What is Absorption Costing? (2024)

For any manufacturer, knowing how much it costs to produce products is key to understandingthe company’s profitability. While assigning manufacturing costs to products may soundsimple, that’s only true for companies that make one thing, or a few. The larger thenumberof diverse products a company makes, the harder it is to determine each product’sshare ofcommon costs like labor, electricity and assembly-line machines. For such manufacturers,absorption costing is the accounting method to use for valuing product inventory so that thefull costs of producing a single unit of a product can be derived — and it’s theonlymethodthat is compliant with U.S. Generally Accepted Accounting Principles (GAAP).

So, while many companies also use other product-costing methods to look at their productioncosts from different points of view for internal analyses, any public or private companythat needs to produce GAAP-compliant financial statements must use absorption costing.Let’sexplore absorption costing in more detail.

What Is Absorption Costing?

Absorption costing is one method used to allocate production costs to products. It isrequired by GAAPfor external reporting, and, in the U.S., it’s required by the IRS for tax purposes.Absorption costing includes all direct and indirect costs associated with manufacturing aproduct. It is required by GAAP because it’s considered the best way to determine the“true”cost of producing an item for proper matching with revenue. An important aspect ofabsorption costing is that, because it captures all costs, it allows a manufacturer to priceits products so that all manufacturing costs are covered.

Aka “full absorption costing” or “full costing.”

Absorption costing is also known as “full absorption costing” or “fullcosting.” These namesall refer to the fact that the method, however it is referred to, absorbs into the cost ofthe product all associated manufacturing costs, including a proportion of overhead that canbe associated with the product.

Key Takeaways

• Absorption costing incorporates all direct costs and overhead associated withmanufacturing a product.
• Absorption costing allocates fixed and variable overhead costs to each unit producedduring a reporting period whereas variable costing considers only variable overhead, notfixed, as a product cost.
• Using the absorption costing method means that, compared to other product-costingmethods, more cost is included in a company’s period-ending inventory account.Inventoryis reported as an asset on the balance sheet at the end of an accounting reportingperiod.
• Because absorption costing becomes increasingly complex for companies that manufacturemany diverse products, thoughtful setup of general ledger accounts and effectiveintegration between operational and accounting systems make accurate absorption costingfar easier to achieve.

Absorption Costing Explained

Absorption costing is a managerial accounting method of valuing inventory that includesdirect costs and fixed and variable overhead. Fixed manufacturing overhead includes itemsthat are not altered by production volume, like factory rent, mortgage or insurancepayments, as well as the depreciation on, for example, factory-floor machines. Variablemanufacturing overhead items, such as electricity, do vary with production output. Inabsorption costing, all of these expenses are included as part of the value of theinventory, along with direct materials and labor. Other business expenses, such asadministrative and sales expenses, are not included.

A savvy reader may conclude from this explanation that absorption costing can sometimesbecome quite complex. Applying it properly — especially for companies with a largenumber ofdifferent products — requires close collaboration between an organization’smanufacturingexperts, who understand the nuances of production and the costs involved, and its managerialor cost accountants, who can apply GAAP rules while they determine the averages andestimates necessary for absorption costing calculations.

An apparel maker, for example, may make scarves and dresses from the same fabric and in thesame facility. But the amount of fabric in those two products is very different, and ittakes far more labor to produce a dress than a scarf. The company’s cost accountantsmustdetermine the different materials (in this example, fabric) and labor costs for scarves anddresses and factor those into the absorption cost of each product.

A key way to make absorption costing more efficient and effective for such manufacturers isto set up their chartof accounts (and, by extension, their generalledger) with the right number of detailed accounts to truly reflect thecompany’smanufacturing operations — which, again, requires collaboration between manufacturingandaccounting experts.

With the right accounts established, and an enterpriseresource planning (ERP) system that integrates operational processes and data fromthe factory floor with accounting data and processes, the cost pools necessary forabsorption costing calculations can be more easily determined — and even automated.

Notably, absorption costing applies to manufactured inventory in much the same way as jobcosting applies to tracking expenses on broader projects; constructionjob costing applies to construction project expenses; and processcosting is used by companies that produce a lot of the same or very similarproducts, such as providers of gasoline, cement, glass and paint. In fact, GAAP considersjob costing and process costing to be types of absorption costing.

Components of Absorption Costing

Absorption costing encompasses all product manufacturing costs — product costs, periodcostsand all overhead. Because absorption costing captures more cost components than othermethods, it excels at matching costs to revenue within the same fiscal period. This“matching principle” aims to account for all the expenses associated with aproduct’s salewithin the same fiscal period as when revenue from the sale is recognized.

