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What is the simplest way to explain absorbtion costing to a GM that has never used a ERP costing system

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Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

Assuming you're specifically talking about overhead application (because not understanding DM or DL would be very scary) can be simply put that products aren't made in a bubble.

Just as DL & DM are part of the equation, the cost of support those components, such as cost of electricity to run the machines, maintenance, set-up costs when you switch to another product, etc are really part of the cost of manufacture.

Some of those costs are fixed, such as rent and insurance for the manufacturing floor, for example and having nothing to do with productivity. The rent will be the same if you make 1 unit or n units.

Some are variable, such as electricity, or lubricating fluid; the more you make the more you need to use of these variable cost items.

For overhead application a calculation is used so that at the end of the year, all costs have been allocated to inventory items. If there is a misjudgment (and there always is, because there is a lot of guess work involved in creating the different rates that will be applied, or increases/decreases in unit costs for those items (electricity rates increase)), an accounting adjustment is made.

Hope this helps...

Kendra Minton
Title: Controller
Company: Ohio Metal Technologies Inc
(Controller, Ohio Metal Technologies Inc) |

Thanks Wayne,

Luis Diaz
Title: Sr. Cost Accountant
Company: Aspen Surgical PR Corp.
(Sr. Cost Accountant, Aspen Surgical PR Corp.) |

The Full Absorption process is related with the production for the period covering (absorbing) the overhead expenses of that period. I explain that simple concept to the operations people, to encourage them to give me good absorption numbers, to cover our expenses...and they perform very good...

Robert Price
Title: CFO/Board Advisor
Company: Not Disclosed
(CFO/Board Advisor, Not Disclosed) |

Explain it the same way you would explain the "total" cost of an employee. That is, the "total" cost of an employee is more than his/her salary/wages. The "total" cost of an employee includes: salary/wages; employer payroll taxes; medical/life benefits; desk, computer, monitor, tools, etc. You have to include all of these items to know the "total" cost of an employee.

The same is true with products being manufactured, assembled, or simply purchased and resold (wholesaler). That is the "total" cost of the product is more than just the cost of Direct Materials and Direct Labor. The "total" cost of the product incudes all of the costs of the factory, warehouse, and related overhead.

The real discussion to have is the "method" of absorption. That is should absorption be based on units produced? Based on direct labor? Based on cost of direct materials? Should freight-in be spread across all items, or should it be charged to the specific items it is related too? And, if you want to get even more complex, have more that one absorption factor, e.g. a direct material overhead absorption factor, and a direct labor overhead absorption factor.

My experience is that it isn't the concept of absorption which is troublesome for non-financial managers to understand, rather it is the method of absorption which they don't fully appreciate. In this regard, I always spend a considerable amount of time with these managers and get their input into the absorption method.

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

You could also add insult to injury and talk about the internal political fallout based upon the method of absorption (as well as the possible revenue/tax ramifications); but I think you'll admit that discussion would just add to the confusion... :)

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