Absorption Costing Defined: Features of Absorption Costing

Absorption costing (also known as full costing) accounts for all direct and indirect costs it takes a business to churn out products. As such, the absorption costing formula includes the price of raw materials, labor costs, administrative expenses, income taxes, and more. By factoring in all of these inputs, businesses can get a better handle on both their cost of goods sold (COGS) as well as their inventory as a whole.

This accounting approach takes into account many different variables. Consider these absorption costing elements to start:

• Direct labor costs: To make a product, you must pay the workers who do so for you. In contrast to more fixed costs, the price of labor might fluctuate over time depending on different elements of the economy. Still, no matter what labor of any period costs, you will still factor these direct costs in as part of your full absorption process.
• Direct material costs: Raw materials are the building blocks of any specific product. It’s important to keep track of how much they cost when doing accounting for your business. Also, add in the manufacturing overhead costs to get an even fuller picture of what you’re spending.
• Indirect costs: Some of the standard costs for businesses accrue in a far more indirect way. This is where absorption costing comes in especially handy. It enables you to account for more indirect variables, like the depreciation of your machinery, research and development, and so on to more fully flesh out the cost it takes to build any number of units.

Absorption and variable costing are both useful accounting methods, but they each come with key strengths and weaknesses. Absorption costing is generally more comprehensive and helpful when you’re trying to price a product, whereas variable costing can potentially give you a more precise look at granular details, like fixed overhead costs.

Additionally, absorption costing separates fixed costs into cost of goods sold and total inventory, while variable costing represents both in a single sum.

Absorption costing can help you better understand what it takes to fully fund the creation of your products. Here are three key advantages to utilizing the absorption method of costing:

1. 1. Comprehensiveness: Absorption costing adds up everything it takes to achieve your level of production volume in both a direct and indirect way. This includes administrative costs, material expenses, taxes, and other elements. This grants you the fullest and most thorough inventory valuation possible.
2. 2. Suitability for pricing products: When you make use of absorption costing, you get a comprehensive look at the total cost of production over an accounting period. This affords you a great deal of information you can then use to set the selling price for each good you put on the market. Take what each unit of product costs you to develop and then charge a reasonable amount of markup to make a profit.
3. 3. GAAP compliance: The absorption costing method follows generally accepted accounting principles (or GAAP). You must adhere to these principles for external reporting (e.g., releasing financial statements). In other words, you will inevitably have to use this approach anyway when providing the public with information about your company.

Absorption costing comes with a few potential downsides. Consider these three before you use this cost accounting method yourself:

1. 1. Income statement discrepancies: When totaling up your ending inventory and the cost of the goods you have sold, you will end up with a number that might be a little off from what you actually made in gross profit or net income. This is just one key reason to supplement absorption costing with more granular forms of analysis.
2. 2. Indirect targeting: The total costs this method represents are quite broad. This can cloud your decision-making and make it more difficult for you to accurately assess how you’re doing as a business in a more concrete way. Think of absorption costing as a way to get a bird’s-eye view of your accounting status, rather than an up-close look.
3. 3. Potential to skew gross profit levels: In absorption costing, you carry over your ending inventory amount onto your balance sheet. This allocation of funds can make your company’s profit levels look bigger than they actually are. Keep this in mind when budgeting internally or reporting to external sources.

MasterClass at Work is the learning platform to help unlock the full potential of your employees and inspire a learning lifestyle in everyone. From negotiation to mindfulness to baking—these are just a few things your teams can explore.