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Working out how much your organisation is spending in each area of the business is a crucial element of accountancy. That’s why absorption costing – an accounting method that helps you to determine the full cost of one unit of output – is such an important concept for businesses to understand and know how to use. Explore the finer points of the absorption costing formula, including the pros and cons of absorption costing and how to work out absorption costing.
Absorption costing definition
So, what is absorption costing? Absorption costing, also referred to as full costing or the full costing method, is an accounting method that you can use to capture all of the manufacturing costs associated with the production of one unit of goods. It includes the cost of materials and labour, as well as fixed and variable overhead costs. Absorption costing is a requirement of the Generally Accepted Accounting Principles (GAAP), making it necessary for any businesses that operate in the United States.
How to work out absorption costing
As we mentioned in the previous section, the absorption costing formula stipulates that the following costs should be included in the cost of a finished product:
Variable manufacturing overheads
Fixed manufacturing overheads
However, the following costs are considered “period costs” and are not included in the cost of the finished product:
Variable sales and administrative costs
Fixed sales and administrative costs
Instead, these costs are expensed in the period that they occurred.
As such, we can express the absorption costing formula like so:
Absorption costing formula example
Let’s look at an example of the absorption costing formula in action. Imagine that Company A has the following variable per-unit costs:
Direct materials – $50
Direct labour – $45
Variable manufacturing overheads – $30
Variable sales and administrative costs – $10
And the following fixed costs:
Fixed manufacturing overheads – $100,000
Fixed sales and administrative costs – $90,000
Company A sold 20,000 units (having produced 25,000 units), at a selling price of $50. Therefore, we can use the absorption costing formula like so:
In other words, under absorption costing, each unit of goods has a total production cost of just over $4.
Pros and cons of absorption costing
One of the most significant advantages of absorption costing is the fact that it’s GAAP-compliant. As such, it’s required for stock valuation and the preparation of reports for your firm’s financial statements. It’s also important to note that absorption costing accounts for all production costs (including direct costs and indirect costs, such as property taxes), which means that it can be especially useful for anyone who needs to determine a cost-efficient price-point for their goods.
When it comes to the pros and cons of absorption costing, it’s essential to consider the relevance for inventory management. Absorption costing improves the accuracy of your accounts for ending inventory, as expenses are linked to the total cost of your inventory on hand. Moreover, further expenses are assigned to unsold products, which means that the actual amount of expenses reported on your income statement may end up being reduced, providing a higher net income.
Of course, there are several limitations associated with the absorption costing formula. Most significantly, it can be easy to manipulate. For example, an entity could generate extra “profits” by simply manufacturing more products that don’t sell. This is because absorption costing allocates fixed overheads to the total number of units produced. If units don’t sell, the fixed overheads assigned to the unsold units aren’t expensed, leading to a (false) increase in profits.
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