What Is Absorption Costing?
Absorption Costing is a costing method and a managerial accounting technique which is also known as “full costing“. It accounts for all costs associated with the production of a specific product (means, all the costs of manufacturing). This method is used to account for direct and indirect costs.
Direct costs and Indirect costs
- Direct cost: such as materials and labor used directly in production.
- Indirect costs: such as administration costs, factory rent, insurance, etc.
Absorption costing is required by generally accepted accounting principles (GAAP) for external reporting.
- Absorption costing differs from variable costing because it allocates fixed overhead costs to each unit of a product manufactured during the period.
- Whether or not a product was sold during the period, absorption costing allocates fixed overhead costs to it.
- This method of costing hints that more cost is included in the ending inventory, which is then carried over to the next period as an asset on the balance sheet.
- When using absorption costing, expenses on the income statement are lower because more expenses are included in ending inventory.
Understanding Absorption Costing
Anything that is a direct cost in the production of a good is included in the cost base of absorption costing. As part of the product costs, absorption costing includes fixed overhead charges. Wages for employees physically working on the product, raw materials used in manufacturing the product, and all overhead costs (such as all utility costs) are some of the costs associated with manufacturing a product.
Unlike the variable costing method, all expenses are allocated to manufactured products, regardless of whether they are sold by the end of the period.
Absorption Costing vs Variable Costing
The basic difference between absorption and variable costing is the treatment of fixed overhead costs. Fixed overhead costs are allocated across all units produced for the period using absorption costing. Variable costing, on the other hand, combines all fixed overhead costs into a single line item that is reported separately from the cost of goods sold (COGS) or still available for sale.
Absorption costing determines the per-unit cost of fixed overheads, whereas variable costing does not. When calculating net income on the income statement, variable costing will result in a single lump-sum expense line item for fixed overhead costs. There will be two types of fixed overhead costs as a result of absorption costing: those attributable to the cost of goods sold and those attributable to inventory.
Advantages and Disadvantages of Absorption Costing
At the end of the period, assets such as inventory remain on the balance sheet of the entity. Because absorption costing allocates fixed overhead costs to both cost of goods sold and inventory, costs associated with items still in ending inventory will not be reflected in current period expenses. More fixed costs attributable to ending inventory are reflected in absorption costing.
Because the expenses associated with ending inventory are linked to the full cost of the inventory still on hand, absorption costing ensures more accurate accounting for that inventory. Furthermore, more expenses are accounted for in unsold products, lowering actual expenses reported on the income statement in the current period. When compared to variable costing calculations, this results in a higher net income calculation.
When management is making internal incremental pricing decisions, absorption costing is unfavorable to variable costing because it includes fixed overhead costs in the cost of its products. Because variable costing only includes the additional costs of producing the next incremental unit of a product, this is the case.
Furthermore, using absorption costing results in a situation where simply producing more items that go unsold by the end of the period increases net income. The unit fixed cost will decrease as more items are produced because fixed costs are spread across all units manufactured. As a result, as production rises, net income rises as well, because the fixed-cost component of the cost of goods sold decreases.
When compared to variable costing, absorption costing produces a higher net income.
Example of Absorption Costing
Assume ABC Company is a widget manufacturer. It produces 10,000 widgets in January, 8,000 of which are sold by the end of the month, leaving 2,000 in stock. Each widget consumes $5 in labor and materials that are directly related to the item. In addition, the production facility has a monthly fixed overhead cost of $20,000 per month. ABC will add $2 to each widget for fixed overhead costs ($20,000 total for 10,000 widgets produced in a month) using the absorption costing method.
The per-unit absorption cost is $7 ($5 in labor and materials + $2 in fixed overhead costs). The total cost of goods sold is $56,000 ($7 total cost per unit 8,000 widgets sold) because 8,000 widgets were sold. There will be $14,000 worth of widgets in the ending inventory ($7 total cost per unit 2,000 widgets remaining).
What’s the Difference Between Variable Costing and Absorption Costing?
Fixed overhead costs are treated differently in absorption and variable costing. Fixed overhead costs are allocated across all units produced for the period using absorption costing. In contrast, variable costing adds all fixed overhead costs together and reports the expense as a separate line item from the cost of goods sold or still available for sale. In other words, when calculating net income, variable costing produces a single lump-sum expense line item for fixed overhead costs, whereas absorption costing produces two categories of fixed overhead costs: those attributable to the cost of goods sold and those attributable to inventory.
What Are the Main Advantages of Absorption Costing?
The main advantage of absorption costing is that it complies with the Internal Revenue Service’s generally accepted accounting principles (GAAP) (IRS). Furthermore, it tracks profit more accurately during an accounting period by accounting for all costs of production (including fixed costs) rather than just direct costs.
What Are the Main Disadvantages of Absorption Costing?
Absorption costing‘s main disadvantage is that it can inflate a company’s profitability during a given accounting period because all fixed costs are not deducted from revenues unless all of the company’s manufactured products are sold. It’s also useless for analysis aimed at improving operational and financial efficiency, as well as for comparing product lines.