Absorption Costing Definition
Absorption costing is defined as a method for accumulating the costs associated with a production process and apportioning them to individual products. This type of costing is required by the accounting standards to create an inventory valuation that is stated in an organization's balance sheet.
A product may absorb a broad range of fixed and variable costs. These costs are not recognized as expenses in the month when an entity pays for them. Instead, they remain in inventory as an asset until such time as the inventory is sold; at that point, they are charged to the cost of goods sold.
Absorption Costing Components
The key costs assigned to products under an absorption costing system are:
- Direct materials. Those materials that are included in a finished product.
- Direct labor. The factory labor costs required to construct a product.
- Variable manufacturing overhead. The costs to operate a manufacturing facility, which vary with production volume. Examples are supplies and electricity for production equipment.
- Fixed manufacturing overhead. The costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.
It is possible to use activity-based costing (ABC) to allocate overhead costs for inventory valuation purposes under the absorption costing methodology. However, ABC is a time-consuming and expensive system to implement and maintain, and so is not very cost-effective when all you want to do is allocate inventory to be in accordance with GAAP or IFRS.
You should charge sales and administrative costs to expense in the period incurred; do not assign them to inventory, since these items are not related to goods produced, but rather to the period in which they were incurred.
Absorption Costing Steps
The steps required to complete a periodic assignment of costs to produced goods is:
- Assign costs to cost pools. This is comprised of a standard set of accounts that are always included in cost pools, and which should rarely be changed.
- Calculate usage. Determine the amount of usage of whatever activity measure is used to assign overhead costs, such as machine hours or direct labor hours used.
- Assign costs. Divide the usage measure into the total costs in the cost pools to arrive at the allocation rate per unit of activity, and assign overhead costs to produced goods based on this usage rate.
Overhead Absorption
Absorbed overhead is manufacturing overhead that has been applied to products or other cost objects. Overhead is usually applied based on a predetermined overhead allocation rate. Overhead is overabsorbed when the amount allocated to a product or other cost object is higher than the actual amount of overhead, while the amount is underabsorbed when the amount allocated is lower than the actual amount of overhead.
For example, Higgins Corporation budgets for a monthly manufacturing overhead cost of $100,000, which it plans to apply to its planned monthly production volume of 50,000 widgets at the rate of $2 per widget. In January, Higgins only produced 45,000 widgets, so it allocated just $90,000. The actual amount of manufacturing overhead that the company incurred in that month was $98,000. Therefore, Higgins experienced $8,000 of underabsorbed overhead.
In February, Higgins produced 60,000 widgets, so it allocated $120,000 of overhead. The actual amount of manufacturing overhead that the company incurred in that month was $109,000. Therefore, Higgins experienced $11,000 of overabsorbed overhead.
Absorption Costing Problems
Since absorption costing requires the allocation of what may be a considerable amount of overhead costs to products, a large proportion of a product's costs may not be directly traceable to the product. Direct costing or constraint analysis do not require the allocation of overhead to a product, and so may be more useful than absorption costing for incremental pricing decisions where you are more concerned with only the costs required to build the next incremental unit of product.
It is also possible that an entity could generate extra profits simply by manufacturing more products that it does not sell. This situation arises because absorption costing requires fixed manufacturing overhead to be allocated to the total number of units produced - if some of those units are not subsequently sold, then the fixed overhead costs assigned to the excess units are never charged to expense, thereby resulting in increased profits. A manager could falsely authorize excess production to create these extra profits, but it burdens the entity with potentially obsolete inventory, and also requires the investment of working capital in the extra inventory.
Similar Terms
Absorption costing is also known as full absorption costing or full costing.
Types of Absorption Costing systems
There are three different types of Absorption Costing systems:
Job Order Costing
The cost calculation is assigned to the product in batches (a non-recurring collection of several production units) and LOTS (production unit, linked to the serial numbers of a product).
Process Costing
The cost calculation is systematically assigned to the product because there are not batches or LOTS.
Activity Based Costing (ABC)
Activity Based Costing (abc): the cost calculation is assigned from cost items to the finished product. The use of Absorption Costing could be particularly critical for small organizations that often lack financial reserves. These companies cannot afford to take losses or to sell products without an insight into the accounting of the overhead.
Example: a clothing manufacturer may not just consider the costs of wool and labour for the manufacturing of a jumper, but he may also consider the costs of the knitting machines, the factory in which the machines are installed, the operating costs of the machines, insurance and other types of overhead costs, etcetera.
Looking at the above mentioned example, Absorption Costing could be required to determine the overhead costs of the enterprise. The more items one plant can produce, the lower the costs will be of these items, especially the overhead costs. If the factory starts producing other items or products, it is possible to spread and reduce the overhead costs even further.
Absorption Costing example
Organization X solely produces and sells product Y. The following financial information about product Y is known:
- Sales price per piece: 50 euro
- Direct material costs per product: 8 euro
- Direct labour costs per product: 5 euro
- Variable production overhead costs per product: 3 euro
Detailed information with respect to the months of March and April
| March | April | |
| Production of product Y | 500 | 380 |
| Sales of product | 300 | 500 |
There was no initial stock in March. The fixed overhead costs are now budgeted at 4,000 euro a month and have been absorbed per production. A regular production is 400 pieces per month.
Additional costs:
- Fixed costs for sales: 4,000 euro per month
- Fixed costs for the administration: 2,000 euro per month
- Variable costs for sales (commission): 5% of the sales proceeds
Step 1: Calculation of full production costs per product
| Description | costs |
| Direct material costs per product | 8 euro |
| Direct labour costs per product | 5 euro |
| Variable production overhead costs per product | 3 euro |
| Fixed production overhead costs (4,000 euro/400 pieces) | 10 euro + |
| Full production costs per product | 26 euro |
Step 2: Calculation of stock value and production
| Month | Initial stock | Production | Closing stock |
| March | 0 | 500 pieces x 26 euro = 13.000 euro | 200 pieces x 26 euro = 5.200 euro |
| April | 200 pieces x 26 euro = 5.200 euro | 380 pieces x 26 euro = 9.880 euro | 80 pieces x 26 euro = 2.080 euro |
Step 3: uner / over absorbed fixed production overhead costs
| March | April | |
| Actual fixed production overhead costs | 4.000 euro | 4.000 euro |
| Fixed production overhead costs based on >actual production | 5.000 euro | 3.800 euro |
| under/ over absorbed | 1.000 euro over | 200 euro under |
Step 4: Absorption costing profit calculation
| March | April | |||
| Sales | 15.000 euro | 25.000 euro | ||
| Less sales costs – Initial stock – Production – Closing stockonder/ over absorbed Gross profits | 0 euro 13.000 euro 5.200 euro (7.800 euro) +1.000 euro | 8.200 euro | 5.200 euro 9.880 euro 2.080 euro (13.000 euro) -200 euro | 11.800 euro |
| Less costs– Variable costs for sales (commission) – Fixed administration costs – Fixed sales costs | 750 euro 2.000 euro 4.000 euro – 6.750 euro | 1.250 euro 2.000 euro 4.000 euro – 7.250 euro | ||
| Net profit | 1.450 euro | 4.550 euro |
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