What is Absorption Costing?

Absorption costing is a method for accumulating the costs associated with a production process and apportioning them to individual products. This type of costing is required by the accounting standards to create an inventory valuation that is stated in an organization's balance sheet. A product may absorb a broad range of fixed costs and variable costs. These costs are not recognized as expenses in the month when an entity pays for them. Instead, they remain in inventory as an asset until such time as the inventory is sold; at that point, they are charged to the cost of goods sold.

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The Components of Absorption Costing

The key costs assigned to products under an absorption costing system are noted below.

Direct Materials

Direct materials are materials that are included in a finished product.

Direct Labor

Direct labor includes the factory labor costs required to construct a product.

Variable Manufacturing Overhead

Variable manufacturing overhead includes the costs to operate a manufacturing facility, which vary with production volume. Examples are supplies and electricity for production equipment.

Fixed Manufacturing Overhead

Fixed manufacturing overhead includes the costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.

What Not to Include in an Absorption Costing System

You should charge sales and administrative costs to expense in the period incurred; do not assign them to inventory, since these items are not related to goods produced, but rather to the period in which they were incurred.

Activity-Based Costing

It is possible to use activity-based costing (ABC) to allocate overhead costs for inventory valuation purposes under the absorption costing methodology. However, ABC is a time-consuming and expensive system to implement and maintain, and so is not very cost-effective when all you want to do is allocate costs to be in accordance with GAAP or IFRS.

Absorption Costing Steps

The steps required to complete a periodic assignment of costs to produced goods is noted below.

Step 1. Assign Costs to Cost Pools

The assignment of costs to cost pools is comprised of a standard set of accounts that are always included in cost pools, and which should rarely be changed.

Step 2. Calculate Usage

Calculating usage involves determining the amount of usage of whatever activity measure is used to assign overhead costs, such as machine hours or direct labor hours used.

Step 3. Assign Costs

Assigning costs involves dividing the usage measure into the total costs in the cost pools to arrive at the allocation rate per unit of activity, and assigning overhead costs to produced goods based on this usage rate.

Overhead Absorption

Absorbed overhead is manufacturing overhead that has been applied to products or other cost objects. Overhead is usually applied based on a predetermined overhead allocation rate. Overhead is overabsorbed when the amount allocated to a product or other cost object is higher than the actual amount of overhead, while the amount is underabsorbed when the amount allocated is lower than the actual amount of overhead.

Example of Overhead Absorption

Higgins Corporation budgets for a monthly manufacturing overhead cost of $100,000, which it plans to apply to its planned monthly production volume of 50,000 widgets at the rate of $2 per widget. In January, Higgins only produced 45,000 widgets, so it allocated just $90,000. The actual amount of manufacturing overhead that the company incurred in that month was $98,000. Therefore, Higgins experienced $8,000 of underabsorbed overhead.

In February, Higgins produced 60,000 widgets, so it allocated $120,000 of overhead. The actual amount of manufacturing overhead that the company incurred in that month was $109,000. Therefore, Higgins experienced $11,000 of overabsorbed overhead.

Problems with Absorption Costing

Since absorption costing requires the allocation of what may be a considerable amount of overhead costs to products, a large proportion of a product's costs may not be directly traceable to the product. Direct costing or constraint analysis do not require the allocation of overhead to a product, and so may be more useful than absorption costing for incremental pricing decisions where you are more concerned with only the costs required to build the next incremental unit of product.

It is also possible that an entity could generate extra profits simply by manufacturing more products that it does not sell. This situation arises because absorption costing requires fixed manufacturing overhead to be allocated to the total number of units produced - if some of those units are not subsequently sold, then the fixed overhead costs assigned to the excess units are never charged to expense, thereby resulting in increased profits. A manager could falsely authorize excess production to create these extra profits, but it burdens the entity with potentially obsolete inventory, and also requires the investment of working capital in the extra inventory.