What is Absorption Costing?
Absorption costing is a way of accounting that allocates all the production costs to the goods that are made. This covers both direct costs, like materials and labor, and indirect costs, like overhead and fixed expenses. Absorption costing is applied to value inventory and report income for external uses, such as taxes and financial statements.
Absorption Costing Explained
Absorption costing assigns direct and overhead costs to inventory value. Overhead costs can be either fixed (e.g., rent, insurance, depreciation) or variable (e.g., electricity). Absorption costing considers all these costs, along with direct materials and labor, as part of inventory value. It does not include other business costs (e.g., administration, sales).
This costing method can be complicated. It requires cooperation between manufacturing experts, who have knowledge of production details and costs, and cost accountants, who follow GAAP rules and use averages and estimates. For instance, a company that produces scarves and dresses from the same fabric in the same facility has to estimate each product’s fabric and labor costs and add them to the absorption cost.
A way to enhance absorption costing is to have a well-organized chart of accounts and a general ledger that reflects the manufacturing operations. This also requires cooperation between manufacturing and accounting experts. With the appropriate accounts and an ERP system that connects production and accounting data, the cost pools for absorption costing can be easily and automatically calculated. Absorption costing is similar to job costing and process costing, which monitor expenses for different projects or products. GAAP regards them as forms of absorption costing.