Absorption Costing Definition, How to Calculate and Examples

When pricing a product, absorption costing can provide invaluable insight into the full cost of producing a single product and is a requirement of generally accepted accounting principles.

In this article, we will define absorption costing, compare it to variable costs, list the steps for calculating unit price using this method, review some of the advantages and disadvantages of this methodology and provide an example.

Table Of Contents

1 What is Absorption Costing?
2 Differences between Absorption Costing and Variable Costing
3 How to Calculate Absorption Costing?
3.1 1. Create a Cost Pool
3.2 2. Determine usage for each cost
3.3 3. Calculate the cost
4 Advantages of Calculating Absorption Costing
5 Disadvantages of Calculating Absorption Costing
5.1 Over-assigning overhead costs
5.2 Overproduction to cut costs
5.3 Incomplete data
5.4 Profitability without information
6 Case Examples in Calculating Absorption Costing

What is Absorption Costing?

Calculation of absorption costing —also referred to as “full absorption costing” or “full cost”—is an accounting method designed to capture all costs that go into making a particular product. According To My Commerce Info Marginal Costing & Absorption Costing | Marginal Cost | Marginal & Absorption Costing | Difference

Regardless of whether each manufactured item is sold, each calculated manufacturing cost is allocated to all products. Some of these costs include:

  • Labor: This refers to the direct factory labor used to manufacture a product. These costs are directly related to wages paid during production.
  • Raw materials: The materials used to make the finished product are also counted.
  • Variable manufacturing overhead costs: This refers to the costs required to run a production facility. They are variable costs because they vary with the volume of production. Some examples of variable manufacturing overhead are electricity, utilities and supplies used by manufacturing equipment.
  • Fixed manufacturing overhead costs: There are also costs associated with operating a production facility that are fixed, regardless of the volume of production. Some examples include insurance and rent.

Absorption costing is a calculation based on inventory valuation, which means that it is not an ordinary expense but a capitalized cost that is tracked on the balance sheet until the product is sold.

Generally accepted accounting principles, also known as “GAAP,” require the use of absorption costs when generating external financial statements and income tax reports.

Costs can be categorized as product costs or period costs. Administration and selling costs should be charged to the period cost reporting period—not the cost of product inventory.

This is because they are related to a certain period more than they are related to the goods produced. Product costs, as described in the points above, are more directly related to the manufacture of the product.

In calculating absorption costing, the costs associated with production are recorded as an asset in the inventory account until the product is sold, at which point the costs are allocated to cost of goods sold.

General inventory accounts include raw materials, work in process and finished goods or variants of these names. This account tracks costs through the stages of production: before production begins, during production and after production is completed.

Difference between Absorption Costing and Variable Cost

Absorption costing considers direct materials, direct labor, variable manufacturing overhead and fixed manufacturing overhead as product costs.

Variable costs, also referred to as “direct costs,” use direct materials, direct labor, and variable manufacturing overhead as product costs.

This is the key difference between absorption costing and variable costing. Unlike absorption costing where fixed overhead costs are assigned to each product produced within a certain period, variable costs are all fixed overhead costs as period costs.

How to Calculate Absorption Costing?

Following are the steps for calculating and assigning absorption costing :

1. Create a Cost Pool

First, determine the costs associated with producing a product and then assign them to different cost groups. A cost pool or cost pool groups expenses by activity.

You can group marketing, customer service, and research and development costs into different cost pools. When you spend money, you will charge it to the cost pool that best describes it.

2. Determine usage for each charge

Next, go through each activity and find out the amount of each used during production. You need to define usage for activities such as the number of hours spent on labor or use of equipment during the manufacturing process.

3. Calculate the cost

Finally, calculate the allocation rate, which tells you the cost per unit. You can do this by following this formula:

Absorption cost per unit = (Direct Material Cost + Direct Labor Cost + Variable Manufacturing Overhead + Fixed Manufacturing Overhead) / Number of units produced

Advantages of Calculating Absorption Costing

Although absorption costing must comply with GAAP, there are also many advantages to using this system. An absorption costing takes into account every cost associated with production, making it an invaluable tool when pricing a product accordingly.

This information allows companies to ensure that the price point of their products covers the costs involved in production. It also allows them to price their products more competitively in their market.

Disadvantages of Calculating Absorption Costing

Although absorption costing is very useful, there are some drawbacks to this costing method. Some of the disadvantages of absorption costs include:

Over-assigning overhead costs

With absorption costing, even overhead costs that cannot be traced back directly to products are assigned to each unit.

Overproduction to cut costs

This pricing method makes it possible to increase profitability by overproducing the product. That’s because fixed overhead is assigned to the total number of units produced, lowering the cost for each additional unit produced.

Then when units are not sold, fixed overhead costs are not transferred to the expense report, thereby increasing profitability.

Incomplete data

Data collected to determine product costs through absorption costing includes fixed overhead. This can increase actual production costs and result in insufficient data to carry out a comprehensive analysis.

Profitability without information

Because fixed costs cannot be deducted from revenue until units are sold, absorption costing can provide an incomplete picture of a company’s profit level. This can result in fixed costs not being included in the company’s income statement, temporarily increasing the company’s profitability on the balance sheet.

Case Examples in Calculating Absorption Costing

A company produces 10,000 units of their product in one month. Of the 10,000 units produced, 8,000 units were sold in the same month with 2,000 remaining in inventory.

Each unit requires 5,000 as the total value of directly related materials and labor. In addition, the production facility requires 20,000,000 monthly fixed overhead costs.

The company uses the absorption costing method to determine fixed overhead costs per unit. They calculated that there were 2,000 fixed overhead costs that went into the production of each unit by dividing the fixed overhead costs by the number of units produced that month (20,000,000 / 10,000 units = 2000 per unit).

After determining the fixed overhead costs per unit, the company can add the costs of labor and materials to determine that each unit produced has an absorption costing of 7,000 (2,000 fixed overhead + 5,000 variable overhead = 7,000).

The company can then calculate that its total cost of goods sold is 56,000,000 by multiplying absorption costing times the number of units sold (8,000 units sold x 7,000 cost per unit = 56,000,000). That means there is 14,000,000 worth of inventory remaining (2,000 unsold units 7,000 cost per unit = 14,000,000).

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