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Absorption Costing Definition – Explanation – Example

What Is Absorption Costing?

Absorption CostingAbsorption costing is an accounting method and reporting standard that tracks and allocates expenses associated with a manufacturing process to distinct products.  It is sometimes called full costing.  As an accounting method, it captures all fixed and variable costs associated with manufacturing a particular product. The direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for by using this method. Generally accepted accounting principles (GAAP) require that absorption costing be used for all external reporting.

Absorption costing tracks and allocates the expenses associated with a manufacturing process to distinct products. Accounting standards call for this form of cost accounting in order to generate an inventory valuation for an organization’s balance sheet. A product can absorb both fixed and variable costs. When a company pays these expenses, they are not necessarily recorded in the month in which they are incurred. Instead, they are held as an asset in inventory until the inventory is sold.  At this point, they are charged against the cost of goods sold.

Absorption Costing – A Closer Look

Absorption costing includes any direct cost in the production of a good in its cost base. However, as part of the product costs, full pricing also includes fixed overhead charges. For example, wages for personnel physically working on the product and raw materials required in production.  In addition, all overhead expenditures such as electricity, rent, insurance, and administration costs are allocated to the product.

Unlike the variable costing method, every expense is allocated to manufactured products.  This is regardless of whether they are sold by the end of the period. As a result, ending inventory on the balance sheet is larger with absorption costing.  At the same time, expenses on the income statement are lower.

Absorption Costing vs. Variable Costing

The distinction between absorption and variable costing is in how fixed overhead costs are handled. Fixed overhead costs are allocated across all units produced over time using absorption costing. Variable costing aggregates fixed overhead costs into a single line item separate from the cost of goods sold (COGS).

Variable costing does not include a per-unit cost of fixed overheads, whereas absorption costing does. When calculating net income on the income statement, variable costing will produce one lump-sum expense line item for fixed overhead costs. Absorption costing generates two types of fixed overhead costs.  Those related to the cost of products sold and those related to inventory.

Absorption Costing Pros & Cons

At the end of the period, assets such as inventories remain on the entity’s balance sheet. Absorption costing allocates fixed overhead costs to both cost of goods sold and inventory.  Therefore, the costs associated with items still in ending inventory will not be reflected in the income statement for the current period. Absorption costing accounts for greater fixed costs associated with ending inventory. However, the expenses connected with that inventory are related to the entire cost of the goods still on hand.  As a result, absorption costing assures more accurate accounting for ending inventory. Furthermore, additional expenses are accounted for in unsold products.  This reduces actual expenses reported on the income statement in the current period. When compared to variable costing calculations, this results in a greater net income valuation.

The primary benefit of absorption costing is that it adheres to generally recognized accounting rules as mandated by the Internal Revenue Service (IRS). Furthermore, it considers all production costs (including fixed costs), not just direct costs, and tracks profit more precisely across an accounting period.

Book Accounting: Accounting used on a company’s audited financial statements. Balance Sheets (assets, liabilities, and equity) and income statements should be reported using U.S. GAAP. Tax Accounting: Income and deductions reported on tax returns in accordance with the rules in the I.R.C. and attending regulations. M-1 adjustments: reconciliation of book and taxable income (income and deductions.) Differences exist because of the difference in GAAP and tax law. Deferred tax assets and deferred tax liabilities: book assets or book liabilities involving deferred tax amounts. These deferred tax assets and deferred tax liabilities develop due to timing differences of income and deductions for book and tax purposes. (Source: irs.gov)

Disadvantages

The principal downside of absorption costing is that it might overstate a company’s profitability. This can occur within a given accounting period by not deducting all fixed costs from revenues.  Unless, of course, all of the company’s manufactured products are sold. Furthermore, it is ineffective for analyzing operational and financial efficiency or comparing product lines.

When management is making internal incremental pricing decisions, absorption costing is clumsy compared to variable costing.  This is because it includes fixed overhead expenditures in the cost of its products. Conversely, variable costing only accounts for the additional expenses of producing the next incremental unit of a product. Furthermore, using absorption costing creates a situation in which merely producing additional things that go unsold at the end of the period increases net income. Because fixed costs are distributed over all units produced, the unit fixed cost decreases as more things are produced. Therefore, as output increases, net income rises organically because the fixed-cost element of the cost of goods sold decreases. When compared to variable costing, absorption costing results in a higher net income value.

Example of Absorption Costing

Assume that ABroomCompany Inc. makes hand brooms. In March, it makes 20,000 brooms, of which 16,000 are sold by the end of the month.  This leaves 4,000 still in inventory. Each broom uses $10 of labor and materials directly attributable to the item. In addition, there are $40,000 of fixed overhead costs each month associated with the production facility. Under the absorption costing method, ABroomCompany will assign an additional $2 to each broom.  This extra allocation is for fixed overhead costs ($40,000 total ÷ 20,000 brooms produced in March).

The absorption cost per unit is $12 ($10 labor and materials + $2 fixed overhead costs). A total of 16,000 brooms were sold.  So, the total cost of goods sold is $192,000 ($12 total cost per unit × 16,000 brooms sold). The ending inventory will include $48,000 worth of brooms.  The calculation is ($12 total cost per unit × 4,000 brooms still in ending inventory).

Frequently Asked Questions

Is Absorption Costing the same as variable costing?

Fixed overhead costs are treated differently in absorption costing and variable costing. Fixed overhead costs are allocated across all units produced over time using absorption costing. Variable costing adds up all fixed overhead costs.  Then, it reports the expense as a separate line item from the cost of goods sold or still available for sale. In other words, when calculating net income, variable costing produces a single lump-sum expense line item for fixed overhead expenses.  Conversely, absorption costing produces two kinds of fixed overhead costs.  Those attributable to the cost of goods sold and those attributable to inventory.

Is Activity-Based Costing the same as absorption costing?

Under the absorption costing approach, it is possible to employ activity-based costing (ABC).  It can successfully be used to allocate overhead costs for inventory valuation purposes. However, ABC is a time-consuming and expensive system to create and maintain.  This makes it inefficient when all you want to do is distribute costs in accordance with GAAP or International Financial Reporting Standards (IFRS).

Up Next: What Is a Deferred Annuity?

Deferred AnnuityA deferred annuity is an insurance contract where savers contribute money and defer their income stream until later, usually upon retirement. The contract with an insurance firm is usually structured to pay the owner a regular income or a lump payment at some point in the future. Deferred annuities are frequently used by investors to supplement other retirement income, such as Social Security. A deferred annuity is different from an immediate annuity in that payments begin at a later date.

A deferred annuity is widely utilized in retirement to provide a consistent stream of income. Funding a deferred annuity can occur with a big one-time payment or in smaller amounts over months or years.  Either way gives you flexibility and the chance for growth. Payments from a deferred annuity can begin any time from one year onward after opening it.

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