Small Business

What is Absorption Costing in Accounting?4 min read

Sep 26, 2022 3 min
What is absorption costing

What is Absorption Costing in Accounting?4 min read

Reading Time: 3 minutes

Every production process has its related costs that are both direct and indirect. Absorption costing takes all of these into consideration.

For example, freelance content writers can factor in the time to research, write, review, and update a writing project, whether executed or not.

They could cost for the estimated time of executing each task.

So,

What is Absorption costing?

It is a managerial accounting method that captures all costs associated with valuing an inventory or manufacturing a particular product.

Therefore, calculated costs include direct and indirect costs, such as materials, commissions, wages, quality control costs, insurance, and rent.

The GAAP (Generally accepted accounting principles) requires it for external reporting.

Free online accounting software for absorption costing

Components of Absorption Costing

A unit of product under Absorption costing includes;

  • Direct material (DM)
  • Direct labor (DL)
  • Variable manufacturing overhead (VMOH)
  • Fixed manufacturing overhead (FMOH)

Direct Materials

These are materials used in the production process, which includes the cost of purchasing each material.

Direct labor (DL)

The labor cost involved in the production process includes the salaries or wages of permanent or contract workers.

Variable manufacturing overhead (VMOH)

VMOH is the mandatory cost of running the production facility. 

The cost may vary depending on the production activity. So, if production increases or decreases, variable manufacturing overhead responds accordingly.

Examples of variable manufacturing overhead are utility bills and supplies.

Fixed manufacturing overhead (FMOH)

FMOH is the cost associated with manufacturing a product, irrespective of an increase or decrease in production volume.

Examples of these costs are rent, insurance, depreciation, and the salaries of production managers.

How to calculate Absorption costing

You need to consider direct material cost per unit, direct labor cost per unit, variable manufacturing overhead cost per unit, and fixed manufacturing overhead per unit.

Absorption costing formula

Direct material + Direct labor + Variable overhead + fixed overhead) / No of units produced

Are there benefits of using absorption costing? Let’s highlight the advantages and disadvantages.

Advantages of absorption costingDisadvantages of absorption costing
It takes every cost associated with the production of goods into account, making it easy to determine a product’s pricing.This could lead to overpricing of a product as every overhead cost may not be directly traced to the production of a unit.
A company gets a more accurate picture of profitability, considering situations when all products are not sold.It could lead to overproduction in an attempt to reduce cost per unit.
It is suitable for companies with changing seasonal demandsIt can lead to uninformed profitability. Unaccounted costs on the income statement can temporarily increase a company’s profit on the balance sheet.
Small businesses can conveniently track them since they do not have a large inventory.It can inflate the actual cost of manufacturing and distort the data required for comprehensive analysis.
Expense management accounting software

Final thoughts

Absorption costing is recommended for a growing small business as it is GAAP-compliant. 

To prepare financial statements, you need it. It is necessary for any company that operates in the United States.

Therefore, most companies use the method if they have COGS as it considers all production costs (including fixed costs), not just the direct costs.

It also accurately tracks profit during an accounting period.


Frequently Asked Questions (FAQs)

  • Absorption costing vs. variable costing

Absorption costing includes all costs (direct and indirect) associated with manufacturing a product. Variable costing includes costs directly incurred in manufacturing a product without fixed costs. 

  • How do you prepare an income statement using absorption costing?

According to Accounting Tools, the first line item of an absorption income statement is gross sales for the period. Next comes the cost of goods sold. To find COGS, start with the dollar value of the beginning inventory and add the cost of goods manufactured for the period. The resulting figure is goods available for sale. Subtract the ending inventory dollar value, resulting in the cost of goods sold. To calculate the gross margin, subtract gross sales from the cost of goods sold. Subtract selling expenses to find net operating income for the period.

  • How to find Absorption costing unit product cost

Absorption costing per unit = Direct material per unit + Direct labor per unit + Variable manufacturing overhead cost per unit + fixed manufacturing overhead cost per unit) / No of units produced