Absorption Costing
An accounting method that includes all direct and indirect production costs in determining the cost of a product, ensuring comprehensive expense coverage.
What is Absorption Costing?
Absorption Costing is an accounting method that includes all direct and indirect production costs in determining the cost of a product and allocates associated manufacturing costs to the cost of goods sold (COGS).
The costs here include raw materials and labor directly tied to production, variable, and fixed overheads.
Absorption costing and Full Costing are both used interchangeably. This method of costing is appreciated by the generally accepted accounting principles (GAAP) fo valuing inventory and financial reporting.
It is one way to value inventory. Direct material, and direct labor, along with variable and fixed overhead expenses, are all part of the product costs under absorption costing.
Whereas, Variable Costing, is a technique used by the management and not for official reporting purposes, including direct material, direct labor, and only variable overheads as a part of product costs. And, considers fixed overheads as a part of period costs.
The ABS costing technique allocates fixed overheads to each unit produced regardless of the product sold. This leads to differences in inventory valuation and reporting.
Key Takeaways
- Absorption costing is an accounting method that considers all direct and indirect production costs when determining a product's cost. It allocates manufacturing costs to the cost of goods sold (COGS), including both variable and fixed overhead costs.
- Also known as full costing, absorption costing is endorsed by Generally Accepted Accounting Principles (GAAP) for inventory valuation and financial reporting purposes.
- Absorption Cost = (Direct Labor Expense + Direct Material Expense + Variable Manufacturing Overhead Costs + Fixed Manufacturing Overhead) / Number Of Units Produced
- While advantageous for its accurate cost representation and external reporting suitability, it faces challenges related to cost variability, overhead allocation, and profit accuracy.
Components of Absorption Costing
Direct costs and indirect costs are both included in the ABS costing components.
Expenses directly linked to a particular good or service are referred to as direct costs. Expenses that cannot be linked to a particular good or service are indirect costs. These expenditures, sometimes referred to as overhead expenses, consist of rent, utilities, and insurance.
The main components of absorption costing include:
- Direct Material Costs: The cost of materials directly tied to the production of the good. For example, in the manufacturing of a car, the costs of steel, alloys, aluminum, rubber, glass, fabric/ leather can be considered as direct materials.
- Direct Labor Costs: The cost of labor directly related to the manufacturing of goods or services. For example, in car manufacturing, the labor directly involved in the car assembly can be considered direct labor costs.
- Variable Overheads: The costs that go beyond the head costs (direct material + direct labor) are known as overheads. Variable overheads incur in manufacturing and increase in total amount with the increase in production. Utilities to run the manufacturing and sales commission can amount to variable overheads.
- Fixed Overheads: These are the overheads that remain constant in total regardless of the activity. Some examples of fixed overheads are salaries, rent, and asset depreciation expenses.
- Number of units produced: The total number of units produced by the manufacturing units during the period.
- Number of units sold: The total number of units sold by the company during the year.
The total cost is calculated by summing the costs involved. The total production expenses are then divided by the number of units produced during the year. Therefore, the following is stated as the ABS costing formula:
Absorption Cost = (Direct Labor Expense + Direct Material Expense + Variable Manufacturing Overhead Costs + Fixed Manufacturing Overhead) / Number Of Units of Production
Note
The Administrative and variable selling costs and Fixed Selling and administrative costs are regarded as period costs under ABS costing and are not included in the cost of a product. Instead, they are expensed during the time they occur.
What is Variable Costing?
In cost and management accounting, variable costing refers to the accounting method that considers only the variable costs as product costs and excludes fixed manufacturing overhead from the product cost.
The variable costing technique considers fixed overheads as period costs rather than spreading them out to the produced units.
This approach is in contrast to ABS costing, which allocates fixed production costs to product output. Variable costing cannot be utilized in financial reporting under accounting standards like IFRS and GAAP.
Its more of an internal/management reporting tool and aids in the contribution margin analysis and in break-even analysis.
A variable cost is a recurring expense whose value changes in response to changes in output level. Shipping costs, production costs, and delivery fees are some examples of variable costs.
Small firms with higher variable costs differ from those with higher fixed costs, including expenses like rent and insurance that don't alter with sales and output.
Compared to businesses with high fixed costs, high variable cost businesses must produce less to break even and have smaller profit margins.
Note
The matching principle, which mandates that costs be reported at the same time as the income they contributed to, is better upheld through ABS costing.
Because associated expenditures are not recorded in the same period as related revenue, variable costing fails to preserve the matching principle.
In a scenario where all fixed manufacturing overhead would be expensed for the relevant period under variable costing.
However, if the business could not sell all of the inventory produced that year, the income statement would show a poor match between revenues and costs.
