Absorption Costing

Business, Legal & Accounting Glossary

Definition: Absorption Costing

Absorption Costing

Quick Summary of Absorption Costing

A method of calculating the cost of a product or enterprise by taking into account indirect expenses (overheads) as well as direct costs.

What is the dictionary definition of Absorption Costing?

Dictionary Definition

This is the cost accounting system in which the overheads of an organisation are charged to the production by means of the absorption process.

Costs are first apportioned to cost centres, where they are absorbed using absorption rates.

Although this method is simple; it invokes an essentially arbitrary allocation of costs; as such the activity-based costing system of accounting is now widely preferred.

Full Definition of Absorption Costing

Is the method under which all manufacturing costs, both variable and fixed, are treated as product costs with non-manufacturing costs, e.g. selling and administrative expenses, being treated as period costs.

Absorption costing is a method of accumulating and allocating the costs of a manufacturing process to individual products. Accounting standards require this type of costing in order to create an inventory valuation for an organization’s balance sheet. A product can absorb both fixed and variable costs. When an entity pays for these costs, they are not recorded as expenses in the month in which they are incurred. Instead, they are held as an asset in inventory until the inventory is sold, at which point they are charged to the cost of goods sold.

Absorption Costing FAQ's

What is Absorption Costing?

Absorption costing is a cost accounting method for valuing inventory. Absorption costing includes or “absorbs” all the costs of manufacturing a product including both fixed and variable costs. That means that all costs including direct, like material costs, and indirect, like overhead costs, are included in the price of inventory. Absorption costing gives a much more comprehensive and accurate view of how much it really costs to produce your inventory than the variable costing method.

Think about it like this. If Apple used full absorption costing when they were valuing their inventory of iPods, the inventory value would include the following: the materials to make the iPods, the money paid to workers to manufacture the iPods, the manufacturing overhead, as well as the fixed overhead for the entire operation. In contrast, variable costing only takes into consideration the first three of these costs or the variable costs.

If the management isn’t taking all fixed costs into consideration when valuing the true cost of producing inventory, the sales price might be too low and the company might actually be losing money on every product sold.

What Are The Drawbacks Of Absorption Costing

Because absorption costing necessitates the allocation of potentially significant overhead costs to products, a large portion of a product’s costs may not be directly traceable to the product. Because direct costing and constraint analysis do not require the allocation of overhead to a product, they may be more useful than absorption costing for incremental pricing decisions in which you are only concerned with the costs required to build the next incremental unit of product.

It is also possible for an entity to generate additional profits simply by producing more products that it does not sell. 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, the fixed overhead costs assigned to the excess units are never charged to expense, resulting in increased profits. A manager could falsely authorise excess production in order to generate these extra profits, but this burdens the entity with potentially obsolete inventory and necessitates the investment of working capital in the extra inventory.

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Definition Sources

Definitions for Absorption Costing are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 13th April, 2022 | 0 Views.