What is Absorption Costing?

What is Absorption Costing?

Adsorption costing is a managerial accounting method for capturing all costs associated with the manufacture of a particular product. adsorption costing refers to a methods of costing to account for all the costs of manufacturing. adsorption costing is a also referred to as full costing.    

Understanding Adsorption costing

The costs observed under absorption costing include variable costs, fixed costs, and semi-variable costs. Variable costs increase or decrease in the proportion of the goods produced. Fixed costs do not alter irrespective of the quantity of production. Semi-variable costs increase or decrease in batches.

Absorption costing is part of accounting methods and procedures. Absorption costing determines the cost of the inventory at the end of an accounting period. The closing inventory also consists of fixed costs, thus increasing the value of the inventory. This method of inventory valuation increases the profit of the company.

Absorption costing is also known as full costing since it includes all the costs associated with production. Variable costs are direct labour and material costs. Fixed costs include rent, security, and insurance expenses. Semi-variable costs include electricity charges for the factory. Thus, under full costing, all the expense are absorbed by the product irrespective of the product being sold.

Absorption costing enables precise accounting for the overall cost of production, unlike in variable costing, which considers only variable costs. The method of absorption costing enables reporting of high profit with a high value of closing inventory. This is because the cost of production is completely absorbed.

Components of Absorption Costing

Under the absorption method of costing (aka “full costing”), the following costs go into the product:

  • Direct labor (DL)
  • Variable manufacturing overhead (VMOH)
  • Fixed Direct material (DM)
  • manufacturing overhead (FMOH)

Under absorption costing, the costs below are considered period costs and do not go into the cost of a product. They are, instead, expensed in the period occurred:

  • Variable selling and administrative
  • Fixed selling and administrative

For your reference, the following diagram gives an overview of costs that go into absorption costing compared to variable costing:

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Advantages

There are several advantages to using full costing. Its main advantage is that it is GAAP-compliant. It is required in preparing reports for financial statements and stock valuation purposes.

In addition, absorption costing takes into account all costs of production, such as fixed costs of operation, factory rent, and cost of utilities in the factory. It includes direct costs such as direct material

 or direct labor and indirect costs such as plant manager’s salary or property taxes. It can be useful in determining an appropriate selling price for products.

Disadvantages

Since absorption costing includes allocating fixed manufacturing overhead to the product cost, it is not useful for product decision-making. Absorption costing provides a poor valuation of the actual cost of manufacturing a product. Therefore, variable costing is used instead to help management make product decisions.

Absorption costing can skew a company’s profit level due to the fact that all fixed costs are not subtracted from revenue unless the products are sold. By allocating fixed costs into the cost of producing a product, the costs can be hidden from a company’s income statement in inventory.

Hence, absorption costing can be used as an accounting trick to temporarily increase a company’s profitability by moving fixed manufacturing overhead costs from the income statement to the balance sheet.

For example, recall in the example above that the company incurred fixed manufacturing overhead costs of $300,000. If a company produces 100,000 units (allocating $3 in FMOH to each unit) and only sells 10,000, a significant portion of manufacturing overhead costs would be hidden in inventory in the balance sheet. If the manufactured products are not all sold, the income statement would not show the full expenses incurred during the period.

Example of Absorption Costing

Assume that ABC Company makes widgets. In January, it makes 10,000 widgets, of which 8,000 are sold by the end of the month, leaving 2,000 still in inventory. Each widget uses $5 of labor and materials directly attributable to the item. In addition, there are $20,000 of fixed overhead costs each month associated with the production facility. Under the absorption costing method, ABC will assign an additional $2 to each widget for fixed overhead costs ($20,000 total ÷ 10,000 widgets produced in the month).

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The absorption cost per unit is $7 ($5 labor and materials + $2 fixed overhead costs). As 8,000 widgets were sold, the total cost of goods sold is $56,000 ($7 total cost per unit × 8,000 widgets sold). The

 ending inventory will include $14,000 worth of widgets ($7 total cost per unit × 2,000 widgets still in ending inventory).

What’s the Difference Between Variable Costing and Absorption Costing?

Absorption costing and variable costing treat fixed overhead costs differently. Absorption costing allocates fixed overhead costs across all units produced for the period. Variable costing, on the other hand, adds all fixed overhead costs together and reports the expense as one line item separate from the cost of goods sold or still available for sale.

 In other words, variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income, while absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.

Adsorption costing is a managerial accounting method for capturing all costs associated with the manufacture of a particular product. adsorption costing refers to a methods of costing to account for all the costs of manufacturing. adsorption costing is a also referred to as full costing.    

Understanding Adsorption costing

The costs observed under absorption costing include variable costs, fixed costs, and semi-variable costs. Variable costs increase or decrease in the proportion of the goods produced. Fixed costs do not alter irrespective of the quantity of production. Semi-variable costs increase or decrease in batches.

Absorption costing is part of accounting methods and procedures. Absorption costing determines the cost of the inventory at the end of an accounting period. The closing inventory also consists of fixed costs, thus increasing the value of the inventory. This method of inventory valuation increases the profit of the company.

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Absorption costing is also known as full costing since it includes all the costs associated with production. Variable costs are direct labour and material costs. Fixed costs include rent, security, and insurance expenses. Semi-variable costs include electricity charges for the factory. Thus, under full costing, all the expense are absorbed by the product irrespective of the product being sold.

Absorption costing enables precise accounting for the overall cost of production, unlike in variable costing, which considers only variable costs. The method of absorption costing enables reporting of high profit with a high value of closing inventory. This is because the cost of production is completely absorbed.

Components of Absorption Costing

Under the absorption method of costing (aka “full costing”), the following costs go into the product:

  • Direct labor (DL)
  • Variable manufacturing overhead (VMOH)
  • Fixed Direct material (DM)
  • manufacturing overhead (FMOH)

Under absorption costing, the costs below are considered period costs and do not go into the cost of a product. They are, instead, expensed in the period occurred:

  • Variable selling and administrative
  • Fixed selling and administrative

For your reference, the following diagram gives an overview of costs that go into absorption costing compared to variable costing.

What’s the Difference Between Variable Costing and Absorption Costing?

Absorption costing and variable costing treat fixed overhead costs differently. Absorption costing allocates fixed overhead costs across all units produced for the period. Variable costing, on the other hand, adds all fixed overhead costs together and reports the expense as one line item separate from the cost of goods sold or still available for sale.

 In other words, variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income, while absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.