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Absorption Costing

Absorption Costing means that all of the manufacturing costs are absorbed by the units produced. In other words, the cost of a finished unit in inventory will include direct materials, direct labor, and both variable and fixed manufacturing overhead. As a result, absorption costing is also referred to as full costing or the full absorption method.

Absorption costing is often contrasted with variable costing or direct costing. Under variable or direct costing, the fixed manufacturing overhead costs are not allocated or assigned to (not absorbed by) the products manufactured. Variable costing is often useful for management's decision-making. However, absorption costing is required for external financial reporting and for income tax reporting.[1]

Absorption Costing
source: Management and Accounting Web


Absorption Costing Components [2]

The key costs assigned to products under an absorption costing system are:

  • Direct materials. Those materials that are included in a finished product.
  • Direct labor. The factory labor costs required to construct a product.
  • Variable manufacturing overhead. The costs to operate a manufacturing facility, which vary with production volume. Examples are supplies and electricity for production equipment.
  • Fixed manufacturing overhead. The costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.

It is possible to use activity-based costing (ABC) to allocate overhead costs for inventory valuation purposes under the absorption costing methodology. However, ABC is a time-consuming and expensive system to implement and maintain, and so is not very cost-effective when all you want to do is allocate inventory to be in accordance with GAAP or IFRS.

One should charge sales and administrative costs to expense in the period incurred; do not assign them to inventory, since these items are not related to goods produced, but rather to the period in which they were incurred.


Absorption Costing Steps

The steps required to complete a periodic assignment of costs to produced goods is:

  • Assign costs to cost pools. This is comprised of a standard set of accounts that are always included in cost pools, and which should rarely be changed.

Calculate usage. Determine the amount of usage of whatever activity measure is used to assign overhead costs, such as machine hours or direct labor hours used.

  • Assign costs. Divide the usage measure into the total costs in the cost pools to arrive at the allocation rate per unit of activity, and assign overhead costs to produced goods based on this usage rate.


See Also

Activity-Based Management (ABM)
Activity Based Costing (ABC)
Cost Analysis
Cost Accounting Standards (CAS)
IT Cost Allocation
IT Cost Optimization
Management Accounting
Accounting
Accounting Equation
Accounting Valuation
Accounts Receivable Factoring (FACTORING)
Accounts Receivable Financing


References

  1. Definition - What is Absorption Costing?Accounting Coach
  2. Absorption Costing Components Accounting Tools


Further Reading