Absorption Costing

What Is Absorption Costing?

 Absorption costing, also known as full costing, is an accounting method that captures all costs associated with manufacturing a product. This includes both variable costs (such as direct materials and direct labor) and fixed overhead costs (such as factory rent, utilities, and salaries of production supervisors). Under absorption costing, these costs are absorbed by the units produced and are not expensed until the goods are sold.

Why Is Absorption Costing Important?

Absorption costing is important for several reasons, particularly in the context of financial reporting, inventory valuation, and decision-making. Here are the key reasons why absorption costing is important:

1. Compliance with Accounting Standards

GAAP and IFRS Compliance:

• Absorption costing is required by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) for external financial reporting. This ensures that financial statements are comparable, consistent, and meet regulatory requirements.

2. Comprehensive Cost Allocation

Complete Cost Capture:

• Absorption costing allocates all manufacturing costs (direct materials, direct labor, and both variable and fixed manufacturing overhead) to products. This provides a complete picture of the cost to produce a product, which is useful for pricing and profitability analysis.

3. Inventory Valuation

Accurate Inventory Costs:

• By including fixed manufacturing overhead in product costs, absorption costing provides a more accurate valuation of inventory. This is important for balance sheet reporting and for calculating cost of goods sold (COGS) on the income statement.

4. Profitability Analysis

Matching Principle:

• Absorption costing adheres to the matching principle, where costs are matched with the revenues they help generate. This leads to a more accurate measurement of profitability over accounting periods, especially when inventory levels fluctuate.

5. Decision Making

Long-Term Pricing Decisions:

• By incorporating all costs of production, absorption costing helps businesses set prices that cover both variable and fixed costs, ensuring long-term sustainability and profitability.

6. Performance Evaluation

Comprehensive View of Production Efficiency:

• Absorption costing provides insights into how well a company is managing its production costs, including fixed overhead. This can help in evaluating operational efficiency and making informed management decisions.

7. Financial Planning and Control

Budgeting and Forecasting:

• Absorption costing is used in budgeting and forecasting to estimate the total cost of production. This helps businesses plan for future production needs and control costs effectively.

8. Tax Reporting

Tax Compliance:

• Many tax authorities require absorption costing for reporting taxable income. By including all manufacturing costs in inventory, absorption costing can affect the timing and amount of taxable income.

Key Considerations

While absorption costing has many advantages, it is also important to be aware of its limitations:

• Potential for Overproduction: Managers might be incentivized to overproduce to allocate fixed costs over more units, which can lead to higher inventory levels.
• Less Useful for Internal Decision-Making: Variable costing can sometimes provide more useful information for internal decision-making, as it highlights the impact of variable costs on profitability.

Key Components Of Absorption Costing

1. Direct Costs:

• Direct Materials: The raw materials that can be directly attributed to the product.
• Direct Labor: The wages of employees who work directly on the production of the product.

       2. Indirect Costs:

• Variable Manufacturing Overhead: Costs that vary with production levels but cannot be traced directly to specific units (e.g., machine maintenance, supplies).
• Fixed Manufacturing Overhead: Costs that remain constant regardless of production levels (e.g., depreciation of factory equipment, factory rent).

How Absorption Costing Works

Under absorption costing, both variable and fixed manufacturing costs are included in the cost of each unit produced. Here’s how it typically works:

1. Calculate Total Manufacturing Costs:

Add up all direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead.

      2. Determine the Cost Per Unit:

Divide the total manufacturing costs by the number of units produced to find the cost per unit.

      3. Allocate Costs to Inventory and Cost of Goods Sold (COGS):

Costs are first assigned to inventory (work in process and finished goods). When the goods are sold, the associated costs are transferred from inventory to COGS on the income statement.

 Calculation Of Absorption Costing

Absorption costing, also known as full costing, is a method where all manufacturing costs, both fixed and variable, are allocated to the cost of a product. This includes direct materials, direct labor, and both variable and fixed manufacturing overheads. Here’s a step-by-step guide to calculating absorption costing:

Steps to Calculate Absorption Costing

1. Identify Direct Costs:

• Direct Materials: Cost of raw materials used in production.
• Direct Labour: Wages of employees directly involved in manufacturing.

      2. Identify Variable Manufacturing Overheads:

• Costs that vary with production levels, such as utilities for machinery, indirect materials, etc.

      3. Identify Fixed Manufacturing Overheads:

• Costs that do not vary with production levels, such as salaries of supervisory staff, depreciation, rent of factory building, etc.

      4. Calculate the Total Manufacturing Costs:

• Sum of direct materials, direct Labour, variable manufacturing overheads, and fixed manufacturing overheads.

      5. Determine the Allocation Rate for Fixed Manufacturing Overheads:

• Divide total fixed manufacturing overheads by the number of units produced to get the fixed overhead cost per unit.

      6.Calculate the Absorption Cost Per Unit:

• Add direct materials cost per unit, direct Labour cost per unit, variable manufacturing overhead cost per unit, and fixed manufacturing overhead cost per unit.

