“Absorption costing”, also known as full costing, is an accounting method that includes all manufacturing costs—both variable and fixed—when calculating the total cost of a product. This means that direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead are all assigned to the cost of goods produced.
Absorption costing is required under Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) for external financial reporting. Unlike variable costing, which only includes variable manufacturing costs, absorption costing provides a more comprehensive view of production expenses.
Key Components of “Absorption Costing”
Under absorption costing, the total cost of a product includes four main components:
- Direct Materials: The raw materials that go into making the product.
- Direct Labor: The wages of workers directly involved in production.
- Variable Manufacturing Overhead: Costs that fluctuate with production levels, such as utilities and indirect materials.
- Fixed Manufacturing Overhead: Costs that remain constant regardless of production levels, including rent, salaries of factory supervisors, and depreciation on factory equipment.
By incorporating fixed manufacturing overhead into product costs, absorption costing ensures that all production costs are accounted for when determining profitability.
How to Calculate “Absorption Costing”
The formula for calculating the total cost per unit under absorption costing is:
Total Cost per Unit = (Direct Materials + Direct Labor + Variable Manufacturing Overhead + Fixed Manufacturing Overhead) ÷ Total Units Produced
Example Calculation:
- Direct Materials Cost: $10 per unit
- Direct Labor Cost: $8 per unit
- Variable Overhead: $5 per unit
- Total Fixed Overhead: $100,000
- Units Produced: 10,000
Fixed Overhead Cost per Unit: $100,000 ÷ 10,000 = $10
Total Cost per Unit: $10 + $8 + $5 + $10 = $33
Comparison: “Absorption Costing” vs. “Variable Costing”
Absorption costing differs from variable costing in how it treats fixed manufacturing overhead. Here’s a side-by-side comparison:
| Factor | Absorption Costing | Variable Costing |
|---|---|---|
| Fixed Manufacturing Overhead | Included in product costs | Treated as a period expense |
| Net Income in High Production Periods | Higher because fixed costs are spread across more units | Lower because fixed costs are expensed immediately |
| Impact on Inventory Valuation | Higher inventory values due to included fixed costs | Lower inventory values |
| GAAP and IFRS Compliance | Required for financial reporting | Not accepted for external reporting |
Advantages of “Absorption Costing”
- Required by Accounting Standards: GAAP and IFRS mandate absorption costing for external reporting.
- More Accurate Profit Measurement: Since all manufacturing costs are included, profitability is more accurately reflected.
- Encourages Full Cost Awareness: Helps businesses understand the complete cost structure of their products.
- Better Matching of Costs and Revenues: Costs are expensed when the related products are sold, aligning expenses with revenue generation.
Disadvantages of “Absorption Costing”
- Can Distort Profitability: If production levels fluctuate, net income may appear higher due to unsold inventory carrying fixed overhead costs.
- Not Useful for Decision-Making: Since fixed costs are spread over all units, businesses may struggle to determine the true variable cost per unit.
- Encourages Overproduction: Managers might produce more than necessary to reduce per-unit fixed costs, leading to excess inventory.
Real-World Applications of “Absorption Costing”
Absorption costing is widely used across various industries, including:
- Manufacturing: Companies like automobile manufacturers use absorption costing to calculate the full cost of producing vehicles.
- Retail: Businesses with inventory, such as clothing stores, incorporate all direct and indirect costs into pricing strategies.
- Pharmaceuticals: Drug manufacturers account for all costs, including research and production, to comply with financial reporting requirements.
How “Absorption Costing” Affects Financial Statements
1. Impact on the Income Statement
Under absorption costing, fixed manufacturing overhead is included in the cost of goods sold (COGS), which affects reported profits. If inventory levels increase, a portion of fixed costs is deferred to future periods, boosting current net income.
2. Impact on the Balance Sheet
Since fixed overhead is included in inventory valuation, the inventory line on the balance sheet is higher compared to variable costing.
3. Impact on Cash Flow
While absorption costing affects reported profits, it does not directly impact cash flow. However, overproduction can lead to higher inventory holding costs, which may reduce cash reserves.
Example of “Absorption Costing” in a Financial Statement
Consider a company that produces 10,000 units but sells only 8,000. Under absorption costing, the fixed overhead assigned to the remaining 2,000 unsold units remains in inventory instead of being expensed immediately.
- Revenue: $400,000
- COGS (Absorption Costing): $264,000
- Gross Profit: $136,000
- Operating Expenses: $50,000
- Net Income: $86,000
Under variable costing, fixed overhead would be fully expensed in the period, leading to lower net income.
Is “Absorption Costing” Right for Your Business?
Absorption costing is essential for financial reporting and long-term profitability analysis, but it may not be ideal for short-term decision-making. Businesses that prioritize cost control and pricing strategies often use variable costing internally while adhering to absorption costing for external reports.
Have you used absorption costing in your business or accounting practices? What challenges have you faced? Share your thoughts in the comments below!
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