It is a key principle in GAAP: Under GAAP, the cost of products that remain unsold sit on thecompany’s balance sheet as inventory and are expensed in a future period when the itemissold. And, again, because absorption costing captures more cost components than otherproduct costing methods, it results in a higher per-unit costof goods sold (COGS) value.

What is and is not included in the valueof the inventory on a company’s balance sheet can be broken down into productcostsand period costs.

Product costs:

Product costs are those that are a necessary part of manufacturing the product. Under theabsorption costing method, these include direct materials, direct labor and both fixed andvariable manufacturing overhead. These costs are reflected in the value of the inventorylisted on the balance sheet.

Period costs:

Excluded from product costs under the absorption costing method are all expenses that relateto nonproduction factors, such as marketing, depreciation of assets not directly involved inmanufacturing, and administrative costs. These are considered period costs and are presentedon the income statement in the period during which they occur; thus, they are not includedin the value of inventory on the balance sheet.

Absorption Costing Formula

A simple formula for determining the value of a single unit of inventory under absorptioncosting is the sum of all cost components divided by the number of units produced in theperiod. The formula looks like this:

Absorption cost of 1 unit= (Direct labor costs + Direct material costs + Variable manufacturing overhead+ Fixed manufacturing overhead) / Number of units produced

To determine the value of inventory for the balance sheet, multiply the result of thisformula by the number of remaining (unsold) items at the end of the reporting period. Forillustrations of this formula in action, see the Absorption Costing Examples section, below.

Where absorption costing becomes more complex is the level below this formula — i.e.,whencalculating each of the four components in the formula’s numerator. Consider theapparelcompany making scarves and dresses from the same fabric and in the same factory.

To determine the correct amount of direct labor cost to insert into the formulas for scarvesand dresses, the company’s cost accountants might need to sum the different aspects oflabor(hourly wages, overtime, benefits, 401(k) matching, if any) and then divide the resultproportionally according to the number of labor hours required to make a dress versus ascarf and the number of each produced.

Absorption Costing vs. Variable Costing

While absorption costing is the only GAAP-compliant method for fully costing inventory, thereare other methods that businesses may find useful. One notable method used to valueinventory is variable costing. The difference between variable costing and absorptioncosting is the way fixed manufacturing overhead is treated.

In absorption costing, fixedmanufacturing overhead is portioned out and reflected in the cost of each unitmanufactured during the period. In variable costing, fixed manufacturing overhead is notincluded in the cost of a unit; instead, it is included as a period cost that is charged offon the income statement. Therefore, under variable costing, the value of inventory carriedover into future periods is lower than it would be under absorption costing, as is COGS.

The following graphic depicts the different treatment of product and period costs under theabsorption and variable costing methods.

Variable costing is not allowed for external reporting under GAAP because of the importanceof GAAP’s matching principle. Under variable costing, fixed manufacturing overheadexpensesare booked in the period during which they occur, not carried forward as a component ofproduct inventory to be matched to the revenue from future product sales.

Absorption Costing Steps

There are three steps involved in the absorption costing method that must be appliedseparately to each of the components — direct labor costs, direct material costs,variablemanufacturing overhead and fixed manufacturing overhead — in the absorption costingformula.The results of those separate calculations are then plugged into the formula to determinethe full absorption cost to produce a single unit of a product.

These steps are the complex part of absorption costing that can be made far easier dependingon how well the company’s chart of accounts is set up (to reflect the details ofmanufacturing operations) and how well the organization’s operational and accountingsystemsare integrated.

1. Allocation: All costs must be allocated to a cost pool for eachcomponent. A cost pool is a grouping of general ledger accounts, typically gathered bydepartment. For example, the various labor costs mentioned earlier —hourlywages,overtime, benefits, 401(k) matching — would likely each have its own generalledgeraccounts, and they could all be mapped to one cost pool under direct labor costs.Similarly, the appropriate general ledger accounts must be allocated to direct materialscosts and fixedand variable manufacturing costs. Changes to allocation mappings should not bemade often because such changes may hamper period-to-period comparative analysis.
2. Determine an activity measure: While this is often simply the grossnumber of units produced, different activity measures may be important to getting theright costs for each component. For example, labor hours for calculating direct laborcosts for different products, or machine hours for factoring the depreciation ofmanufacturing equipment into different products’ costs. This activity measurebecomesthe denominator for the calculation in step No. 3.
3. Calculate: Determine the sum for the total of each cost pool and dividethat sum by the relevant activity measure for that pool.

