In our previous lesson on absorption costing, we explored how it considers all manufacturing expenses. But how exactly are these costs allocated to each unit produced? That’s where the absorption rate comes in!
Here’s a breakdown in 5 points:
- The Allocation Tool: The absorption rate is a predetermined rate used in absorption costing to spread the total fixed overhead costs over the estimated number of units to be produced in a specific period.
- Formula for Efficiency: It’s calculated by dividing the budgeted total fixed overhead cost by the budgeted production level (number of units). This formula gives you a cost per unit that factors in the fixed overhead expenses.
- Applying the Rate: Once you have the absorption rate, you can multiply it by the actual number of units produced during a period to determine the total fixed overhead cost to be included in the product cost for that period.
- Impact on Inventory Valuation: The product cost per unit, which includes both variable costs and the fixed overhead cost allocated using the absorption rate, is used to value the company’s ending inventory.
- Sensitivity to Production: The absorption rate can be sensitive to changes in production volume. If the actual production deviates significantly from the budgeted level, the allocated fixed overhead cost per unit might not accurately reflect the true cost.
So, the absorption rate plays a vital role in absorption costing by efficiently distributing fixed overhead costs across produced units. However, it’s important to consider production volume fluctuations when interpreting the results.
