What Is Absorption Costing?
Absorption costing is a method of product costing that assigns all manufacturing costs to each unit produced: direct materials, direct labor, variable overhead, and fixed overhead. Fixed overhead is absorbed into the cost of the product and stays in inventory until the unit is sold. It is also called full absorption costing, and it is the method required for external financial reporting under US GAAP and IFRS.
Costs Included in Absorption Costing
- Direct materials:
The materials that become part of the product. - Direct labor:
Wages for workers who make the product. - Variable manufacturing overhead:
Overhead that changes with output, such as indirect supplies and machine power. - Fixed manufacturing overhead:
Overhead that stays constant in total, such as factory rent and equipment depreciation. - Not included:
Selling and administrative expenses are period costs, expensed when incurred.
Absorption Costing Formula
FORMULA
Unit cost = (Direct materials + Direct labor + Variable overhead + Fixed overhead) / Units produced
Absorption Costing Example
EXAMPLE
A plant makes 10,000 units. Direct materials are $12 per unit, direct labor is $8, and variable overhead is $5. Fixed overhead is $60,000, or $6 per unit. Unit cost is $12 + $8 + $5 + $6 = $31. If 8,000 units are sold, cost of goods sold is 8,000 x $31 = $248,000. The 2,000 unsold units carry $62,000 in inventory, including $12,000 of fixed overhead.
How Production Volume Changes Unit Cost
Because fixed overhead is spread over units produced, unit cost moves with volume even when nothing else changes.
EXAMPLE
In the earlier example, fixed overhead is $60,000. At 10,000 units the fixed cost per unit is $6 and the unit cost is $31. If production rises to 12,000 units, fixed cost per unit falls to $5 and the unit cost to $30. Selling the same 8,000 units would then show a lower cost of goods sold of $240,000.
COMMON MISTAKE
Producing more than you can sell to lower unit cost and lift profit. Under absorption costing, extra units carry fixed overhead into inventory, so reported profit rises even though no extra sales were made. The cost comes back later, when the inventory is sold or written down.
Absorption Costing vs. Variable Costing
- Absorption costing:
Treats fixed manufacturing overhead as a product cost, deferred in inventory until the units sell. - Variable costing:
Treats fixed manufacturing overhead as a period cost, expensed in full when incurred, described in contribution margin. - Where each is used:
Absorption costing is required for external reports. Variable costing is used internally for pricing and break-even analysis, described in break-even point.
When production exceeds sales, absorption costing reports higher profit than variable costing, because some fixed overhead stays in inventory. In the example, 2,000 unsold units hold $12,000 of fixed overhead, so absorption profit is $12,000 higher. When sales exceed production, the effect reverses.
Absorption Costing Income Statement
An absorption costing income statement is organized by function: sales, less cost of goods sold equals gross margin, less selling and administrative expenses equals net operating income. Fixed overhead sits inside cost of goods sold. A variable costing statement is organized by cost behavior and shows contribution margin instead of gross margin.
FORMULA
Gross margin = Sales - Cost of goods sold (including fixed manufacturing overhead)
See cost of goods sold for how that line is built.
Limits of Absorption Costing
- Profit can be steered by production:
Building inventory defers fixed overhead, which can flatter a period's results. - Fixed costs look variable:
Unit cost blends fixed and variable costs, which can mislead pricing and make-or-buy decisions. - Not suited to short-term decisions:
Contribution margin and break-even analysis are clearer for these, described in contribution margin and break-even point.
Frequently Asked Questions About Absorption Costing
1. Why is absorption costing also called full costing?
It is a way of costing products in which every manufacturing cost, including fixed factory overhead, is spread over the units made. Fixed overhead stays in inventory until the units sell, which is why profit can differ from variable costing.
2. What is the absorption costing formula?
Unit cost equals direct materials plus direct labor plus variable overhead plus fixed overhead, divided by the units produced. For example, $12 materials, $8 labor, $5 variable overhead, and $6 fixed overhead give a unit cost of $31.
3. What is the difference between absorption costing and variable costing?
Absorption costing includes fixed manufacturing overhead in product cost and defers it in inventory. Variable costing expenses fixed overhead in the period incurred. Profit differs whenever production and sales differ, and absorption costing is required for external reports.
4. What does an absorption costing income statement look like?
It lists sales, subtracts cost of goods sold, which includes fixed manufacturing overhead, to show gross margin, then subtracts selling and administrative expenses to reach net operating income. It is organized by function rather than by cost behavior.
5. Is absorption costing required by GAAP?
Yes, for external financial statements. US GAAP and IFRS both require inventory to include fixed manufacturing overhead, so absorption costing is used. Variable costing is allowed for internal reports, such as pricing and break-even analysis.