Repeat these three steps for all elements included in each component of manufacturing so thatall costs are absorbed into the cost of the product.

Advantages of Absorption Costing

Two key advantages of absorption costing are that it complies with GAAP, and it moreaccurately reflects profit during the reporting period. It can also be easier to calculate,since manufacturing overhead expenses do not need to be dissected into fixed and variableand treated differently for accounting purposes. Here are the four main advantages ofabsorption costing versus other methods of product costing:

• Establishing a selling price: Absorption costing provides better information fordecision-makers who decide product selling prices because it makes sure all relatedexpenses are included.
• External reporting: This is required for GAAP compliance and for tax reporting.
• Accurate profit forecasting: Absorption costing yields a more accurate determination ofnet profit versus variable costing because it matches expenses with related revenues inthe same reporting period.
• Higher income generation: This method results in a higher net income because a portionof costs related to unsold goods — namely, the fixed manufacturing overhead costs— arenot expensed during the period but carried forward on the balance sheet as endinginventory until the product sells.

Disadvantages of Absorption Costing

Using the absorption costing method can be disadvantageous at certain times because it shiftsthe timing of when fixed manufacturing overhead is expensed on the income statement, whichcan skew internal business analyses. For this reason, business leaders may prefer to replaceabsorption costing with variable costing to support some internal business decisions. Forexample, consider volume analysis.

• An increase in production volume would decrease unit costs under absorption costing,which wouldn’t matter if all the units were sold in the same reporting period. Butifthe goods are not all sold, net income for that period would appear to be inflated,because a portion of fixed manufacturing costs would be carried forward in the inventoryon the balance sheet, not deducted from revenue.
• Absorption costing may skew the profitability analysis for companies thinking of rampingup production.
• Cost per unit under absorption costing includes fixed overhead items like rent,machinery costs which do not notably rise with increased production. In this type ofanalysis, a variable cost per unit method should be used.

Absorption Costing Examples

To build a better understanding of how absorption costing works, let’s look at twodifferentillustrative — and hypothetical — examples.

First, consider T-shirt maker TeesbyT, which produces 15,000 golf tees in its first fiscalquarter and sells 12,000, leaving 3,000 in ending inventory. Each shirt requires $1 ofdirect materials and labor, and 50 cents of variable overhead.Additionally, TeesbyT’smonthly fixed overhead costs are $30,000. Using the absorption costing method to determinethe fixed overhead costs per unit, TeesbyT’s finance team divides the fixed overheadcostsby the number of units produced that month ($30,000 / 15,000 tees) to determine that thereis $2 worth of fixed overhead costs that go into manufacturing each shirt. That means, eachT-shirt produced by TeesbyT during the quarter has an absorption cost of $3.50 ($1 directmaterials and labor, $0.50 variable overhead costs and $2 fixed overhead costs).

The company can then calculate that its total COGS for the quarter is $42,000 by multiplyingthe absorption cost times the number of units sold ($3.50 per tee x 12,000 tees sold). Itcan also determine that there is $10,500 worth of remaining inventory on the balance sheet($3.50 per tee x 3,000 tees).

The second example is WD & Co., which manufactures dog coats. Last month, WD produced10,000 coats and sold 8,000. The company’s total manufacturing costs were as follows:

• Direct labor: $30,000
• Direct materials: $20,000
• Variable manufacturing overhead: $5,000
• Fixed manufacturing overhead: $10,000

WD applies the absorption costing formula as follows to determine its cost per coat: ($30,000+ $20,000 + $5,000 + $10,000) / 10,000, or $65,000 / 10,000, or $6.50 per coat. That means,WD’s cost of coats sold during the month is $6.50 x 8,000, or $52,000. The value ofinventory remaining on WD’s balance sheet is $6.50 x 2,000, or $13,000.

Replace Time-Wasting Spreadsheets With Financial ManagementSoftware that Does It All

Accurate inventory valuations play an important role in strategic production decisions andare crucial to both external reporting and internal analysis. What’s more, theGAAP-compliant absorption costing method is crucial to accurate inventory valuations. Buteven organizations that have the manufacturing and managerial accounting expertise necessaryto identify and track all the costs that go into its production still need integratedmanufacturing-process and accounting solutions to reflect that information and applyabsorption costing rules.

