What Is Absorption Costing and How Does It Work?
Learn absorption costing, an essential accounting method for fully valuing product costs and understanding its financial reporting implications.
Absorption costing is a method companies use to determine the full cost of producing a product, including all fixed and variable manufacturing costs in each unit. It is a widely used accounting method, particularly for external financial reporting, as it is required under U.S. Generally Accepted Accounting Principles (GAAP) and for tax purposes by the IRS.
Understanding Product Costs
Under absorption costing, four key cost components are included in the cost of a product: direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. All are considered product costs because they are directly tied to the manufacturing process.
Direct materials are raw materials that become part of the finished product and are directly traceable, such as wood for a chair or fabric for a shirt. Direct labor refers to wages paid to workers directly involved in production, such as for assembly line workers. Variable manufacturing overhead consists of indirect production costs that change in proportion to production volume, like electricity for factory machinery or lubricants.
Fixed manufacturing overhead includes indirect production costs that remain relatively constant, regardless of units produced. Examples include factory rent, property taxes, insurance on the manufacturing facility, and depreciation on production equipment. Under absorption costing, a portion of these fixed costs is assigned to each unit, ensuring every product bears a share of all manufacturing costs.
Calculating Unit Product Cost
To determine the unit product cost under absorption costing, the four cost components—direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead—are combined. The formula for this calculation is: Unit Product Cost = Direct Materials per unit + Direct Labor per unit + Variable Manufacturing Overhead per unit + Fixed Manufacturing Overhead per unit. This captures the comprehensive cost of producing each unit.
Fixed manufacturing overhead must be allocated to individual units. Since these costs are incurred for a period, they are allocated using a predetermined overhead rate. This rate is calculated by dividing total fixed manufacturing overhead by an activity base, such as direct labor hours, machine hours, or units produced.
For instance, if a company estimates $100,000 in fixed manufacturing overhead and produces 10,000 units, the fixed overhead rate is $10 per unit ($100,000 / 10,000 units). If a unit requires $20 in direct materials, $15 in direct labor, and $5 in variable manufacturing overhead, the total unit product cost would be $20 + $15 + $5 + $10 = $50.
Cost Flow and Financial Statements
Under absorption costing, product costs are initially treated as inventory costs. These costs are recorded on the balance sheet as assets in work-in-process and finished goods inventory accounts. Fixed manufacturing overhead incurred during production is not immediately expensed but absorbed into inventory value.
These absorbed costs only become an expense on the income statement when the product is sold. At the point of sale, the cost of the sold goods is transferred from inventory on the balance sheet to the Cost of Goods Sold (COGS) expense on the income statement. This treatment aligns with the matching principle of GAAP, which requires that expenses be recognized in the same period as the revenues they helped generate.
The treatment of fixed manufacturing overhead under absorption costing can impact a company’s reported inventory values and net income. When production exceeds sales, a portion of the fixed manufacturing overhead costs remains capitalized in unsold inventory on the balance sheet. This defers the expense recognition of these costs to a future period, which can result in a higher reported net income in the current period compared to methods that expense fixed overhead immediately. Conversely, if sales exceed production, fixed overhead costs from previous periods (held in beginning inventory) are expensed, potentially leading to a lower net income.
Absorption Costing Compared to Variable Costing
The difference between absorption and variable costing lies in their treatment of fixed manufacturing overhead. Under absorption costing, fixed manufacturing overhead is a product cost included in each unit’s cost. For example, a portion of factory rent, insurance, or equipment depreciation is assigned to every manufactured item.
In contrast, variable costing treats fixed manufacturing overhead as a period cost. All fixed manufacturing overhead costs are expensed in the period they are incurred, regardless of production or sales volume, and are not attached to the product. This distinction leads to different reported net incomes, especially when inventory levels change.
When production exceeds sales, absorption costing will generally report a higher net income than variable costing because some fixed manufacturing overhead costs are capitalized in unsold inventory on the balance sheet, rather than being expensed immediately. Conversely, when sales exceed production, variable costing may show a higher net income because all fixed overhead was expensed in prior periods, whereas absorption costing would be expensing fixed overhead from prior periods’ inventory. Absorption costing is primarily used for external financial reporting due to its compliance with GAAP, while variable costing is often preferred for internal decision-making because it provides a clearer view of the incremental costs of production.