Absorption Costing Explained, With Pros and Cons and Example

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.

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.

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.

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.