Absorption Costing Explained, With Pros and Cons and Example

Absorption Costing

Investopedia / Michela Buttignol

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. All direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for when using this method.

Under generally accepted accounting principles (GAAP), U.S. companies may use absorption costing for external reporting, however variable costing is disallowed.

Key Takeaways

  • Absorption costing differs from variable costing because it allocates fixed overhead costs to each unit of a product produced in the period.
  • Absorption costing allocates fixed overhead costs to a product whether or not it was sold in the period.
  • This type of costing method means that more cost is included in the ending inventory, which is carried over into the next period as an asset on the balance sheet.
  • Because more expenses are included in ending inventory, expenses on the income statement are lower when using absorption costing.
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Absorption Costing

Understanding Absorption Costing

Absorption costing includes anything that is a direct cost in producing a good in its cost base. Absorption costing also includes fixed overhead charges as part of the product costs. Some of the costs associated with manufacturing a product include wages for employees physically working on the product, the raw materials used in producing the product, and all of the overhead costs (such as all utility costs) used in production.

In contrast to the variable costing method, every expense is allocated to manufactured products, whether or not they are sold by the end of the period.

Higher and Lower Items

Absorption costing means that ending inventory on the balance sheet is higher, while expenses on the income statement are lower.

Components of Absorption Costing

The components of absorption costing include both direct costs and indirect costs. Direct costs are those costs that can be directly traced to a specific product or service. These costs include raw materials, labor, and any other direct expenses that are incurred in the production process.

Indirect costs are those costs that cannot be directly traced to a specific product or service. These costs are also known as overhead expenses and include things like utilities, rent, and insurance. Indirect costs are typically allocated to products or services based on some measure of activity, such as the number of units produced or the number of direct labor hours required to produce the product.

In absorption costing, both direct and indirect costs are included in the cost of a product. This means that the cost of each unit of a product includes not only the direct costs of producing that unit, but also a portion of the indirect costs that were incurred in the production process. The total manufacturing costs are then divided by the number of units produced to determine the cost of each unit. The formula for absorption costing can be written as follows:

Absorption cost = (Direct labor costs + Direct material costs + Variable manufacturing overhead costs + Fixed manufacturing overhead) / Number of units produced.

Absorption Costing vs. Variable Costing

Absorption costing and variable costing are two different methods of costing that are used to calculate the cost of a product or service. While both methods are used to calculate the cost of a product, they differ in the types of costs that are included and the purposes for which they are used. The differences between absorption costing and variable costing lie in how fixed overhead costs are treated.

Under absorption costing, all manufacturing costs, both direct and indirect, are included in the cost of a product. This means that the cost of each unit of a product includes not only the direct costs of producing that unit, such as raw materials and labor, but also a portion of the indirect costs that were incurred in the production process, such as overhead expenses. Absorption costing is typically used for external reporting purposes, such as calculating the cost of goods sold for financial statements.

Variable costing, on the other hand, only includes direct costs in the cost of a product. Indirect costs, or overhead expenses, are not included in the cost of the product under variable costing. Instead, they are treated as a period expense and are recorded in the income statement in the period in which they are incurred. Variable costing is typically used for management decision-making and planning purposes, as it provides a more accurate representation of the incremental costs associated with producing an additional unit of a product.

Variable costing does not determine a per-unit cost of fixed overheads, while absorption costing does. Variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income on the income statement. Absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.

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Higher Net Income

Absorption costing results in a higher net income compared with variable costing.

Advantages and Disadvantages of Absorption Costing

Assets, such as inventory, remain on the entity’s balance sheet at the end of the period. Because absorption costing allocates fixed overhead costs to both cost of goods sold and inventory, the costs associated with items still in ending inventory will not be captured in the expenses on the current period’s income statement. Absorption costing reflects more fixed costs attributable to ending inventory.

Absorption costing ensures more accurate accounting for ending inventory because the expenses associated with that inventory are linked to the full cost of the inventory still on hand. In addition, more expenses are accounted for in unsold products, which reduces actual expenses reported in the current period on the income statement. This results in a higher net income calculation compared with variable costing calculations.

Because absorption costing includes fixed overhead costs in the cost of its products, it is unfavorable compared with variable costing when management is 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 situation in which simply manufacturing more items that go unsold by the end of the period 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 rises, because the fixed-cost portion of the cost of goods sold will decrease.

