The absorption costing approach, also known as full costing, is a method of accounting that allocates all manufacturing costs, both fixed and variable, to the cost of goods sold. This approach is used to determine the cost of a product or service, which is then used for pricing decisions, inventory valuation, and performance evaluation.
Key Features of Absorption Costing:
- Allocates all manufacturing costs: This includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead.
- Includes fixed overhead costs: This is a key difference from variable costing, which only includes variable manufacturing costs.
- Uses predetermined overhead rates: This is calculated by dividing estimated total fixed overhead costs by the estimated activity level for the period.
- Applies overhead to production: The predetermined overhead rate is then applied to actual production to allocate fixed overhead costs.
Benefits of Absorption Costing:
- Compliance with GAAP: Absorption costing is required for financial reporting purposes under Generally Accepted Accounting Principles (GAAP).
- Provides a more comprehensive view of product costs: By including all manufacturing costs, absorption costing provides a more complete picture of the cost of producing a product.
- Facilitates pricing decisions: By understanding the full cost of a product, companies can make more informed pricing decisions.
Limitations of Absorption Costing:
- Can distort profitability: Since fixed overhead costs are allocated to production, absorption costing can inflate profits in periods of high production and deflate profits in periods of low production.
- Can lead to inefficient decision-making: Absorption costing can lead to poor decisions if it is not used carefully. For example, a company might produce too much inventory if it believes that allocating fixed overhead costs will increase profits.
- Can be complex to implement: Absorption costing can be complex to implement, particularly for companies with multiple products and complex manufacturing processes.
Example of Absorption Costing:
Let's consider a company that manufactures widgets. The company has the following costs:
- Direct materials: $10 per widget
- Direct labor: $5 per widget
- Variable manufacturing overhead: $2 per widget
- Fixed manufacturing overhead: $10,000 per month
The company produces 1,000 widgets per month. Using absorption costing, the company would allocate the fixed manufacturing overhead costs to the widgets as follows:
- Predetermined overhead rate: $10,000 / 1,000 widgets = $10 per widget
- Cost per widget: $10 (direct materials) + $5 (direct labor) + $2 (variable overhead) + $10 (fixed overhead) = $27
Therefore, the cost of each widget using absorption costing is $27.
Conclusion:
Absorption costing is a widely used accounting method that allocates all manufacturing costs to the cost of goods sold. It is required for financial reporting purposes under GAAP and provides a more comprehensive view of product costs. However, it can also distort profitability and lead to inefficient decision-making if not used carefully.
