Absorption Costing

What is Absorption Costing?

Definition: Absorption costing is a cost accounting method for valuing inventory. Absorption costing includes or “absorbs” all the costs of manufacturing a product including both fixed and variable costs. That means that all costs including direct, like material costs, and indirect, like overhead costs, are included in the price of inventory. Absorption costing gives a much more comprehensive and accurate view on how much it really costs to produce your inventory then the variable costing method.

Absorption costing (or full absorption costing) indicates that all of the manufacturing costs have been assigned to (or absorbed by) the units produced. In other words, the cost of a finished product will include the costs of:

  • Direct materials. Those materials that are included in a finished product.
  • Direct labor. The factory labor costs required to construct a product.
  • Variable manufacturing overhead. The costs to operate a manufacturing facility, which vary with production volume. Examples are supplies and electricity for production equipment.
  • Fixed manufacturing overhead. The costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.

Absorption costing is required for external financial reporting and for income tax reporting.

What Does Absorption Costing Mean?

What is the definition of absorption costing? Think about it like this. If Apple used full absorption costing when they were valuing their inventory of iPods, the inventory value would include the following: the materials to make the iPods, the money paid to workers to manufacture the iPods, the manufacturing overhead, as well as the fixed overhead for the entire operation. In contrast, variable costing only takes into consideration the first three of these costs or the variable costs.

I think this table might help show the differences between the two inventory valuable methods. The right column shows the absorption costing method. Notice that all the costs are included in the final inventory valuation. Take a look at the two total values of the inventory. Look how much less the variable costing method values your inventory. This could be a major problem when it comes to marketing and pricing your products.

If the management isn’t taking all fixed costs into consideration when valuing the true cost of producing inventory, the sales price might be too low and the company might actually be losing money on every product sold.

Example

CostsVariable Costing MethodAbsorption Costing Method
Cost of iPod Materials$57.92$57.92
Cost of Hourly Workers per iPod$18.25$18.25
Cost of Salary Workers per iPod$0$22.25
Cost of Utilities$0$2.75
Cost of Shipping Materials$1.85$1.85
Total Costs$78.02$102.77

As you can see, the AC method assigns the cost of the workers’ wages and the utility expenses to the merchandise being produced. In many ways, this is a more accurate way to account for the true cost of producing the products.

Another method of costing (known a direct costing or variable costing) does not assign the fixed manufacturing overhead costs to products.

Absorption Costing vs Variable Costing

The differences between absorption costing and variable costing lie in the treatment of fixed overhead costs. Absorption costing allocates fixed overhead costs across all units produced for the period. Variable costing, on the other hand, lumps all fixed overhead costs together and reports the expense as one line item separate from the cost of goods sold or still available for sale.

Variable costing does not determine a per-unit cost of fixed overheads while absorption costing does. Variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income on the income statement. Meanwhile, absorption costing will result in two categories of fixed overhead costs: those attributable to cost of goods sold and those attributable to inventory.

Advantages and Disadvantages of Absorption Costing

Assets, such as inventory, remain on the entity’s balance sheet at the end of the period. Because absorption costing allocates fixed overhead costs to both cost of goods sold and inventory, the costs associated with items still in ending inventory will not be captured in the expenses on the current period’s income statement. Absorption costing reflects more fixed costs attributable to ending inventory.

Absorption costing ensures more accurate accounting for ending inventory because the expenses associated with that inventory are linked to the full cost of the inventory still on hand. In addition, more expenses are accounted for in unsold products, which reduces actual expenses reported in the current period on the income statement. This results in a higher net income calculation when compared to variable costing calculations.

Because absorption costing includes fixed overhead costs in the cost of its products, it is unfavorable when compared to variable costing when management is making internal incremental pricing decisions. This is because variable costing will only include the extra costs of producing the next incremental unit of a product.

In addition, the use of absorption costing generates a unique situation in which simply manufacturing more items that go unsold by the end of the period will increase net income. Because fixed costs are spread across all units manufactured, the unit fixed cost will decrease as more items are produced. Therefore, as production increases, net income naturally rises because the fixed cost portion of the cost of goods sold will decrease.

Summary Definition

Define Absorption Costing: Absorption costing means a way to value inventory by assigning all fixed and variable manufacturing costs to the merchandise.

Absorption costing is a method for accumulating the costs associated with a production process and apportioning them to individual products. This type of costing is required by the accounting standards to create an inventory valuation that is stated in an organization’s balance sheet. A product may absorb a broad range of fixed and variable costs. These costs are not recognized as expenses in the month when an entity pays for them. Instead, they remain in inventory as an asset until such time as the inventory is sold; at that point, they are charged to the cost of goods sold.

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