Under generally accepted accounting principles (GAAP), absorption costing is required for external reporting. All normal manufacturing costs must be treated as product costs and subsequently included as inventory in the financial statements. Inventory costs are reflected in the income statement and the balance sheet.

What Is Absorption Costing?

Full absorption costing – normally simplified to absorption costing – is an accounting method that applies the fixed costs of production towards a good. This is often described as produced goods consuming or absorbing all costs associated with their manufacture.

In terms of financial reporting, inventory costs under full absorption costing include all direct materials, direct labor, variable overhead and fixed overhead. Alternatively, period costs include all Selling, General and Administrative (SG&A) expenses, whether variable or fixed.

External Reporting

GAAP only requires absorption costing for external reporting, not internal reporting. External reports are generated for public consumptions; in the case of publicly traded corporations, shareholders interact with external reports. External reports are designed to reveal financial health and attract capital.

Companies can use absorption, variable or throughput costing for internal reports. The U.S. Securities and Exchange Commission (SEC) and GAAP are primarily concerned with external reporting.

Absorption Costing Process

To complete periodic assignments of absorption costs to produced goods, a company must assign manufacturing costs and calculate their usage. Most companies use cost pools to represent accounts that are always used.

Once the cost pools have been determined, the company can calculate the amount of usage based on activity measures. Direct labor hours is an example of an activity measure. This usage measure can be divided into the cost pools, creating a cost rate per unit of activity.

Each unit of a produced good can now carry an assigned total production cost. This eliminates the distinctions between fixed and variable costs, thereby reflecting the impact of overhead on manufacturing.