What is the cost of absorption?
The absorption cost, sometimes called the full absorption cost, is a management accounting method that captures all the costs associated with manufacturing a particular product. Direct and indirect costs, such as direct materials, direct labor, rent and insurance, are accounted for using this method. The absorption costs are required by generally accepted accounting principles (GAAP) for external reports.
Key points to remember
- The absorption cost differs from the variable cost in that it charges fixed overhead costs to each unit of a product produced during the period.
- The absorption cost attributes fixed overheads to a product, whether or not it has been sold during the period.
- This type of valuation means that more costs are included in the final inventory, which is carried over to the next period as an asset on the balance sheet.
- Since more expenses are included in the final inventory, expenses in the income statement are lower when using the absorption cost.
Understanding absorption costs
The cost of absorption, also called full cost, includes everything that is a direct cost to produce a good in its cost base. The absorption costs also include fixed overheads as part of the product costs. Some of the costs associated with making a product include the wages of workers who physically work on the product; the raw materials used to make the product; and all overhead costs, 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.
- The absorption cost means that the end-of-stock costs are higher, but the expenses in the income statement are lower.
Absorption cost vs variable cost
The differences between absorption costs and variable costs lie in the treatment of fixed overheads. The absorption cost distributes the fixed overhead costs over all the units produced for the period. Variable cost, on the other hand, groups all fixed overhead costs and reports expenses in a single item separate from the cost of goods sold or still available for sale.
Variable cost does not determine the unit cost of fixed overhead costs, unlike the absorption cost. The variable cost will generate a fixed expense item for fixed overheads when calculating the net result in the income statement. At the same time, absorption costs will entail two categories of fixed overheads: those attributable to the cost of goods sold and those attributable to stocks.
Advantages and disadvantages of absorption costs
Assets, such as inventories, remain on the entity’s balance sheet at the end of the period. Since absorption costs allocate fixed overhead costs to both the cost of goods sold and to inventory, the costs associated with items still in closing inventory will not be recognized as expenses in the income statement for the period in Classes. The absorption costs reflect fixed costs more attributable to the closing of stocks.
The absorption costs guarantee a more precise accounting of the end of the inventory, because the expenses associated with this inventory are linked to the total cost of the inventory always available. In addition, more expenses are recorded in unsold products, which reduces the actual expenses declared during the current period in the income statement. This results in a higher net income calculation compared to the variable cost calculations.
Since absorption costs include fixed overhead costs in the cost of its products, they are unfavorable compared to variable costs when management makes internal incremental price decisions. Variable costs will only include the additional costs of producing the next incremental unit of a product.
In addition, the use of absorption costs creates a unique situation in which the simple production of more unsold items by the end of the period will increase net income. Since the fixed costs are spread across all units produced, the fixed unit cost will decrease as more items are produced. Therefore, as production increases, net profit naturally increases because the fixed cost portion of the cost of goods sold will decrease.
The absorption cost results in a higher net profit compared to the variable cost.
Example of absorption cost
Suppose that ABC Company creates widgets. In January, they manufacture 10,000 widgets, of which 8,000 are sold in January and 2,000 are still in inventory at the end of the month. Each widget uses $ 5 of labor and materials directly attributable to the article. In addition, $ 20,000 in fixed overhead costs are associated with the production facility each month. Under the absorption cost method, the company will allocate an additional $ 2 to each widget for fixed overheads (total $ 20,000 / 10,000 widgets produced during the month).
The absorption cost per unit is $ 7 ($ 5 of labor and materials + $ 2 of fixed overhead costs). Since 8,000 widgets have been sold, the total cost of goods sold has been $ 56,000 (total cost of $ 7 per unit * 8,000 widgets sold). The end inventory will include $ 14,000 of widgets ($ 7 total cost per unit * 2,000 widgets still in the end inventory).