Absorption costing is a process that takes all production costs into account to determine a selling price. Without it, setting sustainable profit margins gets difficult. To be successful when absorption costing, you need to follow certain accounting best practices. Here’s what you need to know about absorption costing and how to apply it in your business.
What is absorption costing?
Absorption costing, also called full costing, is an accounting method for manufacturers to calculate all the expenses of making a product. These expenses range from costs for materials and factory labor to various overhead costs. Ascertaining these costs gives a business a basis for setting a profitable price for a product. Absorption costing also is required under generally accepted accounting principles (GAAP) for companies that prepare financial reports for regulators and investors. It’s also required for tax filings.
A key aspect of absorption costing is that it lets a company allocate some production costs to the income statement and some to the balance sheet—specifically for goods produced but not yet sold and held as inventory. This is because GAAP accounting is guided by the matching principle, meaning that the cost of making goods is matched to sales of those goods in the same period. As goods held in inventory are sold in subsequent quarters, the past cost of those goods is recorded in subsequent income statements to match those sales.
Absorption costing formula
The formula to calculate absorption cost per unit has four components, typically measured in a period such as a month or quarter.
- Direct materials (DM): These are any materials used to make a product.
- Direct labor (DL): This includes hourly pay or other wages, as well as benefits such as pension contributions.
- Variable manufacturing overhead (VMOH): The costs needed to run a factory vary with output. Energy, water, and supplies for equipment are examples of variable manufacturing overhead.
- Fixed manufacturing overhead (FMOH): These costs occur every period regardless of production volume. Examples are rent or mortgage payments, property taxes, insurance, and depreciation of fixed assets.
The absorption costing formula sums up the four component costs, then divides the total by the number of units manufactured:
Absorption cost = (DM + DL + VMOH + FMOH) / Number of units produced
Companies often do separate per-unit cost calculations for materials, labor, and variable manufacturing overhead. Then they separate the portion of fixed overhead attributable to manufacturing. Some fixed overheads, such as selling and administrative expenses, are excluded because they aren’t connected to manufacturing volume. In such cases, the formula for absorption cost looks a little different:
Absorption cost = DM per unit + DL per unit + VMOH per unit + (FMOH / Number of units produced)
Absorption costing steps
There are three steps to determining absorption costs:
1. Allocate costs by type
Determine the costs associated with making your product and group them by activity into cost pools for each of the four major components listed above. For example, pool wages, overtime, and benefits to hourly workers under the direct labor cost component. As the business incurs costs, business managers can assign them to the pool that best describes them. Having a well-constructed, detailed chart of accounts and general ledger helps with this.
2. Measure usage tied to each cost
Base usage on quantity or activity—for example, square feet of cloth, hours of labor, watts of electricity, and gallons of water. You will need to measure usage for each of the four cost components—direct labor, direct materials, variable manufacturing overhead, and fixed manufacturing overhead—against the number of product units manufactured, to determine a per-unit cost for each component. For example, total factory labor costs against the total number of units manufactured.
3. Tally the costs
Aggregate cost pools are aggregated under the four main components listed above: direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Add the cost pools for each component and divide by the number of units produced.
Advantages of absorption costing
Absorption costing offers several advantages to manufacturers, including:
GAAP compliance
Absorption costing adheres to GAAP, which requires matching product costs to product sales in the same period. It also requires recording the costs of unsold goods as inventory, an asset on the balance sheet. Because it complies with GAAP, absorption costing meets regulatory guidelines for publicly disclosed financial reports, as well as tax filings.
Providing a complete cost picture
Full costing covers all the costs of producing goods, giving your company a basis for a selling price that’s profitable. Without this information, you risk selling at a loss and lack a good basis for determining the cause.
Boosting current net income
By shifting some production costs from the income statement to the balance sheet as inventory, a company may lower its overall costs and thus increase net income. At the same time, accurate absorption costing boosts the value of inventory by valuing it at full production cost.
