How to Calculate Unit Product Cost Using Absorption Costing
Learn the comprehensive approach to calculating unit product cost with absorption costing. Gain clarity on your manufactured goods' full production expenses.
Absorption costing is an accounting method used to determine the full cost of a manufactured product. It ensures that all manufacturing costs, both fixed and variable, are included in the cost of inventory. This approach is required for external financial reporting under Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) globally. Absorption costing provides a comprehensive valuation of inventory on the balance sheet. This method is also known as “full costing” because it captures a broader range of costs compared to other costing methods.
Classifying Costs for Absorption Costing
To calculate unit product cost using absorption costing, manufacturing costs are categorized into four main types. These categories represent all expenses directly or indirectly associated with the production process. Understanding each cost type is fundamental to accurately determining a product’s total cost.
Direct materials are raw materials that become an integral part of the finished product and can be directly traced to it. For example, in furniture manufacturing, wood, screws, and fabric used to build a chair are direct materials.
Direct labor refers to wages paid to workers directly involved in the manufacturing process whose efforts can be specifically traced to the product. An example is the hourly wages paid to an assembly line worker or a carpenter building furniture.
Variable manufacturing overhead includes indirect manufacturing costs that change in total in direct proportion to the volume of production. Examples include the cost of indirect materials, such as lubricants for machinery, or utilities like electricity that vary with machine usage in the factory.
Fixed manufacturing overhead consists of indirect manufacturing costs that remain constant in total, regardless of the production volume within a relevant range. Common examples include factory rent, depreciation on factory equipment, and salaries of factory supervisors.
Calculating Unit Product Cost: Step-by-Step
Calculating the unit product cost under absorption costing involves summing all manufacturing costs and dividing by the number of units produced. The overall formula for unit product cost is: (Direct Materials + Direct Labor + Variable Manufacturing Overhead + Allocated Fixed Manufacturing Overhead) / Total Units Produced.
The first step involves identifying the total direct materials cost and total direct labor cost incurred for a period. These represent the raw materials and wages for workers directly involved in manufacturing.
Next, the total variable manufacturing overhead for the period is added. Finally, the total allocated fixed manufacturing overhead is included.
Once all these manufacturing costs are summed, the total is divided by the number of units produced during that period to arrive at the unit product cost. For instance, if a company incurs $10,000 in direct materials, $15,000 in direct labor, $5,000 in variable manufacturing overhead, and $8,000 in allocated fixed manufacturing overhead, and produces 1,000 units, the total manufacturing cost is $38,000. Dividing $38,000 by 1,000 units yields a unit product cost of $38.00.
Allocating Fixed Manufacturing Overhead
Fixed manufacturing overhead costs cannot be directly traced to individual products. Therefore, these indirect costs must be systematically allocated to the units produced. The allocation process involves several steps to accurately assign a portion of these indirect costs to each unit.
The initial step is to determine the total estimated fixed manufacturing overhead costs for a specific period. This involves summing all fixed expenses related to the production facility, such as rent, depreciation, and factory management salaries.
Next, a suitable allocation base must be chosen. This base should be a cost driver, meaning it is a factor that causes or influences overhead costs. Common allocation bases include direct labor hours, machine hours, or units produced.
The third step is to calculate the predetermined overhead rate. This rate is computed by dividing the total estimated fixed manufacturing overhead by the total estimated amount of the chosen allocation base. For example, if estimated fixed overhead is $50,000 and estimated machine hours are 10,000, the predetermined overhead rate would be $5 per machine hour ($50,000 / 10,000 hours).
Finally, the fixed overhead is applied to individual units by multiplying the predetermined overhead rate by the actual amount of the allocation base used per unit. If a product requires 2 machine hours and the rate is $5 per machine hour, then $10 of fixed manufacturing overhead is allocated to that product.