Is Absorption Costing Required by GAAP?
Explore why U.S. GAAP requires absorption costing for financial statements, a method that aligns costs with revenue and impacts reported profitability.
U.S. Generally Accepted Accounting Principles (GAAP) require absorption costing for any financial statements prepared for external use. This mandate applies to public companies and private organizations that need GAAP-compliant financial statements. The objective is to present a company’s financial performance and position in a consistent and transparent manner. By using this method, companies ensure their reported asset values and profitability align with the principles of accrual accounting.
The GAAP Mandate for External Reporting
The primary reason GAAP requires absorption costing is its adherence to the matching principle. This principle dictates that expenses incurred to generate revenue should be recognized in the same accounting period as the revenue itself. This prevents the overstatement or understatement of income in any single period.
Absorption costing achieves this by treating fixed manufacturing overhead as a product cost. This means costs like factory rent or equipment depreciation are attached to the inventory produced and held on the balance sheet as an asset. These costs are not recorded as an expense until the inventory is sold.
When a sale occurs, the associated costs are transferred from inventory to the Cost of Goods Sold, directly matching them against the revenue. This treatment contrasts with variable costing, which is not permitted for external reporting under GAAP. Under variable costing, fixed manufacturing overhead is treated as a period expense and recorded in the period it is incurred, which violates the matching principle and can distort a company’s reported profitability.
Differentiating Product and Period Costs
Absorption costing separates costs into two categories: product costs and period costs. Product costs are all expenses directly associated with the manufacturing process. These include direct materials, direct labor, and all manufacturing overhead, which encompasses both variable overhead, like the electricity to run machinery, and fixed overhead, such as the factory’s property taxes or insurance.
The accounting treatment for these two cost types is different. Product costs are capitalized, meaning they are recorded as an asset on the balance sheet under the “Inventory” line item and remain there as long as the product is unsold. This capitalization impacts the value of a company’s assets, as the full cost to produce the goods is reflected on the balance sheet.
Period costs are not related to the manufacturing process and are expensed on the income statement in the period they are incurred. These costs typically include selling, general, and administrative (SG&A) expenses, such as sales commissions, marketing campaigns, or the salaries of corporate executives. Because they are expensed immediately, they reduce a company’s net income in the current period.
The Role of Variable Costing for Internal Use
While not permissible for external financial reporting, variable costing is a valuable analytical tool for internal management. Instead of allocating fixed manufacturing overhead to products, variable costing treats it as a period cost, expensing it immediately in the period it is incurred. This approach is used for internal decision-making because it provides a clearer picture of the incremental costs of producing one more unit.
By separating variable and fixed costs, managers can calculate the contribution margin, which is revenue less all variable costs. This figure is useful for determining product-line profitability, making pricing decisions for special orders, and conducting cost-volume-profit (CVP) analysis to find a company’s breakeven point.
For example, when considering a one-time special order, management can use variable costing to see if the offered price covers the variable costs of production. Any amount above the variable cost contributes to covering fixed costs and generating a profit. This analysis helps managers make informed operational decisions that may not be as clear when using data prepared under the absorption costing method.