Disadvantages of absorption costing
At the same time, there are potential drawbacks to absorption costing including:
Inflated profitability
By shifting some portion of production costs to the balance sheet rather than on the income statement when they are incurred, absorption costing can result in temporarily inflated net income. The risk is that unsold goods in inventory may not fetch the same price when they are eventually sold, squeezing profit margins in future periods.
Incentive to overproduce
Because costs of unsold goods aren’t reflected as cost of goods sold (COGS) on the income statement, but rather get shifted to the balance sheet, companies may be tempted to overproduce, because it doesn’t harm profitability in the current period.
Not for marginal-cost analysis
Absorption costing isn’t useful when a company considers production changes. For example, imagine that you want to determine how much costs would increase if your online blanket business boosted production to 12,000 units per month from 10,000, and how much profit the extra production would generate—or whether it will cost more than it’s worth. In this case, you would need to use variable costing to conduct what’s known as marginal cost analysis.
Absorption costing vs. variable costing
Although manufacturing companies must use absorption costing when preparing external reports such as regulatory filings, they typically use other cost accounting methods, such as variable costing, for internal analysis.
The main difference between absorption and variable costing is that absorption costing includes some fixed manufacturing overhead expenses in product costs. Variable costing excludes these fixed costs from product cost; instead, it treats them as a separate one-time expense known as a period cost that is recorded in a specific period—whether goods are sold or not. Period costs, such as selling, general, and administrative expenses (SG&A), don’t change with output volume.
Product costs are those considered essential to making an item or good. Under the absorption costing method, these include direct materials, direct labor, and the portions of fixed and variable overhead costs attributable to manufacturing activity.
Absorption costing generally results in a somewhat higher cost of goods sold and lower gross profit than variable costing, while potentially boosting net income. This is because SG&A costs are lower, a result of shifting fixed manufacturing overhead into production costs. At the same time, the value of inventory increases by the amount of production costs for unsold goods.
Let’s use the hypothetical online blanket seller as an example. Imagine that you produced 10,000 blankets in the latest quarter, and absorption costs broke down as follows:
- Direct labor: $300,000 = $30 unit cost
- Direct materials: $300,000 = $30 unit cost
- Variable manufacturing overhead: $100,000 = $10 unit cost
- Fixed manufacturing overhead: $300,000 = $30 unit cost
Your production costs by the absorption method are $100 per blanket, or a total of $1 million.
Now let’s assume your company sold 6,000 of the 10,000 blankets produced in the current quarter for $150 each, for revenue of $900,000. Meanwhile, fixed and variable manufacturing overhead is $400,000 to cover things like monthly rent and energy to power machinery. But there’s also non-manufacturing overhead, such as administrative costs—let’s say $50,000—bringing total overhead to $450,000.
Under absorption costing, you would record $600,000 as COGS for the 6,000 blankets sold in the quarter, and the other $400,000 as inventory (the unsold blankets). Total costs will be the $600,000 in COGS plus the $50,000 in marketing costs and salaries, or $650,000. That means net income in the quarter is $900,000 - $650,000 = $250,000.
Under variable costing, COGS is only $420,000, because per-unit costs are $70, excluding the $30 per unit in fixed manufacturing overhead. Total overhead, meanwhile, is $350,000, which is made up of the $300,000 in fixed manufacturing overhead and $50,000 in non-manufacturing overhead. Adding COGS to total overhead brings costs to $770,000. That means net income is $900,00 - $770,000 = $130,000.
Absorption costing FAQ
What is another name for absorption costing?
Absorption costing also is called full costing, or full absorption costing. It refers to the accounting method of fully absorbing all the costs to make a product.
How do you calculate absorption cost?
Absorption costing is calculated by adding the four major cost components—materials directly used in manufacturing, labor directly employed, variable manufacturing overhead, and fixed manufacturing overhead—in a period and dividing by the number of units manufactured.
What is the difference between absorption costing and standard costing?
Standard costing involves setting predetermined costs for products and services, based on estimated prices of resources and manufacturing efficiency. Standard costing excludes fixed manufacturing overhead as a production cost. By contrast, absorption costing includes some fixed manufacturing overhead costs to match product sales in a period. It also shifts the cost of unsold goods to inventory on the balance sheet until they’re sold in future periods.
