Absorption Costing – What is it and how is Full Costing different from Variable Costing?
You may be asking yourself what absorption costing is and simply put, absorption costing may also be referred to as “full costing” and is a method in managerial accounting that captures every cost linked with any particular product’s manufacturing process.
The direct and indirect costs of producing a product inclusive of the direct materials, labor, insurance and rent involved are accounted for through the application of the absorption costing method.
As a requirement by the generally accepted accounting principles (GAAP), absorption costing is used for external reporting.
Understanding Absorption Costing
Any direct cost incurred when producing a product is considered as an absorption cost in the cost base of that product.
Absorption costing will also include any fixed overhead charges incurred as part of the cost of the product.
The costs associated when manufacturing a product include the following:
- Salaries and wages of employees who are physically working on making the product
- Raw supplies and materials used when making the product
- All overhead costs incurred such as every utility cost charged to the business when making the product
Unlike the variable costing method of accounting, all expenses incurred during the manufacturing of a product is allocated as an expense in that product’s cost base whether it is sold by the end of the period accounted for or not.
It is important to note that absorption costing would always decrease the amount of expenses on the business’ income statement while in contrast, the amount of the ending inventory on the business’ balance sheet would be higher.
Variable Costing Vs. Absorption Costing
The differences between the variable costing and absorption costing methods of accounting start in how the fixed overhead costs are recorded.
When it comes to absorption costing, fixed overhead costs are allocated on every unit produced for the specified period.
On the contrary, when it comes to variable costing, all fixed overhead costs are added together and are recorded as an expense via recording it as a one line item that is separate from the cost of goods sold as well as recording it as an entry that is separate from the goods that are still available for sale.
The cost per unit of fixed overhead fees is not accounted for when using the variable costing method although the absorption costing method does account for each fixed overhead fee incurred.
When calculating the net income of a business on its income statement, variable costing will reflect a lump sum expense line item for the business’ fixed overhead costs.
When absorption costing, two categories of fixed overhead costs will be generated to reflect the expenses that can be attributed to the cost of goods sold and the expenses that can be attributed to inventory.
Advantages and Disadvantages of the Absorption Costing Method
The assets of a business which includes its inventory stays recorded on its balance sheet at the end of the accounting period.
Since absorption costing allocates the business’ fixed overhead costs to both its inventory and cost of goods sold, the charges that were incurred to produce the products that are still in the business’ ending inventory will not be reflected as an expense on the income statement of the current accounting period.
The absorption costing method records added fixed costs that are attributed to the business’ ending inventory.
An accurate accounting of an entity’s ending inventory can be done through absorption costing since the expenses linked to the inventory are associated with the full cost of whatever inventory is still left on hand.
Moreover, additional expenses are accounted for in products that were not sold which lessens the actual amount of expenses reported on the business’ income statement for the current accounting period.
All these factors are the reason why the absorption costing method results in a greater net income calculation in comparison to the calculations that are a result of variable costing.
When the management of a business has to make incremental pricing decisions that are internal, absorption costing can be unfavorable in comparison to variable costing since the business’ fixed overhead costs are included in the cost base of its products.
On the other hand, variable costing will only incorporate the additional expenses of producing the succeeding incremental units of a product.
Additionally, using the absorption costing method will result in a circumstance that will increase net income simply by manufacturing more products even if those are not sold by the end of the accounting period.
Since fixed costs are distributed among every product manufactured, the fixed costs of every unit will lessen with every item that is further produced.
Thus, as the production of the product increases, so does the business’ net income since a portion of fixed costs for the business’ cost of goods sold will likewise decrease.
It is important to note that absorption costing will result in a higher reported net income compared to that of variable costing.
An Example of Absorption Costing
Let us say that XYZ Company produces toys to sell. In February, they made 10,000 units of toys and 8,000 of those units were sold before the end of the month which left 2,000 units still in the company’s inventory by the end of February.
Each toy that XYZ Company produces costs $5 in direct labor and materials. Furthermore, $20,000 in fixed overhead costs are paid every month in association with the company’s production facility.
When using the absorption costing method, XYZ Company will record an extra $2 to every toy made to compensate for the fixed overhead costs which was derived from dividing the total overhead costs of $20,000 by the number of toys produced for the month of February.
Each toy produced will have an absorption cost of $7 from the $5 incurred in direct labor and materials added to the $2 incurred for the distributed fixed overhead costs.
Since 8,000 toys were sold, the total cost of goods sold is reflected as $56,000 which is the amount of the total cost per unit multiplied by the number of units sold.
The company’s ending inventory will be composed of toys worth $14,000 which is the total cost per unit multiplied by the 2,000 units of toys still left in the company’s ending inventory.
Frequently Asked Questions
Below are some frequently asked questions on the absorption costing method that have been briefly answered for you.
What is the difference between absorption costing and variable costing?
The way fixed overhead costs are recorded and treated differ depending on which costing method is used.
The absorption costing method will allocate the fixed overhead costs incurred among every unit of the product produced for the current accounting period.
In contrast, the variable costing method adds every fixed overhead cost into a lump sum amount and records that expense as a one line item that is separate from the goods that are still available for sale and the cost of goods sold.
When calculating the net income of the business, the variable costing method will generate a lump sum expense line item for the fixed overhead costs of the business.
On the other hand, the absorption costing method will generate two categories of fixed overhead costs that can be attributed to the expenses reflected on the business’ cost of goods sold and the expenses attributed to the business’ inventory.
What are the advantages and benefits of using the absorption costing method?
The prime advantage and benefit of absorption costing is the fact that it is compliant with generally accepted accounting principles (GAAP) which is required by the Internal Revenue Service (IRS) for external reporting.
Additionally, absorption costing records and takes into account every expense incurred when producing the business’ products inclusive of the fixed costs that results in direct costs not being the only expenses recorded which allows for the more accurate measurement of profit during the business’ accounting period.
What are the disadvantages of using the absorption costing method?
The principal disadvantage of absorption costing is the fact that it has the ability to inflate the profitability of the company during any given accounting period which is due to all fixed costs not being deducted from the business’ revenue unless every single unit produced by the business has been sold.
Furthermore, the absorption costing method is not the most effective and helpful when it comes to analysis conducted in an effort to improve and develop the financial and operational efficiency of the business.
Absorption costing is also not effective or helpful in the comparison of product lines.
- Absorption costing is not the same as variable costing since this method allocates the fixed overhead costs of the products to every unit produced within a specified accounting period.
- Absorption costing allocates the product’s fixed overhead costs to every unit produced regardless of whether it was sold or not within a specified accounting period.
- Absorption costing is a type of costing that includes more costs in the products’ ending inventory which is then carried over to the next accounting period as an asset on the balance sheet of the business.
- Absorption costing lowers the expenses recorded on the income statement of the business since these expenses are reflected on the ending inventory instead.
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