For any manufacturer, knowing how much it costs to produce products is key to understanding the company’s profitability. While assigning manufacturing costs to products may sound simple, that’s only true for companies that make one thing, or a few. The larger the number of diverse products a company makes, the harder it is to determine each product’s share of common costs like labor, electricity and assembly-line machines. For such manufacturers, absorption costing is the accounting method to use for valuing product inventory so that the full costs of producing a single unit of a product can be derived — and it’s the only method that is compliant with U.S. Generally Accepted Accounting Principles (GAAP).
So, while many companies also use other product-costing methods to look at their production costs from different points of view for internal analyses, any public or private company that needs to produce GAAP-compliant financial statements must use absorption costing. Let’s explore absorption costing in more detail.
What Is Absorption Costing?
Absorption costing is one method used to allocate production costs to products. It is required by GAAP for external reporting, and, in the U.S., it’s required by the IRS for tax purposes. Absorption costing includes all direct and indirect costs associated with manufacturing a product. It is required by GAAP because it’s considered the best way to determine the “true” cost of producing an item for proper matching with revenue. An important aspect of absorption costing is that, because it captures all costs, it allows a manufacturer to price its products so that all manufacturing costs are covered.
Aka “full absorption costing” or “full costing.”
Absorption costing is also known as “full absorption costing” or “full costing.” These names all refer to the fact that the method, however it is referred to, absorbs into the cost of the product all associated manufacturing costs, including a proportion of overhead that can be associated with the product.
- Absorption costing incorporates all direct costs and overhead associated with manufacturing a product.
- Absorption costing allocates fixed and variable overhead costs to each unit produced during a reporting period whereas variable costing considers only variable overhead, not fixed, as a product cost.
- Using the absorption costing method means that, compared to other product-costing methods, more cost is included in a company’s period-ending inventory account. Inventory is reported as an asset on the balance sheet at the end of an accounting reporting period.
- Because absorption costing becomes increasingly complex for companies that manufacture many diverse products, thoughtful setup of general ledger accounts and effective integration between operational and accounting systems make accurate absorption costing far easier to achieve.
Absorption Costing Explained
Absorption costing is a managerial accounting method of valuing inventory that includes direct costs and fixed and variable overhead. Fixed manufacturing overhead includes items that are not altered by production volume, like factory rent, mortgage or insurance payments, as well as the depreciation on, for example, factory-floor machines. Variable manufacturing overhead items, such as electricity, do vary with production output. In absorption costing, all of these expenses are included as part of the value of the inventory, along with direct materials and labor. Other business expenses, such as administrative and sales expenses, are not included.
A savvy reader may conclude from this explanation that absorption costing can sometimes become quite complex. Applying it properly — especially for companies with a large number of different products — requires close collaboration between an organization’s manufacturing experts, who understand the nuances of production and the costs involved, and its managerial or cost accountants, who can apply GAAP rules while they determine the averages and estimates necessary for absorption costing calculations.
An apparel maker, for example, may make scarves and dresses from the same fabric and in the same facility. But the amount of fabric in those two products is very different, and it takes far more labor to produce a dress than a scarf. The company’s cost accountants must determine the different materials (in this example, fabric) and labor costs for scarves and dresses and factor those into the absorption cost of each product.
A key way to make absorption costing more efficient and effective for such manufacturers is to set up their chart of accounts (and, by extension, their general ledger) with the right number of detailed accounts to truly reflect the company’s manufacturing operations — which, again, requires collaboration between manufacturing and accounting experts.
With the right accounts established, and an enterprise resource planning (ERP) system that integrates operational processes and data from the factory floor with accounting data and processes, the cost pools necessary for absorption costing calculations can be more easily determined — and even automated.
Notably, absorption costing applies to manufactured inventory in much the same way as job costing applies to tracking expenses on broader projects; construction job costing applies to construction project expenses; and process costing is used by companies that produce a lot of the same or very similar products, such as providers of gasoline, cement, glass and paint. In fact, GAAP considers job costing and process costing to be types of absorption costing.
Components of Absorption Costing
Absorption costing encompasses all product manufacturing costs — product costs, period costs and all overhead. Because absorption costing captures more cost components than other methods, it excels at matching costs to revenue within the same fiscal period. This “matching principle” aims to account for all the expenses associated with a product’s sale within the same fiscal period as when revenue from the sale is recognized.
