Absorption Costing: Definition and Overview
Absorption costing, often referred to as full absorption costing or total absorption costing, is a cost accounting method that assigns all manufacturing overhead costs to products, making them part of the product cost. This includes both variable and fixed overhead costs, which are spread across all units produced during a period.
Unlike marginal costing, where only variable costs are allocated to products, absorption costing ensures that all production costs, including electricity, rent, and salaries paid to factory workers, are absorbed into the cost of the product. This method facilitates businesses in understanding the full cost of producing an item and aligning pricing strategies accordingly.
Examples of Absorption Costing
Example 1: Manufacturing Firm
A furniture manufacturing company incurs various fixed and variable overhead costs. Under absorption costing, the company allocates the following overheads to each product:
- Fixed overhead costs: $10,000 (e.g., rent, salaries)
- Variable overhead costs: $5 per unit (e.g., utilities, raw materials)
If the company produces 1,000 chairs in a month, the total overhead cost of $15,000 is divided by the number of units, resulting in an overhead cost per unit of $15.
Example 2: Electronics Production
An electronics company is determining the cost of producing its latest gadget. The total fixed manufacturing overhead is $50,000 for the month, and variable manufacturing costs amount to $20 per unit. If the company produces 5,000 gadgets:
- Total overhead cost = Fixed cost + (Variable cost per unit * Number of units)
- Total overhead cost = $50,000 + ($20 * 5,000) = $150,000
- Overhead cost per gadget = $150,000 / 5,000 = $30
Hence, each gadget produced will include an overhead absorption cost of $30.
Frequently Asked Questions (FAQs)
What is the main advantage of absorption costing?
Absorption costing gives a comprehensive view of the total production costs by including both fixed and variable overheads, which can aid in setting prices that cover all production expenses.
Why is activity-based costing (ABC) preferred over absorption costing?
ABC is often preferred because it provides more accurate cost allocation based on activities that drive costs, rather than employing potentially arbitrary rates used in traditional absorption costing.
How does absorption costing affect financial statements?
Absorption costing affects both the income statement and the balance sheet. Fixed manufacturing overhead costs are included in the valuation of inventory on the balance sheet and in the cost of goods sold on the income statement when the inventory is sold.
Can absorption costing lead to overproduction?
Yes, because fixed costs are spread over all units produced, managers might be incentivized to produce more inventory to lower the per-unit cost, potentially leading to overproduction.
What are absorption rates?
Absorption rates are the rates used to allocate overhead costs to products. These are typically calculated based on direct labor hours, machine hours, or other relevant bases.
Does absorption costing comply with Generally Accepted Accounting Principles (GAAP)?
Yes, absorption costing is required by GAAP for external reporting because it includes all costs of production.
How does absorption costing handle under or over-absorbed overhead?
Any under or over-absorbed overhead is usually adjusted at the end of the period and either carried forward or written off against the profit.
What costs are not included in absorption costing?
Non-manufacturing costs such as selling, general, and administrative expenses are not included in absorption costing.
What is the primary criticism of absorption costing?
The primary criticism is that it can distort product costing and lead to poor decision-making since the allocation of fixed overheads is essentially arbitrary.
How is absorption costing calculated?
Absorption costing is calculated by assigning both fixed and variable overhead costs to the total production costs and dividing by the number of units produced.
Related Terms
- Overheads: Indirect costs that cannot be directly attributed to specific products.
- Absorption Rates: The rates used to allocate overhead costs to products, typically based on labor or machine hours.
- Cost Centres: Departments or units within an organization where costs are accumulated and tracked.
- Activity-Based Costing (ABC): A more refined approach to cost allocation that assigns costs based on activities that drive costs.
- Marginal Costing: A costing approach where only variable costs are charged to product units, while fixed costs are treated as period costs.
Online Resources
- Investopedia on Absorption Costing
- Accounting Tools: Absorption Costing
- Corporate Finance Institute - Absorption Costing
Recommended Books
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren
- “Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
- “Management and Cost Accounting” by Colin Drury
Accounting Basics: “Absorption Costing” Fundamentals Quiz
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