Cost Absorption

Definition of Cost Absorption

Cost absorption is a method in accounting used to assign all the manufacturing costs to the products being produced. These costs include both fixed and variable overheads, direct materials, direct labor, and any other costs that contribute to the production or delivery of a good or service. The goal of cost absorption is to ensure that all costs are accounted for in the cost of the product, providing a complete picture of the production cost.

Examples of Cost Absorption

Example 1: Manufacturing Firm

A manufacturing company produces bicycles. The company has both fixed costs, such as rent and salaries, and variable costs, such as materials and labor hours. Under the cost absorption method, all these costs are allocated to each bicycle produced. If the company produces 1,000 bicycles in a year, the total cost of producing all bicycles is divided by 1,000 to determine the cost per bicycle.

Example 2: Service Industry

A consulting firm operates with several fixed costs, including rent and staff salaries, as well as variable costs like travel expenses and subcontractor fees. Using cost absorption, the firm assigns a portion of these costs to each project. By doing this, the firm can better determine the total cost incurred for each consulting project and set pricing accordingly.

Example 3: Job Order Costing

Consider a custom furniture shop that produces bespoke items. Under cost absorption, direct materials (wood, varnish), direct labor (craftspeople’s wages), and a share of overhead (utility bills, workshop rent) are all allocated to each job order. This ensures that the business fully understands the cost structure for each item produced.

Frequently Asked Questions (FAQs)

1. What is the main difference between cost absorption and variable costing?

Cost absorption allocates all costs, both fixed and variable, to the products or services. Variable costing, on the other hand, assigns only variable costs to products, with fixed costs being treated as period expenses.

2. Why is cost absorption also known as full costing?

Cost absorption is called full costing because it includes all the costs associated with production, not just direct costs but also a fair share of indirect costs.

3. How does cost absorption impact financial statements?

In cost absorption, fixed overhead costs are included in the cost of goods sold, which can lead to higher inventory values on the balance sheet and lower expenses on the income statement during periods of high production.

4. Is cost absorption required by generally accepted accounting principles (GAAP)?

Yes, GAAP requires that companies use cost absorption for external financial reporting as it ensures that all costs of production are captured in the financial statements.

5. What are the disadvantages of cost absorption?

One potential disadvantage is that it can obscure the true variable cost of production, making it harder to make informed decisions about pricing and product mix. It also may lead to overproduction to absorb more fixed costs.

Related Terms

Absorption Costing

Absorption costing is another term for cost absorption, emphasizing that all production costs are absorbed by the units produced.

Fixed Costs

Fixed costs are expenses that do not change with the level of production or sales, such as rent, salaries, and insurance.

Variable Costs

Variable costs change directly with the level of production, including costs for materials, labor, and utilities used in production.

Overhead Costs

Overhead costs are ongoing business expenses not directly attributed to creating a product or service, such as rent, utilities, and administrative expenses.

Online References

1. Investopedia’s Guide to Absorption Costing
2. AccountingTools’ Explanation on Absorption Costing
3. Corporate Finance Institute on Absorption Costing

Suggested Books for Further Studies

1. “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan

   • This book provides comprehensive coverage of cost accounting principles, including detailed exploration of cost absorption.

2. “Accounting for Managers: Interpreting Accounting Information for Decision Making” by Paul M. Collier

   • A valuable resource for managers looking to deepen their understanding of how accounting information impacts business decisions.

3. “Management and Cost Accounting” by Colin Drury

   • This textbook covers key concepts in management and cost accounting with a clear focus on practical applications.

Accounting Basics: “Cost Absorption” Fundamentals Quiz

Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!