NetSuite’scloud-based accounting software is just such an integrated solution. It canseamlessly integrate inventory management and costing processes with accounting andreporting via links with modules, such as NetSuiteInventory and NetSuiteFinancial Management. For example, NetSuite inventory provides forward and backwardinventory traceability, which is especially helpful to absorption costing in a business withmultiple products and locations. And unlike manual spreadsheets, NetSuite’s financialmanagement solution can generate financial statements using absorption costing as requiredby GAAP and the IRS, while also automatically using variable costing to produce internalanalyses for business decision-makers.

Absorption costing is a method of valuing inventory that incorporates all manufacturingcosts, both fixed and variable, that are part of a product’s cost. It becomesincreasinglychallenging for companies that make many different products. For such a diversemanufacturer, doing absorption costing well requires good execution in the setup of thecompany’s chart of accounts, as well as good integration between operational andaccountingsystems. For external reporting purposes, absorption costing is required under GAAP and bythe IRS for tax purposes, whereas other costing methods may be useful for certain internalbusiness analyses.

Absorption Costing FAQs

Can absorption costing cause an increase in net income?

Yes, under certain circ*mstances absorption costing can cause an increase in net income whenproduction volume rises. Here’s how: Higher production volume would lower theproductioncost of one unit because fixed costs would be spread over more units; the lower unit costwould be reflected in a lower cost of goods sold on the income statement, resulting in ahigher net income.

Why is absorption costing required by GAAP?

Absorption costing is required by GAAP because of the primacy of GAAP’s matchingprinciple.Under absorption costing, expenses associated with the manufacture of products are notreflected on the income statement until those products are sold. Therefore, revenue andexpenses are appropriately matched in the period of sale.

Is absorption costing and full costing the same?

Yes. Absorption costing captures all costs associated with manufacturing a product;therefore, it is also referred to as full costing.

What does absorption of costs mean?

Absorption costing is a method of valuing inventory that captures, or absorbs, allmanufacturing costs into the product cost. Therefore, the product cost reflects anabsorption of all costs.

What is the difference between marginal costing and absorptioncosting?

Absorption costing is the GAAP-compliant accounting method for determining the full cost ofmanufacturing a product. Marginal costing is an analysis that helps business managersunderstand how much it would cost to produce one additional unit beyond what was alreadyplanned. Because such an increase in volume would not change fixed expenses, the variablecosting method, not absorption costing, should be used to determine the marginal cost.Absorption costing analysis includes fixed overhead expenses and would thereforeartificially inflate the cost of an additional unit.

What is meant by absorption of overhead?

Absorption costing is a method of valuing inventory that captures, or absorbs, labor,materials and manufacturing overhead (both fixed and variable) into the product cost.Therefore, under absorption costing, the product cost reflects an absorption of overhead.

When can absorption costing be used?

Absorption costing should be used to establish a product’s selling price, thus ensuringthatall related expenses will be covered. It also must be used for external reporting under U.S.Generally Accepted Accounting Principles (GAAP) and for tax purposes.

Why is absorption costing more likely to be used by largerbusinesses?

Absorption costing is more likely to be used by larger businesses because it is required forU.S. GAAP reporting and because it more accurately tracks profit versus variable costing, incompliance with GAAP’s matching principle.

What is absorption costing with example?

Absorption costing is an accounting method used to comprehend the full production costs ofone item. It includes all direct and indirect costs associated with manufacturing theproduct. To illustrate, consider the fictional LHR Co., which manufactures widgets. Lastmonth, LHR produced 1,000 widgets and sold 800, leaving 200 unsold. The company’stotalmanufacturing costs include direct labor of $20,000, materials costing $10,000, variablemanufacturing overhead of $1,000 and fixed manufacturing overhead of $2,000. Using theabsorption costing formula (Product cost = (Direct labor costs + Direct material costs +Variable manufacturing overhead + Fixed manufacturing overhead) / Number of units produced),LHR determines that the full cost of producing each widget was $33 (($20,000 + $10,000 +$1,000 + $2,000) / 1,000). The cost of all the widgets LHR sold that month was $26,400 ($33x 800), and the value of the remaining inventory on its balance sheet was $6,600 ($33 x200).

What is absorption costing formula?

The formula for absorption costing is: Product cost of one unit = (Direct labor costs +Direct material costs + Variable manufacturing overhead + Fixed manufacturing overhead) /Number of units produced.

What is the purpose of absorption costing?

The purpose of absorption costing is to determine the cost of producing a single unit, givenall manufacturing costs involved. It is considered the best way to determine the“true” costof producing an item, allowing the manufacturer to price its products to ensure that allmanufacturing costs will be covered. It is also the only method of valuing inventory thatcomplies with U.S. Generally Accepted Accounting Principles (GAAP).