Pros and Cons of Absorption Costing

Pros
  • Provides a more complete picture of the total cost of a product by including both direct and indirect costs.

  • Helps in determining the total actual cost of goods sold and the cost of inventory on the balance sheet.

  • Allows a company to understand the full cost of each product or service it provides.

Cons
  • May not accurately reflect the incremental costs associated with producing an additional unit of a product, as it includes fixed overhead costs that do not vary with production volume.

  • Can lead to distorted cost data if there are significant changes in production volume.

  • May not provide as much information for management decision-making as variable costing.

Example of Absorption Costing

Assume that ABC Company makes widgets. In January, it makes 10,000 widgets, of which 8,000 are sold by the end of the month, leaving 2,000 still in inventory. Each widget uses $5 of labor and materials directly attributable to the item. In addition, there are $20,000 of fixed overhead costs each month associated with the production facility. Under the absorption costing method, ABC will assign an additional $2 to each widget for fixed overhead costs ($20,000 total ÷ 10,000 widgets produced in the month).

The absorption cost per unit is $7 ($5 labor and materials + $2 fixed overhead costs). As 8,000 widgets were sold, the total cost of goods sold is $56,000 ($7 total cost per unit × 8,000 widgets sold). The ending inventory will include $14,000 worth of widgets ($7 total cost per unit × 2,000 widgets still in ending inventory).

What’s the Difference Between Variable Costing and Absorption Costing?

Absorption costing and variable costing treat fixed overhead costs differently. Absorption costing allocates fixed overhead costs across all units produced for the period. Variable costing, on the other hand, adds all fixed overhead costs together and reports the expense as one line item separate from the cost of goods sold or still available for sale. In other words, variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income, while absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.

What Are the Advantages of Absorption Costing?

The main advantage of absorption costing is that it complies with generally accepted accounting principles (GAAP), which are required by the Internal Revenue Service (IRS). Furthermore, it takes into account all of the costs of production (including fixed costs), not just the direct costs, and more accurately tracks profit during an accounting period.

What Are the Disadvantages of Absorption Costing?

The main disadvantage of absorption costing is that it can inflate a company’s profitability during a given accounting period, as all fixed costs are not deducted from revenues unless all of the company’s manufactured products are sold. Additionally, it is not helpful for analysis designed to improve operational and financial efficiency or for comparing product lines.

When Is It Appropriate to Use Absorption Costing?

Absorption costing is typically used in situations where a company wants to understand the full cost of producing a product or providing a service. This includes cases where a company is required to report its financial results to external stakeholders, such as shareholders or regulatory agencies.

Absorption costing is also often used for internal decision-making purposes, such as determining the selling price of a product or deciding whether to continue producing a particular product. In these cases, the company may use absorption costing to understand the full cost of producing the product and to determine whether the product is generating sufficient profits to justify its continued production.

What Are the Types of Absorption Costing?

There are two main types of absorption costing: full absorption costing and partial absorption costing:

  • Full absorption costing includes all of the costs associated with producing a product or providing a service, including both fixed and variable costs. Under full absorption costing, the total cost of a product or service is absorbed, or spread out, over the units produced. This means that the cost of each unit produced includes a portion of the fixed costs, as well as the variable costs associated with that unit.
  • Partial absorption costing includes only some of the costs associated with producing a product or providing a service. Under partial absorption costing, only a portion of the fixed costs are included in the cost of each unit produced. The remainder of the fixed costs are treated as a period cost and are expensed in the period in which they are incurred.

The Bottom Line

Absorption costing is a method of costing that includes all manufacturing costs, both fixed and variable, in the cost of a product. It is also known as full costing or full absorption costing. Absorption costing is used to determine the cost of goods sold and ending inventory balances on the income statement and balance sheet, respectively. It is also used to calculate the profit margin on each unit of product and to determine the selling price of the product.

Under absorption costing, the fixed manufacturing overhead costs are included in the cost of a product as an indirect cost. These costs are not directly traceable to a specific product but are incurred in the process of manufacturing the product. The fixed manufacturing overhead costs are allocated to each unit of product based on a predetermined overhead allocation rate, which is calculated by dividing the total estimated fixed manufacturing overhead costs by the total number of units that are expected to be produced. In addition to the fixed manufacturing overhead costs, absorption costing also includes the variable manufacturing costs in the cost of a product. These costs are directly traceable to a specific product and include direct materials, direct labor, and variable overhead.