Variable costing is thus not allowed for external reporting. However, it is frequently used for internal decision-making and managerial accounting.
Note
When using variable costing, all variable production costs must be accounted for in inventory, and all fixed production costs (fixed manufacturing overhead) must be recorded as period expenses. Therefore, all fixed manufacturing expenses are deducted as they are incurred.
The only distinction between ABS costing and variable costing is how fixed production overhead is handled.
Fixed manufacturing overhead is recorded as
- A product cost using ABS costing.
- A period cost when using variable costing.
Although the use of variable costing in financial reporting is prohibited by accounting standards like GAAP and IFRS, managers frequently utilize this costing strategy to
- By performing a break-even analysis, find out how many units must be sold before a profit can be made.
- Find the product's contribution margin to comprehend better the connection between cost, volume, and profit.
- To simplify decision-making, eliminate fixed manufacturing overhead costs, which can be troublesome due to how fixed costs are allocated across each product.
Absorption vs. Variable Costing
The costs involved in manufacturing goods and services can be calculated in two primary ways: absorption costing and variable costing.
How fixed manufacturing overhead expenses are handled differs between ABS and variable costing. The following are the differences:
| Aspect | Absorption Costing | Variable Costing |
|---|---|---|
| Treatment Of Fixed Costs | The product costs under absorption costing include fixed costs as part of the inventory valuation process. Then, these fixed costs are expensed products. | Fixed costs under variable costing are treated as period expenses and are deducted from the revenues. |
| Treatment Of Variable Costs | Variable costs are included in the period costs with fixed costs. | Fixed manufacturing costs are included in the period expenses, whereas, the variable manufacturing costs are a part of product costs. |
| Reporting Income | Absorption costing can definitely lead to variations in reported income because of the changes in the inventory levels affecting the fixed cost allocation. | VC generally results in more stable income reporting as fixed costs are expensed in the current period. |
| Decision Making | Since fixed overheads are spread out over a number of units, overproduction is encouraged here. | Variable cost is the only cost that is directly associated with production, profitability assessment is more encouraged here. |
| Compliance GAAP | Required under the Generally Accepted Accounting Principles (GAAP) | Not required under the GAAP, but more relevance in internal accounting and management decision-making. |
Variable costing regards fixed production overhead as a period cost. In contrast, ABS costing treats it as a product cost (included in inventories on the balance sheet until sold) (expensed on the income statement as incurred).
The following three guidelines apply when contrasting ABS pricing with variable costing:
- When the quantity of units produced and sold is identical, the profit for both costing techniques is the same.
- ABS costing produces the best profit when the number of units produced exceeds the number of units sold.
- Variable costing produces the maximum profit when units made are less than sold.
When a business employs just-in-time inventory, there is never any starting or ending inventory; hence profit is constant regardless of the costing strategy applied.
Note
At the end of the reporting period, most businesses still have production units in stock.
Since ABS costing considers fixed production overhead as a product cost, all goods ending in inventory (i.e., unsold at the end of the period) constitute a component of those expenses as an asset on the balance sheet.
All fixed manufacturing overhead expenses are recorded as expenditures on the income statement when they are incurred since variable costing recognizes them as period costs.
ABS costing will yield a more significant profit if the number of units produced exceeds the number of units sold.
Advantages of Absorption Costing
Absorption costing appropriately acknowledges the significance of factoring in fixed production costs when determining product costs and formulating an appropriate pricing strategy.
All production-related expenses (both fixed and variable) ought to be billed to the units produced. ABS costing pricing guarantees that all expenses are paid for.
Considering Fixed Costs
Absorption costing recognizes the significance of factoring in fixed production expenses when evaluating product costs and pricing strategies.
Proponents of this costing technique contend that both fixed and variable production expenses are employed in creating goods and services. Similarly, pricing based on ABS costing assures that all costs are paid.
In the long run, pricing established only in terms of variable costs (as encouraged by variable costing) may leave a contribution margin insufficient to cover fixed expenses.
Note
It's crucial that sales match or surpass the planned level of output since, otherwise, all fixed manufacturing costs won't be paid and will only be partially absorbed.
Income Smoothing
In the event of fluctuating production levels, absorption costing can lead to more reported income over the course of time. This is possible because the fixed overheads are spread out through units produced.
Since the technique includes consideration of variable and fixed overheads, it provides a clear and concise picture of the organization's income and expense picture.
External Reporting
The use of absorption costing for stock valuation and the preparation of external reporting has been acknowledged. For these objectives, absorption costing has been advocated by organizations like
- FASB (USA)
- ASC (UK)
- ASB (India).
Resource Allocation
When we include fixed overheads in the product costs, absorption costing provides a clear picture of the amount of resources consumed by the organization.
This information will aid management can allocating the resources more efficiently than it was doing.
