Under generally accepted accounting principles (GAAP), absorption costing is required for external reporting. Absorption costing is an accounting method that captures all of the costs involved in manufacturing a product when valuing inventory. The method includes direct costs and indirect costs and is helpful in determining the cost to produce one unit of goods.

Key Takeaways

  • Full absorption costing–also called absorption costing–is an accounting method that captures the costs involved in manufacturing a product.
  • The costs can include both direct costs, indirect costs, variable overhead, and fixed overhead.
  • Under full absorption costing, it allocates fixed overhead costs to each unit of a good produced in the period.

Understanding Absorption Costing

Full absorption costing–also called absorption costing–is an accounting method that captures all of the costs involved in manufacturing a product. The costs can include both direct costs and indirect costs.

Under absorption costing, the cost of each product will include:

  • Direct materials, such as inventory or raw materials
  • Direct labor, such as workers directly involved production
  • Variable costs and overhead, such as the electricity needed for the building and production
  • Fixed costs that are involved in production, such as rent for the building

Under full absorption costing, variable overhead and fixed overhead are included, meaning it allocates fixed overhead costs to each unit of a good produced in the period–whether the product was sold or not. The treatment of fixed overhead costs is different than variable costing, which does not include manufacturing overhead in the cost of each unit produced.

It's important to note that period costs are not included in full absorption costing. Period costs are the overhead costs not involved in production. In other words, a period cost is not included within the cost of goods sold (COGS) on the income statement. COGS are the costs directly involved in production, such as inventory. Instead, period costs are typically classified as 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.