Absorption costing, also known as full costing, is a managerial accounting method used to determine the total cost of producing a product. It is a comprehensive costing method that includes all manufacturing costs, both direct and indirect, in the cost of a product. This article delves into the concept of absorption costing, its components, formula, and advantages and disadvantages.
Key Facts
- Components of absorption costing: Absorption costing includes both direct costs (such as direct labor and direct material costs) and indirect costs (such as variable and fixed manufacturing overhead costs) in the cost of a product.
- Formula for absorption cost: The formula for calculating absorption cost per unit is as follows:
Absorption cost per unit = (Direct labor costs + Direct material costs + Variable manufacturing overhead costs + Fixed manufacturing overhead costs) / Number of units produced. - Direct costs: Direct costs are costs that can be directly traced to a specific product or service. These costs include raw materials, labor, and other direct expenses incurred in the production process.
- Indirect costs: Indirect costs, also known as overhead expenses, cannot be directly traced to a specific product or service. These costs include expenses like utilities, rent, and insurance. Indirect costs are typically allocated to products based on some measure of activity, such as the number of units produced or the number of direct labor hours required.
- Allocation of fixed overhead costs: Absorption costing allocates fixed overhead costs to each unit of a product produced, regardless of whether it is sold in the period. This means that more cost is included in the ending inventory, which is carried over into the next period as an asset on the balance sheet.
Components of Absorption Costing
Absorption costing encompasses both direct and indirect costs. Direct costs are those that can be directly traced to a specific product or service. These costs include raw materials, labor, and other direct expenses incurred in the production process. Indirect costs, also known as overhead expenses, cannot be directly traced to a specific product or service. These costs include expenses like utilities, rent, and insurance. Indirect costs are typically allocated to products based on some measure of activity, such as the number of units produced or the number of direct labor hours required.
Formula for Absorption Costing
The absorption costing formula is used to calculate the cost per unit of a product. The formula is as follows:
Absorption cost per unit = (Direct labor costs + Direct material costs + Variable manufacturing overhead costs + Fixed manufacturing overhead costs) / Number of units produced.
Advantages of Absorption Costing
Absorption costing offers several advantages, including:
- Compliance with GAAP: Absorption costing is compliant with Generally Accepted Accounting Principles (GAAP), which is required for external reporting.
- Accurate Profit Calculation: It provides a more accurate determination of net profit by matching expenses with related revenues in the same reporting period.
- Higher Income Generation: This method results in a higher net income because a portion of costs related to unsold goods—namely, the fixed manufacturing overhead costs—are not expensed during the period but carried forward on the balance sheet as ending inventory until the product sells.
Disadvantages of Absorption Costing
Despite its advantages, absorption costing also has some disadvantages:
- Skewed Profitability Analysis: Absorption costing may skew the profitability analysis for companies considering ramping up production. An increase in production volume would decrease unit costs under absorption costing, which wouldn’t matter if all the units were sold in the same reporting period. However, if the goods are not all sold, net income for that period would appear to be inflated because a portion of fixed manufacturing costs would be carried forward in the inventory on the balance sheet, not deducted from revenue.
- Inaccurate Internal Analysis: Absorption costing can be disadvantageous at certain times because it shifts the timing of when fixed manufacturing overhead is expensed on the income statement, which can skew internal business analyses.
Conclusion
Absorption costing is a comprehensive costing method that includes all manufacturing costs in the cost of a product. It is required for external reporting under GAAP and provides a more accurate determination of net profit. However, it can also skew profitability analysis and internal business analyses. Therefore, businesses should carefully consider the advantages and disadvantages of absorption costing before implementing it.
Sources
- https://www.netsuite.com/portal/resource/articles/accounting/absorption-costing.shtml
- https://www.investopedia.com/terms/a/absorptioncosting.asp
- https://gridlex.com/a/everything-you-need-to-know-about-absorption-costing-st27/
FAQs
1. What is the formula for calculating absorption cost?
> **Answer:** The formula for calculating absorption cost per unit is as follows:
Absorption cost per unit = (Direct labor costs + Direct material costs + Variable manufacturing overhead costs + Fixed manufacturing overhead costs) / Number of units produced.
2. What costs are included in absorption costing?
> **Answer:** Absorption costing includes both direct and indirect costs in the cost of a product. Direct costs include raw materials, labor, and other direct expenses incurred in the production process. Indirect costs, also known as overhead expenses, include expenses like utilities, rent, and insurance.
3. How are fixed overhead costs allocated in absorption costing?
> **Answer:** In absorption costing, fixed overhead costs are allocated to each unit of a product produced, regardless of whether it is sold in the period. This means that more cost is included in the ending inventory, which is carried over into the next period as an asset on the balance sheet.
4. What is the difference between absorption costing and variable costing?
> **Answer:** Absorption costing includes all manufacturing costs, both direct and indirect, in the cost of a product, while variable costing only includes variable costs. This means that absorption costing results in a higher cost per unit than variable costing.
5. Why is absorption costing required for external reporting?
> **Answer:** Absorption costing is required for external reporting under Generally Accepted Accounting Principles (GAAP) because it provides a more accurate determination of net profit by matching expenses with related revenues in the same reporting period.
6. What are the advantages of absorption costing?
> **Answer:** The advantages of absorption costing include compliance with GAAP, accurate profit calculation, and higher income generation.
7. What are the disadvantages of absorption costing?
> **Answer:** The disadvantages of absorption costing include skewed profitability analysis and inaccurate internal analysis.
8. When should absorption costing be used?
> **Answer:** Absorption costing should be used for external reporting purposes, such as calculating the cost of goods sold for financial statements, and for internal decision-making purposes, such as determining the selling price of a product or deciding whether to continue producing a particular product.