Absorption costing — a concise explainer
What it is
Absorption costing (also called full costing) is an accounting approach that assigns every manufacturing cost to the product. That means each finished unit carries a share of:
– Direct materials (raw inputs used in the product)
– Direct labor (wages for workers who make the product)
– Variable manufacturing overhead (costs that change with production volume, e.g., utilities tied to run time)
– Fixed manufacturing overhead (costs that do not vary with short‑term output, e.g., factory rent)
Key point: fixed manufacturing overhead is capitalized into inventory under absorption costing and becomes an expense (cost of goods sold, COGS) only when the units are sold.
Why it matters
Absorption costing is required for external financial reporting under U.S. generally accepted accounting principles (GAAP). Because some fixed costs are held in inventory when production exceeds sales, reported profit can rise or fall depending on inventory changes.
Short definitions (jargon)
– Capitalize: record a cost as an asset (inventory) instead of an immediate expense.
– Cost of goods sold (COGS): expense recognized when inventory is sold.
– Period cost: expense recognized in the period incurred (under variable costing, fixed manufacturing overhead is treated as a period cost).
How to calculate cost per unit (formula)
Absorption cost per unit =
(Direct materials + Direct labor + Variable manufacturing overhead + Fixed manufacturing overhead) ÷ Total units produced
Step-by-step checklist for applying absorption costing
1. Identify and classify manufacturing costs as direct materials, direct labor, variable overhead, or fixed overhead.
2. Choose an allocation base for fixed overhead (common choices: units produced, machine hours, labor hours).
3. Compute fixed overhead rate = Total fixed manufacturing overhead ÷ Allocation base.
4. Compute per‑unit variable costs (materials + labor + variable overhead per unit).
5. Add per‑unit fixed overhead allocation to the per‑unit variable cost to get absorption cost per unit.
6. Capitalize produced units at absorption cost; recognize COGS at that cost when units are sold.
7. Disclose inventory costing policy in financial statements (required for external reporting).
Worked numeric example (illustrates income effect)
Assumptions:
– Production in period: 5,000 units
– Direct materials per unit: $10
– Direct labor per unit: $5
– Variable manufacturing overhead per unit: $3
– Total fixed manufacturing overhead: $50,000
– Units sold in period: 4,000
– Selling price per unit: $40
1) Compute per‑unit costs
– Variable cost per unit = $10 + $5 + $3 = $18
– Fixed overhead per unit (absorption) = $50,000 ÷ 5,000 = $10
– Absorption cost per unit = $18 + $10 = $28
2) Income under absorption costing
– Revenue = 4,000 × $40 = $160,000
– COGS = 4,000 × $28 = $112,000
– Operating income (before other expenses) = $160,000 − $112,000 = $48,000
3) Income under variable costing (for comparison)
– Variable COGS = 4,000 × $18 = $72,000
– Fixed overhead expensed in period = $50,000
– Total expense = $72,000 + $50,000 = $122,000
– Operating income = $160,000 − $122,000 = $38,000
Difference: Absorption income is $10,000 higher because $10,000 of fixed overhead (1,000 unsold units × $10 fixed overhead per unit) remains capitalized in ending inventory under absorption costing and is deferred to future periods.
Advantages and disadvantages — practical view
Advantages
– Required by GAAP for external reporting.
– Produces a “full cost” per unit useful for external stakeholders and asset valuation on the balance sheet.
– Matches inventory valuation to total manufacturing cost, which can be useful for pricing that aims to recover all production costs.
Disadvantages / risks
– Can obscure incremental (marginal) cost information; variable costing is often clearer for short‑term decisions.
– May create perverse incentives to overproduce (managers can increase reported profit by producing more and deferring fixed costs into inventory).
– Allocation of fixed overhead can distort unit costs when production volumes or allocation bases are unstable.
Practical notes and assumptions
– The typical absorption approach allocates fixed overhead on a per‑unit basis (or another chosen base). Other allocation methods (activity‑based costing) may be used to refine allocations.
– When comparing profitability across periods, check production and inventory levels—changes in inventory can cause sizable swings in reported profit under absorption costing.
– Absorption costing does not change the total amount of costs eventually recognized; it changes the timing of recognition.
Quick checklist for auditors / preparers
– Confirm classification of costs into fixed vs. variable manufacturing categories.
– Verify method used to allocate fixed overhead and that it’s consistently applied.
– Reconcile ending inventory calculated at absorption cost with general ledger and physical inventory.
– Disclose costing policy and any significant changes in allocation bases.
Reputable sources for further reference
– Investopedia — Absorption Costing overview: https://www.investopedia.com/terms/a/absorptioncosting.asp
– Financial Accounting Standards Board (FASB): https://www.fasb.org
– U.S. Securities and Exchange Commission (SEC) — Financial statement basics: https://www.sec.gov/fast-answers/answersreadafshtm.html
– American Institute of CPAs (AICPA): https://www.aicpa.org
Educational disclaimer
This explainer is for educational purposes only. It does not constitute individualized accounting, tax, or investment advice. For specific financial reporting or tax questions, consult a licensed accountant or other qualified professional.