Absorption costing

What Is Absorption Costing?

Absorption costing, also known as full costing, is an accounting method that includes all manufacturing costs—both fixed and variable—in the cost of a product. This approach treats fixed factory overhead costs as product costs, meaning they are "absorbed" into the cost of each unit produced. It is a fundamental concept within cost accounting, particularly for businesses involved in the production of goods. Under absorption costing, the cost of a unit includes direct materials, direct labor, variable overhead, and fixed manufacturing overhead. These costs remain attached to the inventory until the goods are sold.

History and Origin

The evolution of accounting practices, including cost accounting methods like absorption costing, is deeply intertwined with the development of industrial economies. Early accounting records can be traced back to ancient civilizations, but modern accounting, particularly the double-entry method, gained prominence with Luca Pacioli's work in 1494. As² businesses grew in complexity and scale, especially during the Industrial Revolution, the need for more sophisticated cost tracking and allocation became evident. Industries with high fixed capital investments, such as manufacturing, naturally gravitated towards methods that recognized these substantial costs as part of the production process. The concept of absorbing fixed costs into the product was a logical progression to accurately reflect the full economic effort required to create a good, becoming integral to statutory financial reporting requirements.

Key Takeaways

• Absorption costing includes all direct costs and both fixed and variable manufacturing overheads in the cost of a product costs.
• It is required for external financial reporting under Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS).
• Under absorption costing, fixed manufacturing overhead is capitalized into inventory and expensed only when the goods are sold as part of the cost of goods sold.
• This method can result in higher reported gross profit and operating income when production exceeds sales, as fixed costs are deferred in inventory.
• It provides a comprehensive view of the full cost of production, which is useful for setting long-term prices and evaluating overall profitability.

Formula and Calculation

The absorption costing formula for the cost per unit includes all costs associated with production:

Where:

• Direct Materials: The raw materials that become an integral part of the finished product and can be directly traced to it.
• Direct Labor: The cost of wages paid to workers who are directly involved in the manufacturing process and can be traced to specific products.
• Variable Manufacturing Overhead: Indirect factory costs that vary with the level of production (e.g., indirect materials, factory utilities related to usage).
• Fixed Manufacturing Overhead Per Unit: Total fixed manufacturing overhead costs divided by the number of units produced. These are indirect factory costs that do not change with the level of production (e.g., factory rent, depreciation of factory equipment).

The cost of goods sold (COGS) under absorption costing is then calculated as:

Interpreting Absorption Costing

Interpreting absorption costing results requires understanding that fixed manufacturing overheads are embedded within the value of goods in inventory and only expensed when those goods are sold. This means that if a company produces more units than it sells in a given period, a portion of its fixed manufacturing overhead costs will remain on the balance sheet as part of the inventory value, rather than being expensed on the income statement. Conversely, if a company sells more units than it produces, it will expense not only the fixed overhead from current production but also fixed overhead from prior periods' inventory. This can lead to fluctuations in reported profitability that are influenced by production levels, not just sales volume.

Hypothetical Example

Consider a company, "Widgets Inc.," that produces a single product.
In a given month, Widgets Inc. incurs the following costs:

• Direct Materials: $5 per unit
• Direct Labor: $10 per unit
• Variable Manufacturing Overhead: $3 per unit
• Fixed Manufacturing Overhead: $20,000

Widgets Inc. produces 5,000 units and sells 4,000 units during the month.

Absorption Costing Calculation:

First, calculate the fixed manufacturing overhead per unit:

Next, calculate the full product cost per unit under absorption costing:

Now, calculate the Cost of Goods Sold for the 4,000 units sold:

The value of ending inventory for the 1,000 unsold units would be:

This example demonstrates how fixed overhead is "absorbed" into each unit, affecting both the cost of goods sold and the value of inventory on the balance sheet.

Practical Applications

Absorption costing is primarily used for external reporting purposes, mandated by accounting standards like GAAP for entities in the United States and IFRS internationally. This is because it presents a more complete picture of the cost of producing goods, including the fixed costs necessary for production. For tax purposes in the U.S., businesses must use absorption costing for their inventories, as outlined by the IRS in publications such as IRS Publication 334, "Tax Guide for Small Business". This ensures that the income reported for tax purposes reflects all costs associated with generating revenue from manufactured goods.

Beyond statutory requirements, companies may use absorption costing internally for long-term pricing decisions, as it ensures that all production costs are covered in the sales price over time. It helps in evaluating the full cost of manufacturing and can inform strategic decisions about product lines and overall profitability. Additionally, it affects inventory valuation shown on a company's financial statements, which in turn impacts the calculation of gross profit and other key metrics for investors and creditors.

Limitations and Criticisms

While absorption costing is essential for external financial reporting, it has several limitations, particularly for internal management decision-making. One significant criticism is that it can incentivize overproduction. Since fixed manufacturing overhead is expensed only when goods are sold, producing more units than are sold results in a larger portion of fixed costs being deferred in inventory, leading to a higher reported gross profit and operating income in the current period. This can create a misleading picture of profitability, as it doesn't necessarily reflect increased sales or operational efficiency. Real-world events, such as the piling up of inventories in sectors like automotive and chips due to cooling demand, highlight the financial pressures companies face when production outpaces sales, regardless of how costs are accounted for.

F¹urthermore, absorption costing does not separate fixed and variable costs, making it less useful for short-term decision-making, such as determining the true marginal cost of producing an additional unit or assessing the impact of changes in sales volume on profit. For these reasons, management often relies on internal reporting that uses different costing methods, such as variable costing, to gain clearer insights into cost behavior and product line performance. This method also makes it more challenging to perform variance analysis or to assess the direct impact of production volume on per-unit costs for planning purposes. The dynamic nature of business inventories also impacts the economy, as evidenced by fluctuations in Total Business Inventories, demonstrating the broader economic implications of inventory management strategies.

Absorption Costing vs. Variable Costing

The primary distinction between absorption costing and variable costing lies in their treatment of fixed manufacturing overhead.