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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 rises because the fixed cost aspect of the cost of goods sold will decrease.

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