Absorbed costs

What Is Absorbed cost?

Absorbed cost, also known as absorption cost, is a managerial accounting method that includes both the variable and fixed overhead costs of producing a particular product. Knowing the full cost of producing each unit enables manufacturers to price their products.

Calculating absorbed costs is part of a broader accounting approach called absorption costing, also referred to as full costing or the full absorption method.

The absorbed cost is a method in management accounting that takes into account the general costs of producing a product (variable and fixed). Knowing the total cost of manufacturing the device, the manufacturer can price his products.

Absorbed Costs and Unabsorbed cost

The importance of this classification in the income determination process emanates from the fact that variable production cost is not the only true cost. Product costs should include some proportion of fixed costs. This can be understood by an example. Let us assume that the management decides that product manufactured on an operator-controlled machine be henceforth manufactured on an automated process involving high-cost machinery. Assume further, that as a result of the change in the production process, there will be no variation in material costs or variable manufacturing costs per unit. There will be a change indirect labor cost which henceforth will become part of the fixed cost associated with the machine. According to the definitions of product costs ( as per variable costing), the cost of production will be reduced by the direct labor cost, simply because of a change in the method of manufacture. Certainly, this is not a logical viewpoint. Therefore, the argument that the benefits of fixed costs lapse with the passage of time and, hence, must be absorbed by the revenues of that period only to which they relate ignores the point that facilities represented by those cost are value-creating.

From the above, it follows that fixed cost add value to the product and this value is a well-taken account of in determining the selling price. Therefore, such costs must be absorber by revenues of the period in which the products have been sold and not necessarily in the year in which they have been incurred, This fact that good is held as inventories so that can be sold in future further reinforces that above contention. Therefore, fixed costs are relevant and inventoriable. This argument is in line with another cost concept, namely, expired and unexpired cost.

Marginal costing:

  • In marginal costing, closing inventories are valued at marginal (variable) production cost whereas, in absorption costing, inventories are valued at their full production cost which includes absorbed fixed production overhead,
  • If the opening and closing inventory levels differ, the profit reported for the accounting period under the two methods of cost accumulation will, therefore, be different
  • But in the long run, total profit for a company will be the same whichever is used because, in the long run, total costs will be the same either method of accounting. Different accounting conventions merely affect the profit of individual periods

Fully Absorbed Cost vs. Variable Cost (Direct Cost)

Fully absorber cost refers to costs where fixed costs have been allocated to units or departments as required by generally accepted accounting principles. Variable costs, in contrast, may be more relevant for making decisions, such as setting prices.

Absorbed cost gives a much more comprehensive and accurate view of how much it costs to produce your inventory, in comparison to the variable cost method, which does not allocate any of the fixed manufacturing overhead. It breaks down fixed overhead into two categories: costs attributable to the cost of goods sold and those attributable to inventory. Either way, with variable costing (also called direct costing or marginal costing), fixed costs (those that don’t tend to change over time, like insurance or property tax) are not absorbed by the finished product.

Absorbed cost calculations produce a higher net income figure than variable cost calculations because more expenses are accounted for in unsold products, which reduces actual expenses reported. Also, net income increases as more items are produced, because fixed costs are spread across all units manufactured.

While absorbed costs are needed to prepare financial statements for financial reporting, variable costing is more useful for making internal pricing decisions, because it only includes the extra costs of producing the next incremental unit of a product. Variable costs can be more valuable for short-term decision-making, giving a guide to operating profit if there’s a bump-up in production to meet holiday demand, for example.

Fully Absorbed Cost vs. Full Cost

In full costing, all costs, manufacturing cost as well as central corporate expenses (including financing expenses), ale allocated to products or decisions, In full absorption costing, only manufacturing costs are allocated to products. Only in full costing will revenues, expenses, and income summed over all products or divisions equal corporate revenues, expenses, and income.

Pros and Cons of Absorbed Costs

By including overhead, in addition to more direct costs like materials and wages, calculating absorbed cost helps companies determine the overall cost of making and bringing to market a single product line, brand, or item—and which of these are the most profitable.

In corporate lingo, “absorbed costs” often refer to a fixed amount of expenses a company has designated for manufacturing costs for a single brand, line, or product. Absorbed cost allocations for one product produced may be greater or lesser than another.

If you want to get a clearer understanding of how much of your costs are being covered by sales income, you’ll need to take into account not just the actual expenses of making your product, but also the overhead expenses in running your company, which is where absorbed costs come into play.

On the downside, things can get a little tricky when it comes to making an exact calculation of absorbed costs, and knowing how much of them to include. If all of the variables are not considered carefully (including depreciation, administrative expenses, and yearly fluctuations in your expenses), it can give you misleading results.