Absorption Costing

Loading the player...

What is 'Absorption Costing'

Absorption costing is a managerial accounting cost method of expensing all costs associated with manufacturing a particular product and is required for generally accepted accounting principles (GAAP) external reporting. Some of the direct costs associated with manufacturing a product include wages for workers physically manufacturing a product, the raw materials used in producing a product, and all of the overhead costs, such as all utility costs, used in producing a good. Absorption costing includes anything that is a direct cost in producing a good as the cost base.

BREAKING DOWN 'Absorption Costing'

Absorption costing is also called full costing as all costs – including fixed overhead charges – are included as product costs. As opposed to the other alternative costing method called variable costing, every expense is allocated to products manufactured whether or not they are sold.

Absorption Costing Vs. Variable Costing

Absorption costing entails allocating 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. Variable costing does not determine a per-unit cost of fixed overhead while absorption costing does. Variable costing will yield one lump-sum expense for fixed overhead costs when calculating net income. 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 of Absorption Costing

Absorption costing does not account for all fixed expenses which reflects certain situations in which all the inventory is not sold. Because assets remain part of the entity’s books at the end of the period, absorption costing reflects more fixed costs attributable to those items within ending inventory. For some, absorption costing will result in more accurate accounting regarding ending inventory. In addition, more expenses are accounted for in unsold products which reduces actual expenses reported. This results in a higher net income calculation when compared to variable costing calculations.

Disadvantages of Absorption Costing

Because absorption costing includes overhead costs, it is unfavorable when compared to variable costing when 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 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 increase due to the fixed cost aspect of the cost of goods sold decreasing.

RELATED TERMS
  1. Full Costing

    A managerial accounting method that describes when all fixed ...
  2. Unit Cost

    The cost incurred by a company to produce, store and sell one ...
  3. Operating Cost

    Expenses associated with the maintenance and administration of ...
  4. Overhead Rate

    In managerial accounting, a cost added on to the direct costs ...
  5. Cost Accounting

    A type of accounting process that aims to capture a company's ...
  6. Variable Cost

    A corporate expense that varies with production output. Variable ...
Related Articles
  1. Investing

    What is Absorption Costing?

    Absorption costing is an accounting method primarily used in manufacturing. In absorption costing, the cost of a manufactured product includes the direct costs plus an apportioned share of the ...
  2. Personal Finance

    Understanding Absorption Rate

    Absorption rate is the rate at which homes sell in a given area over a given time period.
  3. Markets

    Understanding Marginal Cost of Production

    Marginal cost of production is an economics term that refers to the change in production costs resulting from producing one more unit.
  4. Entrepreneurship & Small Business

    What Are The Different Types Of Costs In Cost Accounting?

    Cost accounting measures several different types of costs associated with a company’s production processes.
  5. Investing

    What is Incremental Cost?

    Incremental cost is the added cost of manufacturing one more unit.
  6. Investing

    What are Fixed Costs?

    Fixed costs are business expenses that do not change as the level of production goes up or down. They are one of two types of business expense, the other being variable costs. Variable costs ...
  7. Investing

    Variable Costs

    Variable costs go up when a company produces more goods or services, and go down when it produces fewer goods or services. This is compared to fixed costs, which do not change in proportion to ...
  8. Markets

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  9. Markets

    What's Overhead?

    Overhead is an accounting term used for expenses that have to be paid even if the business doesn’t earn any revenue. The business would not be able to operate without paying its overhead expenses, ...
  10. Investing

    Explaining Prime Cost

    Prime cost is a way of measuring the total cost of the production inputs needed to create a given output.
RELATED FAQS
  1. What are the differences between absorption costing and variable costing?

    Examine the main differences between absorption costing and variable costing, along with the advantages and disadvantages ... Read Answer >>
  2. What are some of the advantages and disadvantages of absorption costing?

    Examine the absorption costing method for accounting purposes, and learn about the advantages and disadvantages associated ... Read Answer >>
  3. Why are fixed manufacturing costs included in inventories through the absorption ...

    Learn about the absorption costing method. Understand why fixed manufacturing costs are included in inventories through the ... Read Answer >>
  4. How is absorption costing treated under GAAP?

    Read about the required use of the absorption costing method for all external reports under generally accepted accounting ... Read Answer >>
  5. How is overhead distributed through total absorption costing?

    Learn how overhead is distributed through total absorption costing, and the steps required for a company to determine its ... Read Answer >>
  6. How are fixed costs treated in cost accounting?

    Learn how fixed costs and variable costs are used in cost accounting to help a company's management in budgeting and controlling ... Read Answer >>
Hot Definitions
  1. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  2. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  3. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  4. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
  5. Weighted Average Life - WAL

    The average number of years for which each dollar of unpaid principal on a loan or mortgage remains outstanding. Once calculated, ...
  6. Real Rate Of Return

    The annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other ...
Trading Center