Absorption Costing

What it is

Absorption costing (also called full costing) is a product-costing method that assigns all manufacturing costs—both variable and fixed—to units produced. It includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Under generally accepted accounting principles (GAAP), absorption costing is required for external financial reporting.

How it works

Absorption costing allocates every manufacturing cost to inventory. Fixed manufacturing overhead (rent, insurance, depreciation, etc.) is capitalized as part of inventory and recognized as an expense only when the related units are sold. This contrasts with variable costing, which treats fixed manufacturing overhead as a period expense.

Cost components under absorption costing:
* Direct materials — raw materials used in a product.
* Direct labor — wages of workers who make the product.
* Variable manufacturing overhead — costs that vary with production (e.g., utilities, indirect materials).
* Fixed manufacturing overhead — costs that remain constant regardless of output.

Because fixed overhead is spread across units produced, net income can be affected by changes in production and inventory levels: higher production that increases inventory can defer fixed costs to the balance sheet and raise reported profit in the current period.

Formula

Absorption cost per unit = (Direct materials + Direct labor + Variable overhead + Fixed overhead) / Total units produced

Example:
* Direct materials: $10 per unit
Direct labor: $5 per unit
Variable overhead: $3 per unit
Fixed overhead: $50,000 total
Units produced: 5,000 → fixed overhead per unit = $50,000 ÷ 5,000 = $10

Absorption cost per unit = $10 + $5 + $3 + $10 = $28 per unit

If only 4,000 units are sold, the remaining 1,000 units retain $10,000 of fixed overhead ($10 × 1,000) on the balance sheet, delaying that expense until those units are sold.

Under variable costing, fixed overhead is expensed in the period incurred. Using the same data:
Variable cost per unit = $10 + $5 + $3 = $18 per unit
Fixed overhead = $50,000 expensed immediately

Absorption vs. Variable Costing — key differences

Treatment of fixed overhead
* Absorption: included in inventory cost (capitalized).
* Variable: treated as a period expense.

Impact on reported profit
* Absorption: reported profit can increase when inventory rises (fixed costs deferred).
* Variable: profit reflects incremental costs and is often preferred for internal decision-making.

Reporting requirements
* Absorption: required for external financial reporting under GAAP.
* Variable: not permitted for external reporting under GAAP, but useful internally.

Pros and cons

Pros
* GAAP-compliant for external financial statements and tax reporting.
* Captures the full cost of production, useful for inventory valuation.
* Can show higher asset values on the balance sheet by capitalizing fixed manufacturing costs.

Cons
* Can defer fixed costs in inventory and inflate short‑term profits when production exceeds sales.
* May encourage overproduction to spread fixed costs over more units.
* Less useful than variable costing for incremental analysis, break-even, and short-term pricing decisions.

Practical considerations

• Use absorption costing for external reporting and statutory compliance.
• Use variable costing or contribution-margin analysis for internal decisions (pricing, cost control, product mix), because it highlights incremental costs and profitability.
• Monitor inventory levels and managerial incentives; production policies driven by accounting treatment rather than demand can increase carrying costs and risk obsolescence.

Conclusion

Absorption costing provides a complete view of product costs and is necessary for GAAP-compliant financial statements. However, because it capitalizes fixed manufacturing overhead, it can affect reported profits and managerial behavior. Businesses commonly combine absorption costing for external reporting with variable-costing-based analyses for internal decision-making.