Definition of absorption costs
What is the absorption cost?
Absorption cost, sometimes referred to as “full cost,” is a management accounting method for capturing all of the costs associated with the manufacture of a particular product. Direct and indirect costs, such as direct materials, direct labor, rent and insurance, are accounted for using this method. Absorption cost is required by generally accepted accounting principles (GAAP) for external reports.
Key points to remember
- Absorption cost differs from variable cost in that it assigns a fixed overhead cost to each unit of a product produced during the period.
- Absorption costs assign a fixed overhead to a product whether or not it was sold during the period.
- This type of costing means that a higher cost is included in the final inventory, which is carried forward to the next period as an asset on the balance sheet.
- Since more expenses are included in the closing inventory, the expenses in the income statement are lower when using absorption cost.
The absorption cost includes all that is direct cost by producing a good in its cost base. The absorption cost also includes fixed overhead costs that are part of the product costs. Some of the costs associated with making a product include the salaries of employees physically working on the product, raw materials used in manufacturing the product, and all overheads, such as all utility costs, used in production. . Unlike the variable cost method, each expense is allocated to manufactured goods whether or not they are sold at the end of the period.
Absorption cost means that closing inventories on the balance sheet are higher, while expenses on the income statement are lower.
Absorption cost vs variable cost
the differences between absorption cost and variable cost is how fixed overheads are handled. The absorption cost allocates the fixed overheads over all units produced for the period. Variable cost, on the other hand, combines all fixed overhead costs and presents the expense as a separate item from the cost of goods sold or available for sale.
The variable cost does not determine the unit cost of the fixed overheads, whereas the absorption cost does. The variable valuation will produce a lump sum expense item for fixed overheads when calculating net revenue on the income statement. The absorption cost will result in two categories of fixed overhead costs: those attributable to cost of goods sold and those attributable to inventory.
Advantages and disadvantages of the cost of absorption
Assets, such as inventories, remain on the entity’s balance sheet at the end of the period. Since absorption cost affects fixed overheads on both cost of goods sold and inventory, costs associated with items still in closing inventory will not be reflected in expenses in the income statement of the company. current period. Absorption costs reflect more fixed costs attributable to the final inventory.
Absorption cost guarantees more accurate accounting for end of stocks, because the expenses associated with this inventory are linked to the total cost of the inventory still available. In addition, more expenses are recorded in unsold products, which reduces the actual expenses declared in the current period in the income statement. This results in a higher net income calculation compared to the variable cost calculations.
Since absorption cost includes fixed overheads in the cost of its products, it is unfavorable to variable cost when management incremental pricing decisions. This is because variable costs will only include the additional costs of producing the next additional unit of a product.
In addition, the use of absorption cost generates a situation where simply making more unsold items at the end of the period will increase the net profit. Since the fixed costs are spread across all units manufactured, the unit fixed cost will decrease as more items are produced. Therefore, as production increases, net income naturally increases, as the fixed cost share of the cost of goods sold will decrease.
Absorption cost results in higher net benefit than variable cost.
Example of absorption cost
Suppose ABC Company creates widgets. In January, it makes 10,000 widgets, of which 8,000 are sold at the end of the month, leaving 2,000 still in inventory. Each widget uses $ 5 of labor and materials directly attributable to the item. In addition, $ 20,000 of fixed overhead costs are associated with the production facility each month. Using the absorption cost method, ABC will allocate an additional $ 2 to each widget for fixed overhead ($ 20,000 total ÷ 10,000 widgets produced during the month).
The absorption cost per unit is $ 7 ($ 5 labor and materials + $ 2 fixed overhead). Since 8,000 widgets have been sold, the total cost of goods sold is $ 56,000 ($ 7 total cost per unit X 8,000 widgets sold). The final inventory will include $ 14,000 worth of widgets (total cost of $ 7 per unit X 2,000 widgets still in final inventory).
Frequently Asked Questions
What is the difference between variable costs and absorption costs?
Absorption costs and variable costs treat fixed overheads differently. Absorption costs distribute fixed overhead costs over all units produced for the period. Variable cost, on the other hand, adds all fixed overhead costs and presents the expense as a separate item from cost of goods sold or available for sale. In other words, calculating variable costs will produce a lump sum expense item for fixed overheads when calculating net income, while absorption cost will result in two categories of fixed overhead: those attributable to cost of goods. sold and those attributable to inventory.
What are the advantages of absorption cost?
The main advantage of absorption cost is that it complies with generally accepted accounting principles (GAAP), which are required by the Internal Revenue Service (IRS). In addition, it takes into account all production costs (including fixed costs), not just direct costs, and more accurately tracks profits over an accounting period.
What are the disadvantages of the absorption cost?
The main disadvantage of absorption cost is that it can inflate a company’s profitability over a given accounting period because not all fixed costs are deducted from income unless all of the manufactured goods in the company are not sold. In addition, it is not useful for analysis designed to improve operational and financial efficiency or to compare product lines.