Introduction
Full absorption costing, often simply referred to as absorption costing, is an accounting method where all manufacturing costs are included in the cost of a product. This method accounts for all costs related to manufacturing whether they are direct costs, such as raw materials and labor, or indirect costs, such as utilities and machinery depreciation. By using full absorption costing, firms can determine the complete cost of producing a product, which is useful for inventory valuation and profitability analysis.
Detailed Explanation
Under full absorption costing, both variable and fixed manufacturing costs are allocated to products. This comprehensive approach to cost allocation ensures that prices cover all costs incurred in the production process.
Components of Full Absorption Costing:
- Direct Materials: Raw materials directly used in the production of the product.
- Direct Labor: Wages of workers directly involved in manufacturing.
- Variable Manufacturing Overhead: Costs that vary with production volume, such as electricity used by machines.
- Fixed Manufacturing Overhead: Costs that do not vary with production volume, such as factory rent, salaries of production supervisors, and equipment depreciation.
Application:
Absorption costing is often used for:
- Financial reporting: It is mandatory under generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).
- Internal decision-making: Evaluating production efficiency and inventory management.
- Cost markup pricing: Determining product pricing based on full production cost coverage.
Examples
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Example 1: Widget Manufacturing
- Direct Materials: $2 per unit.
- Direct Labor: $3 per unit.
- Variable Manufacturing Overhead: $1 per unit.
- Fixed Manufacturing Overhead: $40,000 annually.
If the company produces 10,000 units annually, the absorption cost per unit is:
- Fixed Manufacturing Overhead per Unit: $40,000 / 10,000 = $4
- Total Cost per Unit = $2 (Direct Materials) + $3 (Direct Labor) + $1 (Variable Overhead) + $4 (Fixed Overhead) = $10
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Example 2: Furniture Production
- Assume a furniture manufacturer has the following costs:
- Direct Materials: $50.
- Direct Labor: $70.
- Variable Manufacturing Overhead: $30.
- Fixed Manufacturing Overhead: $100,000 for producing 5,000 units.
Per unit cost calculation:
- Fixed Manufacturing Overhead per Unit: $100,000 / 5,000 = $20
- Total Cost per Unit = $50 + $70 + $30 + $20 = $170 per unit.
- Assume a furniture manufacturer has the following costs:
Frequently Asked Questions (FAQs)
What is the main advantage of full absorption costing?
The main advantage is its compliance with GAAP and IFRS, making it mandatory for external financial reporting. It provides a complete view of per-unit production costs.
How does absorption costing differ from variable costing?
Absorption costing includes all manufacturing costs (fixed and variable), while variable costing includes only variable manufacturing costs. Fixed overheads are treated as period costs in variable costing.
Can full absorption costing affect management decisions?
Yes, it can affect management decisions related to inventory levels, pricing, and production volume, as it integrates all incurred costs into product pricing.
Is absorption costing useful for cost control?
While it ensures all costs are covered in product pricing, it may sometimes obscure the impact of fixed costs on overall expenses, possibly leading to less effective short-term cost control.
Why do companies use absorption costing for pricing products?
It ensures that the pricing covers all production-related costs, thereby safeguarding the company’s profitability through comprehensive cost recovery.
Related Terms
- Variable Costing: An accounting method that includes only variable manufacturing costs in product cost.
- Fixed Cost: Costs that remain constant regardless of production volume.
- Direct Cost: Costs that can be directly attributed to production.
- Indirect Cost: Costs that cannot be directly traced to a single unit of production but are necessary for manufacturing.
Suggested Online Resources
- Investopedia: Absorption Costing
- AccountingCoach: Absorption Costing
- Corporate Finance Institute: Absorption Costing
Suggested Books for Further Studies
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan
- “Management and Cost Accounting” by Colin Drury
- “Cost Accounting: Foundations and Evolutions” by Michael R. Kinney and Cecily A. Raiborn
- “Horngren’s Cost Accounting: A Managerial Emphasis” by Srikant M. Datar and Madhav V. Rajan
Accounting Basics: Full Absorption Costing Fundamentals Quiz
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