 Absorption Costing Example

Assume the following data for a company producing 1,000 units of a product:

• Direct Materials: ₹300 per unit
• Direct Labour: ₹150 per unit
• Variable Manufacturing Overheads: ₹100 per unit
• Total Fixed Manufacturing Overheads: ₹500,000

Step-by-Step Calculation in Rupees

1. Direct Costs Per Unit:

• Direct Materials: ₹300
• Direct Labour: ₹150

2. Variable Manufacturing Overheads Per Unit: ₹100
3. Fixed Manufacturing Overheads Per Unit:

• Total Fixed Overheads / Number of Units Produced
• ₹500,000 / 1,000 units = ₹500 per unit

4. Total Absorption Cost Per Unit:

• Direct Materials: ₹300
• Direct Labor: ₹150
• Variable Manufacturing Overheads: ₹100
• Fixed Manufacturing Overheads: ₹500
• Total: ₹300 + ₹150 + ₹100 + ₹500 = ₹1,050 per unit

Advantages Of Absorption Costing

• Compliance with GAAP and IFRS:

Required by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) for external financial reporting.

• Comprehensive Costing:

Includes all manufacturing costs, providing a complete picture of production costs.

• Inventory Valuation:

Results in higher inventory valuations since fixed overhead costs are included.

Disadvantages of Absorption Costing

• Complexity:

More complex to implement and maintain compared to variable costing.

• Cost Behavior Visibility:

Less transparency regarding the behavior of fixed and variable costs, which can be important for internal decision-making.

• Potential for Under/Overproduction:
• Can incentivize managers to overproduce to allocate more fixed costs to inventory, improving profitability in the short term but potentially leading to inefficiencies and higher storage costs.

 Absorption Costing Vs Variable Costing

Absorption costing and variable costing are two distinct methods used in managerial accounting to allocate costs to products. Here’s an overview of each method, including their differences, advantages, and disadvantages:

Absorption Costing

Absorption costing, also known as full costing, includes all manufacturing costs—direct materials, direct labor, and both variable and fixed manufacturing overhead—in the cost of a product.

Components:

• Direct Materials
• Direct Labor
• Variable Manufacturing Overhead
• Fixed Manufacturing Overhead

Characteristics:

• Costs are absorbed by the units produced.
• Fixed manufacturing overhead is spread across all units produced.
• Required by Generally Accepted Accounting Principles (GAAP) for external reporting.

Advantages:

• Provides a comprehensive view of product costs.
• Matches all manufacturing costs with revenues, which can be useful for external reporting.
• Helps in pricing decisions by including fixed overheads in product costs.

Disadvantages:

• Can obscure the relationship between cost, volume, and profit.
• May lead to overproduction to absorb fixed costs, which can increase inventory levels and associated holding costs.
• Less useful for internal decision-making, particularly in short-term scenarios.

Variable Costing

Variable costing, also known as direct costing or marginal costing, includes only variable manufacturing costs—direct materials, direct labor, and variable manufacturing overhead—in the cost of a product. Fixed manufacturing overhead is treated as a period expense and not included in product cost.

Components:

• Direct Materials
• Direct Labor
• Variable Manufacturing Overhead

Characteristics:

• Only variable costs are included in product cost.
• Fixed manufacturing overhead is expensed in the period incurred.
• Not compliant with GAAP for external reporting.

Advantages:

• Provides clearer insights into the impact of fixed and variable costs on profits.
• Useful for internal decision-making, particularly for short-term and operational decisions.
• Helps in analyzing the contribution margin, which is the difference between sales and variable costs.

Disadvantages:

• Excludes fixed manufacturing costs from product costs, which might lead to underestimating total product costs.
• Not suitable for external financial reporting.
• May not provide a comprehensive view of total manufacturing costs per unit.

Key Differences

Inclusion of Fixed Overhead:

• Absorption Costing: Includes both variable and fixed manufacturing overhead in product costs.
• Variable Costing: Includes only variable manufacturing costs; fixed overhead is treated as a period expense.

Inventory Valuation:

• Absorption Costing: Higher inventory valuation as it includes fixed manufacturing overhead.
• Variable Costing: Lower inventory valuation as it excludes fixed manufacturing overhead.

Impact on Financial Statements:

• Absorption Costing: Fixed overhead is allocated to units produced, impacting Cost of Goods Sold (COGS) and inventory values.
• Variable Costing: Fixed overhead is expensed in the period incurred, impacting net operating income directly.

Profit Reporting:

• Absorption Costing: Profit can vary with production levels, as fixed costs are spread over more units.
• Variable Costing: Profit is more closely linked to sales volumes rather than production volumes.

Comparison 

Conclusion

Thus Absorption costing is a managerial accounting method that allocates all production costs, both variable and fixed, to specific units of output. Under absorption costing, the cost of a product includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. This approach treats fixed manufacturing overhead costs as a product cost, meaning they are included in the cost of goods sold (COGS) and inventory valuation.