Definition
Absorption costing, also known as full costing, is an accounting method that includes all manufacturing costs in the calculated unit product cost. These costs encompass direct materials, direct labor, and both variable and fixed overhead costs. Therefore, it absorbs all costs of production into the product, ensuring that each expense is represented in the final evaluation.
Key Takeaways
- Absorption Costing is an accounting method that includes all production-related costs—direct materials, direct labor, and both variable and fixed overhead costs—in the cost of product. This method presents a more comprehensive view of the production cost.
- Under Absorption Costing, companies can report higher profit levels than they would under variable costing, especially if production levels surpass sales volumes. This happens because fixed overhead costs are spread over a larger number of units.
- On the downside, absorption costing can potentially mislead management because in periods of high production but low sales, profit can appear artificially inflated. This discrepancy arises because all fixed costs are not immediately charged against revenue.
Importance
Absorption costing is an important concept in finance as it provides a comprehensive view of the total cost involved in producing a product or service.
By considering all associated costs, including direct materials, direct labor, and both variable and fixed overhead costs, absorption costing helps businesses accurately assess profitability and make informed pricing, budgeting, and financial planning decisions.
It also complies with Generally Accepted Accounting Principles (GAAP) and tax regulations, helping businesses avoid potential legal complications.
Additionally, it aids in understanding the efficiencies and inefficiencies in the production process by recognizing indirect costs, something not captured in other costing methods like variable costing.
Explanation
Absorption costing serves as a comprehensive method to record the costs associated with manufacturing a particular product. The primary purpose of this approach is to take all of the costs involved in production, including fixed and variable costs, and apply them to the individual products.
This method allows businesses to assess the total cost to produce a product and therefore determine an appropriate selling price. It effectively portrays a complete picture of the company’s production costs, thereby providing an accurate overview of overall business profitability.
In management accounting, absorption costing is utilized for cost control, financial reporting, and decision-making purposes. The costs considered under this method include direct material, direct labor, variable overheads, and fixed manufacturing overheads.
This comprehensive costing approach helps in designing strategies for pricing, profit planning, and cost control. Furthermore, for external reporting or inventory valuation, absorption costing is typically required by tax laws and financial accounting standards – it ensures that all costs of production, notably including a share of the company’s overhead, are reflected in the valuation of inventory.
Examples of Absorption Costing
Absorption costing, also known as full costing, is an accounting method that includes all direct costs and indirect costs associated with producing a product. Here are three real-world examples:
Manufacturing Industry: Consider a car manufacturing company like Ford. This company uses absorption costing when it considers both the direct costs such as raw material, direct labor to produce the car and indirect costs such as factory rent, utilities, and factory manager’s salary when computing the total cost of each car produced.
Food Production: Take, for instance, a company like Nestle that produces a wide range of foodstuffs. For each product, it would use absorption costing by including direct costs like the cost of raw materials and direct labor used in production and indirect costs such as factory overhead expenses, utilities, factory rent etc.
Pharmaceutical Industry: A company like Pfizer, which manufactures medication, would use absorption costing. When calculating the cost of a drug, it would include direct costs such as the cost of ingredients, direct labor for manufacturing and packaging, as well as indirect costs such as quality control, factory rent or salaries of support staff in the factory.
Absorption Costing FAQ
What is Absorption Costing?
Absorption costing, also known as full costing, is a method in which all direct and indirect costs associated with the production of a particular product are included. This includes direct materials and labor costs, as well as fixed and variable overhead costs.
How does Absorption Costing work?
Absorption costing assigns a per-unit cost to each product or service produced, through the inclusion of both variable and fixed costs. It looks at the total cost to produce the product, not just the direct costs associated with the production process.
What is the benefit of Absorption Costing?
A benefit of Absorption Costing is that it gives a more comprehensive and accurate view of a product’s complete cost, by including the indirect costs related to production. It provides a more complete picture of how much it costs to manufacture a product, helping businesses make more informed pricing decisions.
What are the drawbacks of Absorption Costing?
In Absorption Costing, fixed costs are spread over all units of output which can lead to the misconception that increasing production will lower the per unit cost. However, fixed costs do not change with the level of production so this can lead to inaccurate decision-making. Also, it might provide less insight into individual product profitability compared to other costing methods, such as variable or direct costing.
When is Absorption Costing used?
Absorption costing is commonly used in financial accounting as it is required for reporting to external stakeholders such as investors, creditors, and regulatory agencies. It’s also used to prepare income statements, balance sheets, and other financial reports.
Related Entrepreneurship Terms
- Overhead Cost
- Fixed Cost
- Variable Cost
- Product Cost
- Direct Cost
Sources for More Information
- Investopedia – It provides a wide range of financial information including a comprehensive article on Absorption Costing.
- AccountingTools – This website gives you specialized knowledge in accounting area, where you can learn more about Absorption Costing.
- Corporate Finance Institute – A professional finance institute’s website that provides a course and detailed articles about finance topics including Absorption Costing.
- My Accounting Course – This website offers many accounting courses and definitions, including those about Absorption Costing.
