Absorption costing is a managerial accounting method used to capture all costs associated with manufacturing a product. It includes both direct costs (such as direct labor and direct materials) and indirect costs (such as rent and insurance) in the cost of a product. This method is typically used for external reporting purposes, such as calculating the cost of goods sold and ending inventory balances on the income statement and balance sheet, respectively.
Components of Absorption Costing
Absorption costing includes all costs associated with manufacturing a product, including:
- Direct CostsCosts that can be directly traced to a specific product, such as direct labor and direct materials.
- Indirect CostsCosts that cannot be directly traced to a specific product, such as rent and insurance. Indirect costs are also known as overhead costs.
Fixed manufacturing overhead costs are allocated to each unit of a product produced in the period, regardless of whether it was sold or not. This is in contrast to variable costing, which only includes variable costs in the cost of a product.
Key Facts
- Absorption costing is a managerial accounting method used to capture all costs associated with manufacturing a product.
- It includes both direct costs (such as direct labor and direct materials) and indirect costs (such as rent and insurance) in the cost of a product.
- Fixed manufacturing overhead costs are allocated to each unit of a product produced in the period, regardless of whether it was sold or not.
- Absorption costing results in higher ending inventory on the balance sheet and lower expenses on the income statement compared to variable costing.
- Absorption costing is typically used for external reporting purposes, while variable costing is used for management decision-making and planning purposes.
Advantages and Disadvantages of Absorption Costing
Absorption costing has several advantages, including:
- GAAP ComplianceAbsorption costing is compliant with generally accepted accounting principles (GAAP), which are required by the Internal Revenue Service (IRS).
- Accurate Profit MeasurementAbsorption costing provides a more accurate measure of profit during an accounting period by matching all costs with related revenues.
- Higher Net IncomeAbsorption costing results in a higher net income compared to variable costing because fixed manufacturing overhead costs are included in the cost of goods sold.
However, absorption costing also has some disadvantages, including:
- Potential for Overstated ProfitsAbsorption costing can overstate profits during periods of increasing production because fixed manufacturing overhead costs are spread over more units, resulting in a lower unit cost.
- Less Useful for Decision-MakingAbsorption costing is less useful for management decision-making and planning purposes compared to variable costing because it does not provide information about the incremental costs associated with producing an additional unit of a product.
Conclusion
Absorption costing is a managerial accounting method used to capture all costs associated with manufacturing a product. It includes both direct costs and indirect costs in the cost of a product. Absorption costing is typically used for external reporting purposes, while variable costing is used for management decision-making and planning purposes.
References
- Absorption Costing | NetSuite
- Absorption Costing Explained, With Pros and Cons and Example | Investopedia
- Absorption Costing and Variable Product Costing – Accounting In Focus
FAQs
What is absorption costing?
Absorption costing is a managerial accounting method that includes all costs associated with manufacturing a product, including direct costs (such as direct labor and direct materials) and indirect costs (such as rent and insurance).
How is product cost per unit calculated using absorption costing?
Product cost per unit using absorption costing is calculated by dividing the total manufacturing costs by the number of units produced. Total manufacturing costs include direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead.
What is the difference between absorption costing and variable costing?
Absorption costing allocates fixed manufacturing overhead costs to each unit of a product produced in the period, regardless of whether it was sold or not. Variable costing only includes variable costs in the cost of a product.
Why is absorption costing used?
Absorption costing is used for external reporting purposes, such as calculating the cost of goods sold and ending inventory balances on the income statement and balance sheet, respectively. It is also used to determine the selling price of a product and to calculate the profit margin on each unit of product.
What are the advantages of absorption costing?
The advantages of absorption costing include GAAP compliance, accurate profit measurement, and higher net income.
What are the disadvantages of absorption costing?
The disadvantages of absorption costing include the potential for overstated profits, less usefulness for decision-making, and more complex calculations.
When is absorption costing most appropriate?
Absorption costing is most appropriate when a company wants to understand the full cost of producing a product or providing a service, particularly for external reporting purposes.
Can absorption costing be used for internal decision-making?
Absorption costing can be used for internal decision-making, but it is less useful than variable costing because it does not provide information about the incremental costs associated with producing an additional unit of a product.