Absorption Costing

What Is Absorption Costing?

Absorption costing, sometimes called full absorption costing, is a managerial
accounting method for capturing all costs associated with manufacturing a
particular product. The direct and indirect costs, such as direct materials, direct
labor, rent, and insurance, are accounted for using this method. Absorption
costing is required by generally accepted accounting principles (GAAP) for
external reporting.

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 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.
Understanding Absorption Costing
Absorption costing, also called full 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 workers 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.

 Absorption costing means that ending inventory on the balance sheet is

higher, but expenses on the income statement are lower.

Absorption Costing vs. Variable Costing

The differences between absorption costing and variable costing lie in the
treatment of fixed overhead costs. Absorption costing allocates 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 separate from the cost of goods sold or still available for sale.
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. 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 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 when
compared to variable costing calculations.

Because absorption costing includes fixed overhead costs in the cost of its
products, it is unfavorable when compared to 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 unique 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.

Fast Fact
Absorption costing results in a higher net income compared to variable costing.
Example of Absorption Costing
Assume ABC Company makes widgets. In the month of January, they make
10,000 widgets, of which 8,000 are sold in January and 2,000 are still in
inventory at month-end. Each widget uses $5 of labor and materials directly
attributable to the item. In addition, there is $20,000 of fixed overhead costs each
month associated with the production facility. Under the absorption costing
method, the company 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). Since 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).

Frequently Asked Questions

What's the Difference Between Variable and Absorption Costing?
The differences between absorption costing and variable costing lie in the
treatment of fixed overhead costs. Absorption costing allocates 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 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 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 is required by the 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.