Absorption Costing: Definition, Tips and Examples
Updated March 10, 2023
Absorption costing is an accounting method that can provide invaluable insight into the full cost of producing an individual product. It is a requirement of generally accepted accounting principles (GAAP) for external reports.
In this article, we'll define absorption costing, compare it to variable costing and list steps for calculating the price per unit using this method. We also review some of the advantages and disadvantages of this methodology and give an example.
Related: SMART Goals: Definition and Examples
What is absorption costing?
Absorption costing—also referred to as “full absorption costing" or "full costing"—is an accounting method designed to capture all of the costs that go into manufacturing a specific product. Absorption costing is necessary to file taxes and issue other official reports. Regardless of whether every manufactured good is sold, every manufacturing expense is allocated to all products. In other words, the company’s products absorb all the company’s costs.
Some of these costs include:
Labor: The direct factory labor used to manufacture a product. This cost is directly associated with wages paid during production.
Raw materials: The materials used to construct a finished product are calculated as well.
Variable manufacturing overhead: The costs necessary to run a production facility. They are variable costs because they vary with the volume of production. Examples of variable manufacturing overhead are electricity, utilities and supplies used by the manufacturing equipment.
Fixed manufacturing overhead: The costs associated with operating a production facility that remain fixed, regardless of production volume. Examples include insurance and rent.
Absorption costing is an inventory valuation, which means that it is not a regular expense but rather a capitalized cost that is tracked on the balance sheet until the product is sold. GAAP requires the use of absorption costing when generating external financial reports and income tax reports.
Costs can be categorized as product costs or period costs. Administrative and sales costs should be assigned to reporting periods—period costs—instead of inventory—product costs. This is because they are related to a specific period more than they are associated with goods produced. Product costs are more directly related to the manufacturing of the product.
In absorption costing, expenses related to production are listed as an asset in inventory accounts until the product is sold, then they are allocated to the cost of sold goods. Common inventory accounts include raw materials, works in progress and finished goods or variants of these names. These accounts track costs through the production stages: before production begins, during production and once production is completed.
Absorption costing vs. variable costing
Absorption costing considers direct materials, direct labor, variable manufacturing overhead and fixed manufacturing overhead as product costs. Variable costing, also referred to as “direct costing,” uses direct materials, direct labor and variable manufacturing overhead as product costs. Unlike absorption costing where fixed overhead costs are assigned to every product manufactured in a specific period, variable costing expenses all fixed overhead costs as period costs.
How to calculate absorption costing
Here are some steps for calculating and assigning absorption costing:
1. Develop cost pools
First, determine the costs associated with the production of a product and then assign them to different cost pools. A cost pool groups expenses by activity. You might group marketing, customer service and research and development into different cost pools. As you spend money, you will assign costs to the cost pool that best describes it.
2. Determine usage for each cost
Next, go through every activity and figure out the amount each was used during production. You will need to determine usage for activities such as the number of hours spent on labor or equipment usage throughout the manufacturing process.
3. Calculate the costs
Lastly, calculate the allocation rate, which tells you the cost per unit. You can do this by following this formula:
Absorption cost per unit = (Direct Material Costs + Direct Labor Costs + Variable Manufacturing Overhead Costs + Fixed Manufacturing Overhead Costs) / Number of units produced
Advantages of absorption costing
Though absorption costing is required to comply with GAAP, there are also several advantages to using this system.
Accounting for all production costs
Absorption costing takes every cost associated with production into account, making it an invaluable tool when determining appropriate product pricing. This information allows companies to ensure that their product's price point covers expenses involved in production. It also enables them to price their products more competitively within their market.
Absorption costing gives a company a more accurate picture of profitability especially if all of its products are not sold during the same period when they are manufactured. This is an important consideration if a company plans to ramp up production in anticipation of a seasonal sales increase.
Suitable for smaller companies
Absorption costing makes it easier for small businesses to track since they probably do not have a large number of products. The companies can absorb fixed costs in advance and sell their products for a more realistic price and profit.
Suitable for changing demands
Absorption costing is an advantage for companies that have a constant demand for products. It provides a simple and systematic costing tool for active businesses while taking into account the fluctuating turnover as costs are already fixed to the products.
Disadvantages of absorption costing
Though absorption costing is extremely useful, there are some disadvantages to this method of costing. Some of absorption costing's disadvantages include:
Over-assigning overhead costs
With absorption costing, even overhead costs that are unable to be directly traced back to the product are assigned to each unit.
Overproduction to cut costs
This pricing method makes it possible to increase profitability by overproducing a product. That is because the fixed overhead is assigned to the total number of produced units, lowering the cost for each additional unit produced. Then, when units are left unsold, the fixed overhead costs aren't transferred to expense reports, increasing profitability.
The data gathered for determining a product's cost through absorption costing includes fixed overhead. This can inflate the actual cost of manufacturing and result in insufficient data to perform a comprehensive analysis.
Since fixed costs are unable to be subtracted from revenue until the units are sold, absorption costing can provide an incomplete view of a company's profit levels. This can result in costs that remain unaccounted for on a company's income statement, temporarily increasing a company's apparent profitability on its balance sheet.
Examples of absorption costing
Here are some examples of absorption costing:
A company produces 10,000 units of its product in one month. Of the 10,000 units produced, 8,000 are sold that month with 2,000 left in inventory. Each unit requires $5 of direct materials and labor. Additionally, the production facility requires $20,000 of monthly fixed overhead costs.
The company uses the absorption costing method to determine the fixed overhead costs per unit. They calculate that there are $2 of fixed overhead costs that go into manufacturing each unit by dividing the fixed overhead costs by the number of units produced that month ($20,000 / 10,000 units = $2 per unit).
After determining the fixed overhead costs per unit, the company can add the cost of labor and materials to determine that each unit produced has an absorption cost of $7 ($2 fixed overhead costs + $5 variable overhead costs = $7).
The company can then calculate that the total cost of goods sold is $56,000 by multiplying the absorption cost times the number of units sold (8,000 units sold times $7 cost per unit = $56,000). That means that there is $14,000 worth of remaining inventory (2,000 units times $7 cost per unit = $14,000).
A company produced 60,000 units in the accounting period. It sold 50,000 units with 10,000 still in inventory. It sold each unit for $100.
Each unit costs $25 in direct materials and $20 in direct labor. Manufacturing overhead was $10 plus $5 in variable administrative costs. Fixed manufacturing overhead was $300,000. Fixed administrative costs were $200,000.
The company applied the absorption cost per unit formula:
(Direct Material Costs + Direct Labor Costs + Variable Manufacturing Overhead Costs + Fixed Manufacturing Overhead Costs) / Number of units produced. ($25+$20+$10+$300,000 / $600,000 = $60 per unit product cost.)
The inventory (10,000 units) left in the company’s warehouse is then valued at $600,000 in absorptive costing.
Read more: What Is the Absorption Costing Formula?
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