Inventory Valuation
The absorption costing method allows the organization to value inventory with a systematic approach, which is then presented on the balance sheet. This allows the organization to analyze the financials, credit, loan collateral, and decision-making regarding inventory.
Disadvantages of Absorption Costing
Different unit prices are determined for various output levels because absorption costing depends on the output level.
Due to fixed costs, an increase in output volume typically leads to lower unit costs, and a decrease in output typically results in a higher cost per unit. This makes cost comparison and controls challenging.
Period Costs Include Fixed Costs
Many accountants contend that fixed costs, whether associated with manufacturing, selling, or administration, are one-time expenses that don't result in future advantages and shouldn't be factored into the price of the goods and inventory.
And since the fixed overheads are spread through the units produced, accountants can have a tough time tracing the fixed costs and the true cost behavior of the expense, making the implementation of such cost-saving techniques challenging.
Appropriations Of Overhead Costs
The accuracy of product costs calculated using absorption costing depends on the reasonable accuracy of the apportionment of overhead expenses.
However, in reality, a lot of overhead expenses are allocated using illogical ways. Therefore, the fees that arise are questionable and, if added to the costs of items, can lead to erroneous and unreliable product costs.
Also, this allocation of fixed overheads across the produced units can also lead to over or under-absorption of the overheads.
Unhelpful In Cost Control
This method is unhelpful for cost control and planning and control activities. Finding who is responsible for cost occurrence is not beneficial. Holding management accountable for expenses it has no control over is not feasible.
Note
A manager’s feeling of responsibility for managing his direct expenses tends to wane once he realizes that he cannot control all the costs assessed.
Aside from making management and decision-making more difficult, allocating indirect expenses also affects operational performance. Because different apportionment grounds yield varied allocation to goods and have distinct effects on results, distortion happens.
Inaccurate Profit
Using absorption costs, management can enhance operational profits during some times by expanding output, even though there is no increased demand from customers.
Note
When this costing method is applied, fixed production overheads are added to product costs.
As a result, the closing stocks are priced at the total cost, which considers fixed overhead. If the closing store is higher than the beginning stock, the overall result is a reduced charge for fixed overheads to the P/L account.
The result of this circumstance is an increase in period profit. Based on reported operating income, a manager's compensation program can be one source of inspiration.
Example Of Absorption Costing
Let us assume there is a manufacturing company, East-Coast Manufacturing Company, that specializes in the manufacture of a widget that is supposed to be used in the manufacture of heavy equipment for the construction industry.
The cost structure of the widget is as follows:
- Direct Material Cost: $100,000
- Direct Labor Cost: $50,000
- Variable Manufacturing Overhead: $30,000
- Fixed Manufacturing Overhead: $20,000
- Variable Selling Expenses: $10,000
- Fixed Selling Expenses: $5,000
- Total Widget Produced: 10,000
- Total Widgets Sold: 8,000
In the calculation of absorption costing, we need to find two figures: the amount transferred to the cost of goods sold and the ending inventory.
The calculation of total manufacturing costs is as follows:
Total manufacturing cost per unit = Direct Material + Direct Labor + Variable Manufacturing Overheads + Fixed Manufacturing Overheads / Number Of Widget Produced
= $100,000 + $50,000 + $30,000 + $20,000 / 10,000
= $20
Cost Of Goods Sold = Manufacturing Cost Per Unit x No. Of Units Sold
= $20 x 8,000 = $160,000
Ending Inventory = No. Of Units Produced - No. Of Units Produced
(10,000 - 8,000) x $20
= $40,000
In absorption costing, the variable and fixed selling expenses are considered as period costs. Whereas, direct material and labor, along with variable and fixed manufacturing costs, are considered product costs.
The example exhibits the absorption costing technique, where it assigns the product costs to units produced and sold. This is very unlikely in the case of variable costing, where it only considers variable manufacturing overheads as product costs.
Conclusion
Absorption costing is an accounting technique that integrates all fixed and variable production expenses into the price of a good.
Other names for it include complete costing and full costing. This method determines the cost of goods sold and ending inventory balances on the income statement and balance sheet, respectively.
Additionally, it is utilized to figure out the selling price of the product as well as the profit margin on each unit of the product.
Under this type of costing, the fixed manufacturing overhead expenses are accounted for as an indirect cost in the product cost. These expenses are spent throughout the production of the product and cannot be linked to a particular product.
The fixed manufacturing overhead costs are distributed among each product unit in accordance with a predetermined overhead allocation rate, which is obtained by dividing the expected fixed overhead costs by the total anticipated number of units to be produced.
In addition to fixed manufacturing overhead costs, variable production costs are incorporated into a product's price. Direct costs associated with a specific product include direct materials, direct labor, and variable overhead.
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