Definition of Absorption Costing
Absorption costing is a management costing technique in which both variable and fixed costs are allocated to the product cost for the purposes of inventory valuation. Since the method includes both variable and fixed costs for the calculation of product manufacturing cost, it is also known as the full costing method.
There are two techniques used in cost accounting namely marginal costing and absorption costing. Absorption costing or full costing method is different from the variable costing method because it also allocates the fixed cost to each unit of the product manufactured. The allocation of fixed costs to each produced unit is done based on an absorption rate derived from the budgeted fixed overheads and budgeted production. This leads to over and under absorption of fixed costs because the actual production may vary from the budgeted production.
Few examples of direct and indirect costs that are included while calculating through absorption costing are direct material, direct labor, variable manufacturing overheads, and fixed manufacturing overheads. While fixed and variable selling and administration expenses are considered as period costs and thus do not go in the product manufacturing cost calculation. They are expensed in the income statement in the same period.
The formula for calculating product manufacturing cost under absorption costing method is as follows:
Total Direct Cost = Direct Labor Cost + Direct Material Cost
Total Manufacturing Overhead = Fixed Manufacturing Overhead + Variable Manufacturing Overheads
Example of Absorption Costing
We have the following information relating to ABC Ltd and we need to calculate the product cost using absorption costing method:
- Manufactured Units – 4000
- Units Sold – 3000
- Direct Labor Cost – $6000
- Direct Material Cost- $8000
- Fixed Overhead – $7000
- Variable Overheads – $1000
Total Product Cost is calculated using the formula given below
Total Product Cost = Total Direct Cost + Total Manufacturing Overheads
- Total Product Cost = (direct Labor Cost + Direct Material Cost + Variable Overhead + Fixed Overhead)
- Total Product Cost = $6000+$8000 + $1000 + $ 7000
- Total Product Cost = $22,000
Components of Absorption Costing
The absorption costing method has the following components basis which the formula is also mentioned in earlier heading:
- Direct Material Cost: Materials that are used in the production of the finished goods inventory.
- Direct Labor Cost: Factory labor cost involved in the manufacturing of the product.
- Variable Manufacturing Overhead: The cost involved in operating the manufacturing unit or facility such as electricity for manufacturing machinery, supplies, etc. The cost varies according to the volume of production.
- Fixed Manufacturing Overhead: The cost involved in operating the manufacturing unit that does vary with the volume of production like rent of the premises, insurance premium, etc.
Uses of Absorption Costing
The uses are as follows:
- It is used in the determination of the profitable selling price of the products as it includes all the costs involved in the manufacturing of the product.
- It is used for inventory or stock valuation purposes.
The advantages of using the absorption costing method are as follows:
- It allocates fixed overheads as well to each unit of product manufactured, therefore, gives a fair presentation of the total manufacturing cost of the products.
- It helps in determining the appropriate selling price of manufactured products.
- It helps in setting the recovery rate for fixed overheads as it involves fixed overheads as part of the product cost.
The disadvantages of the absorption costing method in calculation of product cost are as follows:
- As the method includes fixed overheads, therefore it does not help much in decisions regarding product mix or make or buy of products.
- It is not helpful for cost control purposes as fixed overheads cannot be curbed or curtailed, they will always remain the same.
- As it allocates fixed cost per unit of manufactured products, the fixed cost is not expensed in the income statement which leads to a skewed profit level. Thus, it can be used for manipulating profits by the accountants.
We can conclude from the above discussion that absorption costing is no doubt a very important method for the calculation of product cost. The main difference between absorption costing and variable costing is regarding the recognition of fixed costs.
This is a guide to Absorption Costing. Here we also discuss the definition and Components of Absorption Costing along with advantages and disadvantages. You may also have a look at the following articles to learn more –
- Marginal Costing vs Absorption Costing
- Variable Costing Example
- Job Costing vs Process Costing
- Budgeting Examples