Absorption costing is a costing method that includes all manufacturing costs — direct materials, direct labor and both variable and fixed manufacturing overhead in the cost of a unit of product.
Absorption costing is also referred to as the full cost method. Because absorption costing includes all cost of production as product costs.
It is a conventional costing which is required for both external financial reporting and tax reporting. In the case of absorption costing, the cost of production will be as follows:
Cost of production = Direct material + Direct labor + Direct expense + variable factory overhead + Fixed factory overhead
Absorption costing treats all manufacturing costs as product costs, regardless of whether they are variable or fixed.
The cost of a unit of product under the absorption costing method consists of direct materials, direct labor, and both variable and fixed manufacturing overhead.
Thus, absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing costs.
Because absorption costing includes all manufacturing costs in product costs, it is frequently referred to as the full cost method.
Features of Absorption Costing
The features associated with absorption costing are as follows:
- In the absorption costing a product, the cost is determined on the basis full cost, i.e., variable and fixed manufacturing cost.
- The cost of inventory will be higher in absorption costing as product cost includes fixed factory overhead.
- Absorption costing net income changes with production,
- It is a conventional costing where gross profit is determined by subtracting the cost of goods sold from sales and net profit is determined by subtracting all commercial expenses from the gross profit.
- Under or over-allocation of fixed factory overhead is required to be adjusted in absorption costing as it is included in the cost of production.
Advantages of Absorption Costing
As a conventional technique, absorption costing has some advantages which are discussed below:
Determining the actual cost of production
In absorption costing, fixed factory overhead is treated as product cost. As a result, it helps determine the actual cost of production.
Absorption costing is followed for external reporting, various rules and regulations of GAAP and Tax authority are complied with by absorption costing, As a result, it is acceptable to a tax authority, investors, creditors, etc.
Valuation of inventory
Inventories are valued based on actual production cost, As a result, a balance sheet represents a true and fair view.
Disadvantages of Absorption Costing
Absorption costing has some disadvantages which are discussed as follows:
In absorption costing fixed factory overhead is allowed on production based on pre-determined rate, But it is not easy to determine the accurate denominator volume to determine the rate, So, cost allocution becomes difficult,
No useful for management decision making
Absorption costing does not produce information on contribution margin, As a result, it cannot assist in various
- Cost control and cost comparison become difficult.