Absorption costing is a method of managerial accounting that takes into account all the costs related to the manufacturing of a specific product. For the purpose of external reporting, this method is needed by the GAAP (Generally Accepted Accounting Principles).
Absorption costing is also called ‘full costing’. It includes costs that are direct and are included in the production of the goods and also takes into account the fixed costs that remain constant throughout the production. This includes the costs related to labor, wages of employees who are working on the product, cost of raw materials, and overhead costs during production. Here all the costs are allotted to manufactured products even though they might be sold after the period is fulfilled.
It also leads the price of inventory to be higher on the balance sheets and the expenses to be lower.
Difference between variable costing and absorption costing
The treatment of fixed overhead costs determines the differences between absorption costing and variable costing. In absorption costing, the fixed overhead costs are scattered over the costs of units that are manufactured in a period, while in variable costing this cost is compiled in one and the expenses are reported as one line different from the COGS (Cost of goods sold).
Variable costing does not define the per-unit cost of goods, on the other hand, absorption costing does. Absorption costs take into account two fixed overhead costs: the cost of goods sold and the other which is related to inventory.
Pros and cons
In this method, the assets like inventory still appear on the balance sheet when the fiscal period ends. This is because absorption costing takes into account costs that are related to both inventory and the cost of goods sold. Absorption costing is more concerned with fixed costs that are present in the ending inventory.
Additionally, expenses are also put into the account for the products that are not sold, this decreases the real expenses that are reported in the income statement of the current period. Hence, it leads to a high net income in comparison to the variable costing calculations.
Since absorption costing also has fixed overhead costs for COGS, it might not be of music help to the management when they are making internal incremental pricing policies and decisions. That is because variable costing takes into account only the extra costs that are used in producing the following incremental unit of product.
Additionally, using this method leads to a condition where the manufacturing of products that go unsold at the end of the year, will lead to a rise in the net income.
Example
Suppose Company XYZ creates widgets. During January, 10,000 pieces were made, 8,000 were sold as the month came to an end and 2,000 products remained unsold. The labor cost for each widget is $5. The fixed overhead cost is $20,000. As per the absorption costing method, the company will allot $2 added to each unit ($20,000 x 10,000 widgets for a month).
Hence, the absorption cost will be $7, $5 for materials and labor $2 as fixed overhead cost. Since 8,000 widgets are sold, COGS will be $56,000. And the ending inventory will contain $14,000 in unsold products.
This method complies with GAAP and IRS (Internal Revenue Service). It also includes the cost of production along with direct costs, hence gives a more accurate accounting period picture.