It is a key principle in GAAP: Under GAAP, the cost of products that remain unsold sit on the company’s balance sheet as inventory and are expensed in a future period when the item is sold. And, again, because absorption costing captures more cost components than other product costing methods, it results in a higher per-unit cost of goods sold (COGS) value.
What is and is not included in the value of the inventory on a company’s balance sheet can be broken down into product costs and period costs.
Product costs are those that are a necessary part of manufacturing the product. Under the absorption costing method, these include direct materials, direct labor and both fixed and variable manufacturing overhead. These costs are reflected in the value of the inventory listed on the balance sheet.
Excluded from product costs under the absorption costing method are all expenses that relate to nonproduction factors, such as marketing, depreciation of assets not directly involved in manufacturing, and administrative costs. These are considered period costs and are presented on the income statement in the period during which they occur; thus, they are not included in the value of inventory on the balance sheet.
Absorption Costing Formula
A simple formula for determining the value of a single unit of inventory under absorption costing is the sum of all cost components divided by the number of units produced in the period. The formula looks like this:
Absorption cost of 1 unit = (Direct labor costs + Direct material costs + Variable manufacturing overhead + Fixed manufacturing overhead) / Number of units produced
To determine the value of inventory for the balance sheet, multiply the result of this formula by the number of remaining (unsold) items at the end of the reporting period. For illustrations of this formula in action, see the Absorption Costing Examples section, below.
Where absorption costing becomes more complex is the level below this formula — i.e., when calculating each of the four components in the formula’s numerator. Consider the apparel company making scarves and dresses from the same fabric and in the same factory.
To determine the correct amount of direct labor cost to insert into the formulas for scarves and dresses, the company’s cost accountants might need to sum the different aspects of labor (hourly wages, overtime, benefits, 401(k) matching, if any) and then divide the result proportionally according to the number of labor hours required to make a dress versus a scarf and the number of each produced.
Absorption Costing vs. Variable Costing
While absorption costing is the only GAAP-compliant method for fully costing inventory, there are other methods that businesses may find useful. One notable method used to value inventory is variable costing. The difference between variable costing and absorption costing is the way fixed manufacturing overhead is treated.
In absorption costing, fixed manufacturing overhead is portioned out and reflected in the cost of each unit manufactured during the period. In variable costing, fixed manufacturing overhead is not included in the cost of a unit; instead, it is included as a period cost that is charged off on the income statement. Therefore, under variable costing, the value of inventory carried over into future periods is lower than it would be under absorption costing, as is COGS.
The following graphic depicts the different treatment of product and period costs under the absorption and variable costing methods.
Absorption vs. Variable Costing
|Direct Labor Costs
|Direct Labor Costs
|Direct Material Costs
|Direct Material Costs
|Variable Manufacturing Overhead
|Variable Manufacturing Overhead
|Fixed Manufacturing Overhead
|Fixed Manufacturing Overhead
|Variable Sales and Admin Costs
|Variable Sales and Admin Costs
|Fixed Sales and Admin Costs
|Fixed Sales and Admin Costs
|Costs included in the value of products inventory
|Costs not included in the value of product inventory
Variable costing is not allowed for external reporting under GAAP because of the importance of GAAP’s matching principle. Under variable costing, fixed manufacturing overhead expenses are booked in the period during which they occur, not carried forward as a component of product inventory to be matched to the revenue from future product sales.
Absorption Costing Steps
There are three steps involved in the absorption costing method that must be applied separately to each of the components — direct labor costs, direct material costs, variable manufacturing overhead and fixed manufacturing overhead — in the absorption costing formula. The results of those separate calculations are then plugged into the formula to determine the full absorption cost to produce a single unit of a product.
These steps are the complex part of absorption costing that can be made far easier depending on how well the company’s chart of accounts is set up (to reflect the details of manufacturing operations) and how well the organization’s operational and accounting systems are integrated.
- Allocation: All costs must be allocated to a cost pool for each component. A cost pool is a grouping of general ledger accounts, typically gathered by department. For example, the various labor costs mentioned earlier — hourly wages, overtime, benefits, 401(k) matching — would likely each have its own general ledger accounts, and they could all be mapped to one cost pool under direct labor costs. Similarly, the appropriate general ledger accounts must be allocated to direct materials costs and fixed and variable manufacturing costs. Changes to allocation mappings should not be made often because such changes may hamper period-to-period comparative analysis.
- Determine an activity measure: While this is often simply the gross number of units produced, different activity measures may be important to getting the right costs for each component. For example, labor hours for calculating direct labor costs for different products, or machine hours for factoring the depreciation of manufacturing equipment into different products’ costs. This activity measure becomes the denominator for the calculation in step No. 3.
