What Is Absorption Costing?
A management accounting approach called absorption costing, sometimes known as “full costing,” captures all product production expenses. This technique includes all direct and indirect expenses, including supplies, labor, rent, and insurance.
U.S. corporations may employ absorption costing but not variable costing under GAAP for external reporting.
Understanding Absorption Costing
Absorption costing integrates all direct costs of manufacturing an item in its cost base. Product expenses include fixed overhead in absorption costing. Wages for workers on the product, raw materials, and overhead expenditures like power bills are all part of product manufacturing.
In contrast to variable costing, all expenses are assigned to produced items, regardless of sales.
Components of Absorption Costing
Absorption costing includes direct and indirect expenses. Direct expenses may be linked to a product or service. Production costs include raw materials, labor, and other direct charges.
Indirect expenses cannot be linked to a product or service. Overhead expenditures include electricity, rent, and insurance. Indirect expenses are usually attributed to goods or services based on activity, such as units generated or direct work hours.
In absorption costing, direct and indirect expenses are incorporated into product prices. This implies that each product unit’s cost comprises direct and indirect manufacturing expenses. Divide the total production expenses by the number of units produced to get the unit cost.
The formula for absorption costing can be written as follows:
Absorption cost = (Direct labor costs + Direct material costs + Variable manufacturing overhead costs + Fixed manufacturing overhead) / Number of units produced.
Absorption Costing vs. Variable Costing
Absorption and variable costing are used to determine product and service costs. Both approaches determine product costs but include different expenses and are utilized for different objectives. Absorption and variable costing vary in how fixed overhead expenses are considered.
Under absorption costing, all direct and indirect production expenses are included in product prices. Thus, each unit of a product comprises direct and indirect manufacturing costs, such as raw materials and labor, as well as overhead charges. Absorption costing is used for external reporting, such as financial statement cost of goods sold.
Variable costing solely covers direct product expenses. Variable costing excludes indirect or overhead costs from product costs. They are reflected in the income statement as period expenses in the time they are incurred. Variable costing is utilized for management decision-making and planning because it better represents the incremental costs of manufacturing an extra product unit.
Absorption costing determines constant overhead per-unit costs, but variable costing does not. The net income statement will include one lump-sum expenditure line item for fixed overhead expenses with variable costing. Absorption costing creates two fixed overhead costs: inventory and cost of goods sold.
Advantages and Disadvantages of Absorption Costing
Inventory stays on the balance sheet after the quarter. The current period’s income statement will not include costs connected with products remaining in ending inventory since absorption costing assigns fixed overhead costs to both cost of goods sold and inventory. Ending inventory has higher fixed costs in absorption costing.
Absorption costing better accounts for ending inventory since its expenditures are connected to the entire cost of the remaining goods. More expenditures are accounted for in unsold items, reducing current income statement expenses. This yields a better net revenue than variable costs.
Absorption costing is unfriendly to variable costing when management makes internal incremental pricing choices because it adds fixed overhead expenses to product prices. Variable costing includes the additional expenses of making the next incremental product unit.
Absorption costs also increase net profitability by producing more unsold products. Fixed costs are shared over all units created. Therefore unit fixed costs fall when more is produced. Since output grows, net income rises because the fixed-cost element of the cost of goods sold decreases.
Example of Absorption Costing
Say ABC Company manufactures widgets. It created 10,000 widgets in January, selling 8,000 by month’s end and keeping 2,000. Each widget needs $5 in direct labor and materials. The manufacturing plant has monthly fixed overhead expenses of $20,000. ABC will allocate $2 per widget for fixed overhead expenses using the absorption costing approach ($20,000 total ÷ 10,000 widgets produced monthly).
The unit absorption cost is $7 ($5 labor and materials + $2 fixed overhead). With 8,000 widgets sold, the total cost of products sold is $56,000 ($7 per unit x 8,000 units). The finishing inventory will cost $14,000 worth of widgets ($7 per unit x 2,000 units).
What’s the Difference Between Variable Costing and Absorption Costing?
Fixed overhead expenses are treated differently in absorption and variable costing. Fixed overhead expenses are absorbed overall time units in absorption costing. However, variable costing aggregates all fixed overhead expenses and presents them as one line item distinct from the cost of commodities sold or offered for sale. Thus, when computing net income, variable costing will result in one lump-sum expenditure line item for fixed overhead expenses. In contrast, absorption costing will result in two categories: cost of goods sold and inventory.
What Are the Advantages of Absorption Costing?
The fundamental benefit of absorption costing is that it follows GAAP, which the IRS requires. It also accounts for all production expenses, including fixed costs, and more precisely measures profit within an accounting period.
What Are the Disadvantages of Absorption Costing?
The biggest drawback of absorption costing is that it might exaggerate a company’s profitability during an accounting period since all fixed costs are not subtracted from revenues until all produced items are sold. It also hinders operational and financial efficiency analysis and product line comparison.
When Is It Appropriate to Use Absorption Costing?
Absorption costing is utilized when a corporation wishes to know the whole cost of a product or service. This involves reporting financial outcomes to shareholders or regulatory organizations.
Absorption costing is also utilized for internal decisions like product pricing and production. The corporation may utilize absorption costing to assess the whole cost of manufacturing and if the product generates enough earnings to support its continuous production.
What Are the Types of Absorption Costing?
Absorption costs might be complete or partial:
- Total absorption costing comprises fixed and variable costs for product and service production. Under full absorption costing, a product or service’s complete cost is divided among units produced. The cost of each unit produced comprises a percentage of fixed and variable expenses.
- Partial absorption costing comprises just part of product or service production expenses. Each unit produced under partial absorption pricing includes just a percentage of fixed expenses. The remaining fixed expenses are expensed in the time they are incurred.
- Unlike variable costing, absorption costing assigns fixed overhead expenses to each product produced in time.
- Absorption costing assigns fixed overhead costs to products regardless of sales.
- This costing approach adds greater cost to ending inventory, carried over as a balance sheet asset.
- Absorption costing lowers income statement costs since ending inventory has larger expenditures.