Absorption costing refers to a method of costing to account for all the costs of manufacturing. The management uses this method to absorb the costs incurred on a product. The costs include direct costs and indirect costs. Direct costs include materials, labour used in production. Indirect costs include factory rent, administration costs, compliance, and insurance.
What Is Absorption Costing?
Absorption costing, sometimes called “full costing,” is a managerial accounting method for capturing all costs associated with manufacturing a particular product. The direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for by using this method. Absorption costing is required by generally accepted accounting principles (GAAP) for external reporting.
The Components of Absorption Costing
The key costs assigned to products under an absorption costing system are:
- 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.
- It is possible to use activity-based costing (ABC) to allocate overhead costs for inventory valuation purposes under the absorption costing methodology. However, ABC is a time-consuming and expensive system to implement and maintain, and so is not very cost-effective when all you want to do is allocate costs to be in accordance with GAAP or IFRS.
- You should charge sales and administrative costs to expense in the period incurred; do not assign them to inventory, since these items are not related to goods produced, but rather to the period in which they were incurred.
Steps of Absorption Costing
To utilize the Absorption costing method of cost allocation, we need to follow these three steps:
- Assign costs to cost pools – prepare a mapping of sets of accounts to various cost pools; this must be considered thoroughly, as regular changes are not welcome, because they hinder future analysis;
- Calculate the usage based on activity measures, e.g., labor or machine hours;
- Assing costs – calculate the allocation rate and allocate overhead to produced goods.
Absorption Costing vs. Variable Costing
Absorption costing allocates all non-direct manufacturing overheads to produced goods, whether these are sold or not, which is the main difference with variable costing. That way, in absorption costing, fixed production overheads are split in two – attributable to COGS (cost of goods sold) and attributable to inventory (finished goods ending balance).
Example of Absorption Costing
Company A is a manufacturer and seller of a single product. In 2016, the company reported the following costs:
Variable costs per unit:
- Direct materials cost: $25
- Direct labor cost: $20
- Variable manufacturing overhead cost: $10
- Variable selling and administrative cost: $5
- Fixed manufacturing overhead of $300,000
- Fixed selling and administrative of $200,000
Over the year, the company sold 50,000 units and produced 60,000 units, with a unit selling price of $100 per unit.
Using the absorption method of costing, the unit product cost is calculated as follows:
Direct materials + Direct labor + Variable overhead + Fixed manufacturing overhead allocated = $25 + $20 + $10 + $300,000 / 60,000 units = $60 unit product cost under absorption costing
Recall that selling and administrative costs (fixed and variable) are considered period costs and are expensed in the period occurred. Those costs are not included in the product costs.
Advantages Of Absorption Costing
There are several advantages to using full costing. Its main advantage is that it is GAAP-compliant. It is required in preparing reports for financial statements and stock valuation purposes.
In addition, absorption costing takes into account all costs of production, such as fixed costs of operation, factory rent, and cost of utilities in the factory. It includes direct costs such as direct materials or direct labor and indirect costs such as plant manager’s salary or property taxes. It can be useful in determining an appropriate selling price for products.
Disadvantages Of Absorption Costing
Since absorption costing includes allocating fixed manufacturing overhead to the product cost, it is not useful for product decision-making. Absorption costing provides a poor valuation of the actual cost of manufacturing a product. Therefore, variable costing is used instead to help management make product decisions.
Absorption costing can skew a company’s profit level due to the fact that all fixed costs are not subtracted from revenue unless the products are sold. By allocating fixed costs into the cost of producing a product, the costs can be hidden from a company’s income statement in inventory. Hence, absorption costing can be used as an accounting trick to temporarily increase a company’s profitability by moving fixed manufacturing overhead costs from the income statement to the balance sheet.
For example, recall in the example above that the company incurred fixed manufacturing overhead costs of $300,000. If a company produces 100,000 units (allocating $3 in FMOH to each unit) and only sells 10,000, a significant portion of manufacturing overhead costs would be hidden in inventory in the balance sheet. If the manufactured products are not all sold, the income statement would not show the full expenses incurred during the period.