- Calculate: Determine the sum for the total of each cost pool and divide that sum by the relevant activity measure for that pool.
Repeat these three steps for all elements included in each component of manufacturing so that all costs are absorbed into the cost of the product.
Advantages of Absorption Costing
Two key advantages of absorption costing are that it complies with GAAP, and it more accurately reflects profit during the reporting period. It can also be easier to calculate, since manufacturing overhead expenses do not need to be dissected into fixed and variable and treated differently for accounting purposes. Here are the four main advantages of absorption costing versus other methods of product costing:
- Establishing a selling price: Absorption costing provides better information for decision-makers who decide product selling prices because it makes sure all related expenses are included.
- External reporting: This is required for GAAP compliance and for tax reporting.
- Accurate profit forecasting: Absorption costing yields a more accurate determination of net profit versus variable costing because it matches expenses with related revenues in the same reporting period.
- Higher income generation: This method results in a higher net income because a portion of costs related to unsold goods — namely, the fixed manufacturing overhead costs — are not expensed during the period but carried forward on the balance sheet as ending inventory until the product sells.
Disadvantages of Absorption Costing
Using the absorption costing method can be disadvantageous at certain times because it shifts the timing of when fixed manufacturing overhead is expensed on the income statement, which can skew internal business analyses. For this reason, business leaders may prefer to replace absorption costing with variable costing to support some internal business decisions. For example, consider volume analysis.
- An increase in production volume would decrease unit costs under absorption costing, which wouldn’t matter if all the units were sold in the same reporting period. But if the goods are not all sold, net income for that period would appear to be inflated, because a portion of fixed manufacturing costs would be carried forward in the inventory on the balance sheet, not deducted from revenue.
- Absorption costing may skew the profitability analysis for companies thinking of ramping up production.
- Cost per unit under absorption costing includes fixed overhead items like rent, machinery costs which do not notably rise with increased production. In this type of analysis, a variable cost per unit method should be used.
Absorption Costing Examples
To build a better understanding of how absorption costing works, let’s look at two different illustrative — and hypothetical — examples.
First, consider T-shirt maker TeesbyT, which produces 15,000 golf tees in its first fiscal quarter and sells 12,000, leaving 3,000 in ending inventory. Each shirt requires $1 of direct materials and labor, and 50 cents of variable overhead. Additionally, TeesbyT’s monthly fixed overhead costs are $30,000. Using the absorption costing method to determine the fixed overhead costs per unit, TeesbyT’s finance team divides the fixed overhead costs by the number of units produced that month ($30,000 / 15,000 tees) to determine that there is $2 worth of fixed overhead costs that go into manufacturing each shirt. That means, each T-shirt produced by TeesbyT during the quarter has an absorption cost of $3.50 ($1 direct materials and labor, $0.50 variable overhead costs and $2 fixed overhead costs).
The company can then calculate that its total COGS for the quarter is $42,000 by multiplying the absorption cost times the number of units sold ($3.50 per tee x 12,000 tees sold). It can also determine that there is $10,500 worth of remaining inventory on the balance sheet ($3.50 per tee x 3,000 tees).
The second example is WD & Co., which manufactures dog coats. Last month, WD produced 10,000 coats and sold 8,000. The company’s total manufacturing costs were as follows:
- Direct labor: $30,000
- Direct materials: $20,000
- Variable manufacturing overhead: $5,000
- Fixed manufacturing overhead: $10,000
WD applies the absorption costing formula as follows to determine its cost per coat: ($30,000 + $20,000 + $5,000 + $10,000) / 10,000, or $65,000 / 10,000, or $6.50 per coat. That means, WD’s cost of coats sold during the month is $6.50 x 8,000, or $52,000. The value of inventory remaining on WD’s balance sheet is $6.50 x 2,000, or $13,000.
Replace Time-Wasting Spreadsheets With Financial Management Software that Does It All
Accurate inventory valuations play an important role in strategic production decisions and are crucial to both external reporting and internal analysis. What’s more, the GAAP-compliant absorption costing method is crucial to accurate inventory valuations. But even organizations that have the manufacturing and managerial accounting expertise necessary to identify and track all the costs that go into its production still need integrated manufacturing-process and accounting solutions to reflect that information and apply absorption costing rules.
