurred. The difficulty lies with the fixed production overheads.
3 Illustration
However, in calculating the budgeted profit for individual months, absorption costing causes a problem when the expected production in a month differs from that used to absorb fixed overheads for the cost card.
This problem is illustrated in the following example.
X plc produces one product – desks.
Each desk is budgeted to require 4 kg of wood at $3 per kg, 4 hours of labour at $2 per hour, and variable production overheads of $5 per unit.
Fixed production overheads are budgeted at $20,000 per month and average production is estimated to be 10,000 units per month.
The selling price is fixed at $35 per unit.
There is also a variable selling cost of $1 per unit and fixed selling cost of $2,000 per month.
During the first two months X plc expects the following levels of activity:
January | February | |
Production | 11,000 units | 9,500 units |
Sales | 9,000 units | 11,500 units |
(a) Prepare a cost card using absorption costing
(b) Set out budget Profit Statements for the months of January and February.
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4 Over- and under-absorption of overheads
The full statement in Example 1 shows where the problem comes from, but you do not need to prepare it to find the profit. The standard profit per unit assumes that fixed overheads cost exactly the absorption rate per unit. That is only true if production equals the budgeted level and the overheads cost exactly what was budgeted. So:
Start with the standard profit: units sold × standard profit per unit.
Calculate the overheads absorbed: actual units produced (or actual hours worked) × the overhead absorption rate.
Compare the overheads absorbed with the actual overheads incurred (if no actual figure is given, assume the budgeted figure).
Adjust the profit for the difference.
Meaning | Effect on profit | |
Over-absorbed | Overheads absorbed are MORE than the overheads incurred – too much has been charged as an expense | Add to profit |
Under-absorbed | Overheads absorbed are LESS than the overheads incurred – too little has been charged as an expense | Deduct from profit |
Over- or under-absorption arises for two reasons, which can occur together:
Activity – actual production (or actual hours) is different from the budgeted level used to set the rate. Producing more than budgeted absorbs more; producing less absorbs less.
Expenditure – the actual overheads are different from the budgeted overheads. Fixed overheads do not change with the level of production, but the budget can still be wrong, or prices can rise or fall.
Using Example 1, the January profit can be found in a few lines, without the full statement:
January | $ |
Standard gross profit (9,000 units sold × $8) | 72,000 |
Over-absorbed: absorbed (11,000 units produced × $2) 22,000 – incurred 20,000 | 2,000 |
Gross profit | 74,000 |
Less: selling costs (9,000 × $1 + $2,000) | (11,000) |
Net profit | 63,000 |
The units sold drive the standard profit; the units produced drive the overheads absorbed. Mixing the two up is the commonest mistake.
5 Hourly absorption rates
The previous example assumed that fixed overheads were absorbed on a unit basis. A popular question in the exam is to be asked to calculate the amount of any over- or under-absorption when fixed overheads are absorbed on an hourly basis. The rule is the same: the overheads absorbed are the actual hours worked × the absorption rate per hour.
Y plc budgets on working 80,000 hours per month and having fixed overheads of $320,000. During April, the actual hours worked are 78,000 and the actual fixed overheads are $315,500.
Calculate:
(a) the overhead absorption rate per hour.
(b) the amount of any over- or under-absorption of fixed overheads in April
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6 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
The Management Accountant’s Profit Statement – Absorption Costing
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