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

RELATED TERMS
  1. Absorption Rate

    Absorption rate is the rate at which homes are sold during a ...
  2. Variable Overhead

    Variable overhead is the indirect cost of operating a business, ...
  3. Fixed Cost

    A fixed cost is an expense that remains the same regardless of ...
  4. Operating Cost

    Operating costs are expenses associated with the maintenance ...
  5. Variable Cost Ratio

    The variable cost ratio compares costs, which fluctuate depending ...
  6. Applied Cost

    Applied cost is a term used in cost accounting to denote the ...
Related Articles
  1. Investing

    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.
  2. Investing

    Key Financial Ratios for Manufacturing Companies

    An investor can utilize these financial ratios to determine whether a manufacturing company is efficient, profitable and a good long-term investment option.
  3. Investing

    Analyzing Operating Margins

    Learn how to analyze operating margins and how to put this aspect of equity analysis to work.
  4. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  5. Personal Finance

    Can You Afford Not to Hire a Financial Advisor?

    People often worry about how much a financial advisor costs instead of what it costs not to have one.
  6. Investing

    The Economics of Owning a Coffee Shop

    Understand the economics of owning and running a coffee shop. Learn the basics of taking into account fixed, variable, and initial costs.
  7. Retirement

    How To Use The 4-Box Strategy For Retirement Income

    In today's volatile market, Generation X can't sit around waiting for things to improve. Gen X must implement innovative strategies for retirement planning.
  8. Investing

    Fixed Income Trader: Career Path & Qualifications

    Discover the career path the most fixed income traders follow and learn more about the qualifications needed and the average salary they earn.
RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. 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 >>
  4. What are the types of costs in cost accounting?

    Cost accounting aids in decision-making by helping a company's management evaluate its costs. There are various types of ... Read Answer >>
  5. What are some examples of overhead treatment in cost accounting?

    Look at a brief example of how cost accounting treats overhead expenses, how those expenses are different from direct labor, ... Read Answer >>
  6. Does gross profit include labor and overhead?

    Gross profit is a company's profit after subtracting the costs of producing the goods and services. Several costs impact ... Read Answer >>
Trading Center