Absorption Costing

What Is Absorption Costing?

Absorption costing is a method of cost accounting in which the cost of a manufactured product includes all of its production costs: direct materials, direct labor, and both variable and fixed manufacturing overhead. These costs are "absorbed" into each unit produced and stay in inventory until the units are sold, at which point they flow into cost of goods sold. The method is also called full costing, and it is the approach generally required for external financial reporting under U.S. GAAP and IFRS.

How It Works

Under this method, costs fall into two groups. Product costs are the production costs described above, and they remain on the balance sheet as inventory until a sale occurs. Period costs, such as selling and administrative expenses, are not assigned to products. They are expensed in the period in which they occur.

Because fixed overhead is spread across all units produced, the cost per unit depends on how many units are made. The basic calculation is:

Unit product cost = (direct materials + direct labor + variable overhead + fixed overhead) ÷ units produced

An Illustration

Suppose a hypothetical factory incurs $10,000 of fixed overhead in a month and produces 1,000 units, so $10 of that overhead is absorbed into each unit. If only 800 units are sold, the fixed overhead attached to the remaining 200 units, which is $2,000, stays in inventory rather than reducing profit that month. This is the key feature of the method. When production exceeds sales, absorption costing can report higher operating income than a method that expenses all fixed overhead immediately. The reverse is generally true when sales exceed production.

Advantages and Disadvantages

Absorption costing matches the full cost of making products with the revenue they generate, and it is consistent with financial reporting rules. Its main drawback is that reported profit can be affected by production volume, so a company can raise reported income by producing more than it sells. For short-term internal decisions, such as evaluating how costs change with sales volume, variable costing is often more informative. Investors comparing companies' financial statements should keep this effect in mind, since differences in production levels can distort reported results even when sales and underlying costs are similar.