Absorption Costing: Definition & Overview

KEY TAKEAWAYS

• This method of costing lets you track the costs and expenses that go into manufacturing a product. 
• It also makes it easier to see how things affect your business’s bottom line. 
• However, absorption costing shouldn’t be the only accounting method you use. This is because you’re getting a partial picture of your business’s expenses.

What Is Absorption Costing?

This accounting method is sometimes referred to as “full costing.” Absorption costing is used to figure out the costs associated with the manufacturing of an individual product. 

Included in the administrative costs are both direct costs and indirect costs, like raw materials and overhead costs. The following are the indirect and direct costs associated with product manufacturing:

• Direct materials cost
• Cost of utilities
• Insurance cost
• Cost of labor
• Rent cost

But there’s more to it than just your cost pool. The GAAP (Generally Accepted Accounting Principles) requires absorption costing. They are necessary for the purposes of external reporting.

Absorption Costing: Up Close

You can use the absorption costing method in your business in various ways. One way is to more accurately determine how much each item contributes to your overall overhead costs on your income statement. 

This will allow you to allocate expenses more effectively. What’s more, it may even encourage you to create additional revenue streams that will also absorb some of these costs of production.

For example, let’s assume that you own a coffee shop and have a large amount of coffee-related expenses. An absorption cost would tell you where those expenses come from.

You find out that your coffee machine is driving up these expenses. 

This information might prompt you to rent out the space for parties. Or you might start selling other coffee-related products, like whole beans or coffee mugs.

It can be hard to divide this type of information without help from accountants or bookkeeping services.

Cost allocation software can make it easier for small businesses with limited staff resources. You might also lack experience in this area by calculating these numbers for you automatically. You just need an idea about what areas need better management so your company can grow.

Absorption Costing in Action

Absorption costing is a great tool for measuring the key costs that go into producing your finished product or service. It’s also an effective way to find out what you should charge for your product or service.

Advantages of Absorption Costing

One of the best benefits of absorption costing is that it removes any guesswork from your company’s financials. It ensures that you’re able to track your company’s spending on a particular entity.

You can identify potential problem areas in terms of profitability and cost-effective expenditures. Absorption costing gives you a better calculation of net income compared to variable costing methods.

By understanding absorption costing, you can ensure that your business is making the most out of what it spends its money on. This is why many companies choose to use this method when tracking their expenditures. In this way, they ensure that they aren’t wasting money pursuing an unprofitable venture.

Another advantage of absorption costing is its compliance with GAAP, a metric that the IRS requires. And because absorption costing includes all sales costs, you get a more accurate representation of profit.

With absorption costing, you can make a more informed decision about where to spend your money and what types of ventures to pursue.

Disadvantages of Absorption Costing

Included in absorption costing is the fixed overhead cost base on the product’s cost. This makes it less favorable than variable costing for internal incremental pricing decisions. Variable costs do not include additional costs that go into the production of the next product.

How to Calculate Absorption Costing?

Before calculating absorption costing, get your Variable Manufacturing Overhead Costs and Overhead Costs. When you have the necessary data, you may proceed. Check your balance sheet and income statement to get the information you need.

In determining absorption costing, you first need to know what kind of expenses you’re producing. Once you have these figures, put them in different cost pools. Cost pools group your expenses based on their activity.

This could be anything from marketing to R&D. As you use your expenses, you can assign them to the appropriate pool. 

Then, check your expense activity to determine the exact amount you spent on production costs. This can include things like labor expenses and equipment costs during manufacturing.

Finally, you’re ready to calculate your allocation rate. This is what gives you absorption cost per unit produced, which comes from the following formula:

Summary

Absorption costing is a financial modeling tool used to track the cost of bringing a product to market. It’s a way to track the costs of developing a product in contrast with the costs of selling a product.

The key to absorption costing is understanding how costs are absorbed and spread over a period of time. With this information, you can work towards streamlining your operations—and your expenses.