Absorption costing, which is also known as full absorption costing or full costing, is a method for accumulating fixed costs and variable costs associated with the production process and apportioning them to individual products. Thus, a product must absorb a broad range of costs. The key costs assigned to products are:
- Direct materials. Those materials that are included in a finished product.
- Direct labor. The factory labor costs required to construct a product.
- Variable manufacturing overhead. The costs to operate a manufacturing facility, which vary with production volume. Examples are supplies and electricity for production equipment.
- Fixed manufacturing overhead. The costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.
Because many costs are absorbed into inventory, they 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 cost of goods sold.
Generally Accepted Accounting Principles require that an entity use absorption costing to record the value of inventory in its financial statements. Direct costing does not require the allocation of overhead to a product, and so may be more useful than absorption costing for incremental pricing decisions.
Absorption costing is also known as full costing.