NetSuite’s cloud-based accounting software is just such an integrated solution. It can seamlessly integrate inventory management and costing processes with accounting and reporting via links with modules, such as NetSuite Inventory and NetSuite Financial Management. For example, NetSuite inventory provides forward and backward inventory traceability, which is especially helpful to absorption costing in a business with multiple products and locations. And unlike manual spreadsheets, NetSuite’s financial management solution can generate financial statements using absorption costing as required by GAAP and the IRS, while also automatically using variable costing to produce internal analyses for business decision-makers.
Absorption costing is a method of valuing inventory that incorporates all manufacturing costs, both fixed and variable, that are part of a product’s cost. It becomes increasingly challenging for companies that make many different products. For such a diverse manufacturer, doing absorption costing well requires good execution in the setup of the company’s chart of accounts, as well as good integration between operational and accounting systems. For external reporting purposes, absorption costing is required under GAAP and by the IRS for tax purposes, whereas other costing methods may be useful for certain internal business analyses.
Absorption Costing FAQs
Can absorption costing cause an increase in net income?
Yes, under certain circumstances absorption costing can cause an increase in net income when production volume rises. Here’s how: Higher production volume would lower the production cost of one unit because fixed costs would be spread over more units; the lower unit cost would be reflected in a lower cost of goods sold on the income statement, resulting in a higher net income.
Why is absorption costing required by GAAP?
Absorption costing is required by GAAP because of the primacy of GAAP’s matching principle. Under absorption costing, expenses associated with the manufacture of products are not reflected on the income statement until those products are sold. Therefore, revenue and expenses are appropriately matched in the period of sale.
Is absorption costing and full costing the same?
Yes. Absorption costing captures all costs associated with manufacturing a product; therefore, it is also referred to as full costing.
What does absorption of costs mean?
Absorption costing is a method of valuing inventory that captures, or absorbs, all manufacturing costs into the product cost. Therefore, the product cost reflects an absorption of all costs.
What is the difference between marginal costing and absorption costing?
Absorption costing is the GAAP-compliant accounting method for determining the full cost of manufacturing a product. Marginal costing is an analysis that helps business managers understand how much it would cost to produce one additional unit beyond what was already planned. Because such an increase in volume would not change fixed expenses, the variable costing method, not absorption costing, should be used to determine the marginal cost. Absorption costing analysis includes fixed overhead expenses and would therefore artificially inflate the cost of an additional unit.
What is meant by absorption of overhead?
Absorption costing is a method of valuing inventory that captures, or absorbs, labor, materials and manufacturing overhead (both fixed and variable) into the product cost. Therefore, under absorption costing, the product cost reflects an absorption of overhead.
When can absorption costing be used?
Absorption costing should be used to establish a product’s selling price, thus ensuring that all related expenses will be covered. It also must be used for external reporting under U.S. Generally Accepted Accounting Principles (GAAP) and for tax purposes.
Why is absorption costing more likely to be used by larger businesses?
Absorption costing is more likely to be used by larger businesses because it is required for U.S. GAAP reporting and because it more accurately tracks profit versus variable costing, in compliance with GAAP’s matching principle.
What is absorption costing with example?
Absorption costing is an accounting method used to comprehend the full production costs of one item. It includes all direct and indirect costs associated with manufacturing the product. To illustrate, consider the fictional LHR Co., which manufactures widgets. Last month, LHR produced 1,000 widgets and sold 800, leaving 200 unsold. The company’s total manufacturing costs include direct labor of $20,000, materials costing $10,000, variable manufacturing overhead of $1,000 and fixed manufacturing overhead of $2,000. Using the absorption costing formula (Product cost = (Direct labor costs + Direct material costs + Variable manufacturing overhead + Fixed manufacturing overhead) / Number of units produced), LHR determines that the full cost of producing each widget was $33 (($20,000 + $10,000 + $1,000 + $2,000) / 1,000). The cost of all the widgets LHR sold that month was $26,400 ($33 x 800), and the value of the remaining inventory on its balance sheet was $6,600 ($33 x 200).
What is absorption costing formula?
The formula for absorption costing is: Product cost of one unit = (Direct labor costs + Direct material costs + Variable manufacturing overhead + Fixed manufacturing overhead) / Number of units produced.
What is the purpose of absorption costing?
The purpose of absorption costing is to determine the cost of producing a single unit, given all manufacturing costs involved. It is considered the best way to determine the “true” cost of producing an item, allowing the manufacturer to price its products to ensure that all manufacturing costs will be covered. It is also the only method of valuing inventory that complies with U.S. Generally Accepted Accounting Principles (GAAP).