Absorption Costing Details

Analysis Made for the Internal Accounting Configuration

By Emanuel F. Schwarz

(June 7, 1999) - Throughout their academic career, accounting students will be subjected to conflicting information regarding Absorption Costing.

A few well-known professors have presented graphics that show how the "overhead" costs will be absorbed by the Work In Process account (WIP) But, there is other terminology that could be used, and the overhead costs would, instead, be applied to the Work In Process accounts.

These graphics show just one overhead account and just one Work In Process. It is incorrect to assume that these graphics are only shown to students when they begin learning about cost accounting, or that as students progress in their studies, the graphics merely complement more advanced presentations.

It is my personal opinion that these particular professors do not have graphics showing more realistic presentations adapted to real-world conditions. Students and accounting professionals need more than one overhead and WIP account. They should also continue to recognize the Responsibility Accounting system, which states the departmental operating cost of all departments must be controlled.

Also, the term "overhead" should not be used. Rather, overhead should be replaced with "department." This old-fashioned teaching method has created real-life presentations of our Chart of Accounts with just one overhead and one WIP account.

CPAs and their companies need to develop an interest in accounting structures that account for each and every department in a company. CPA companies that do not adapt the system prefer to continue using one overhead account rather than reeducating their staff on how to use several responsibility centers.

How An Advanced Internal Accounting Structure Develops An Absorption System.

Within the Class 5 structure, there are accounts referring to all Functional Activities. These accounts will be debited with the absorbed values that are transferred from different department accounts in Class 4. The Direct Production Departments are the most important departments that will apply their Departmental Operating Cost to the different Production cost accounts in Class 5.

These Direct Production Departments work to fulfill the quantity of production planned by management. Their departmental operating cost is budgeted in order to meet production requirements established by management.

As seen in Exhibit 5-1, the first group of accounts in Class 5 will start with the Production Cost Accounts of the Finished Products. These product will finally be transferred to the Inventory of Finished Products.

The next group of Class 5 accounts refers to the purported Semi-Finished Products, produced with the purpose of being used in the final production line. Normally these Semi-Finished Products will not be sold. From the production departments, the products enter the inventory of Semi-Finished Products.

The Indirect Production costs, in Direct Production Department, Class 3, will be charged to different Production cost accounts by using corresponding accounts in Class 4.

The table provides an illustration of the different rates that are used to apply the departmental operating cost (Indirect Production cost) to the corresponding Production cost accounts. Observe the transfer in Exhibit 5-1 along the lines that move from the circles of Class 4 (crediting these accounts) to the debits in Class 5.

This first step applies to the Production cost accounts, the corresponding part of the departmental operating cost of the Direct Production Departments. The next step would be to use the same procedure with the departmental operating cost of Direct Production Department while working with the Semi-Finished Products. Apply a corresponding amount from the maintenance department to the Maintenance Costs accounts in Class 5, Group 3.

Use the same procedure with the Repair Departments operating cost, which will be taken to the specific Repair Cost accounts in Class 5, Group 4. Finally, charge the Construction Cost account with the amounts of Indirect Cost for departments who worked with these constructions.

As soon as the Indirect Production costs (from Class 4 ) are fully applied to the Functional Activity accounts in Class 5, the amounts charged to these activity accounts can be analyzed.

The values we charged to the Direct Production Departments in Class 3 are the amounts transferred from Class 4 to the Finished Product accounts. Remember that the Direct Production Departments in Class 3 were not only charged the Indirect Operating Cost of the department, but also reallocated amounts of different departments that gave some type of support to these Direct Production Departments.

These conditions must be realized to fulfill the ideas of the Activity Based Costing system (ABC).

Under special circumstances some of the Maintenance Costs can be reapplied to the Finished Products Production cost accounts. An example: if equipment is used consistently during a fiscal year with the same final product; the monthly Maintenance Costs of this equipment could be reapplied to the Finished Product account.

Both the Repair Cost and the Cost of Constructions projects should be taken monthly to Class 7, which should have accounts for keeping these investments with the assts.