Definition: Absorption costs are defined as a percentage of the total manufacturing cost and include all direct and indirect costs associated with the production of a particular line or product.
The term “absorption cost” is used to describe all of the materials and equipment used in the production process. It is the part of the production cost that can be recovered from customers after they have paid for the goods or services purchased.
It usually includes materials and equipment used in raw material sourcing and manufacturing, materials used in production processes, overhead creation – consumed by the manufacturer in creating goods and packaging them for shipment, setting up retail outlets for marketing and advertising the products, etc.
Absorption costing has been applied to a number of manufacturing processes. Accounts for all materials and equipment used to produce a product, including labor, parts, raw materials, packaging materials, and energy.
In general absorption costs are higher for manufacturing a good that requires multiple steps to produce than other goods. This is because every stage in the production process has a cost associated with it and the producer must recover that cost to get money back into his pocket.
The main idea behind absorption cost is that production, raw material supply, and distribution costs should be separately accounted for to correctly record cost information for these stages of a manufacturing process.
Steps of Absorption Costing
Below are the steps of Absorption Costing:
- Assign costs to cost pools – decision of adding accounts to the cost pool should be carefully taken as regular changes might hinder future analysis;
- Calculate the amount of usage based on overhead costs, e.g., labor or machine hours, etc;
- Allocate costs – Determine the allocation rate and allocate overhead cost to produced goods based on the usage rate.
Absorption Costing vs. Variable Costing
1. Absorption costing treats fixed overhead costs as an expense to be incurred regardless of whether or not the product is sold. A producer may incur these costs even if no one buys his product because the producer must maintain his overhead to satisfy creditors, maintain his facility for R&D, maintain stock and warehouses, and so forth. On the other hand, variable costing treats variable overhead costs as an expense to be incurred only when the revenue from a specific product type exceeds some certain threshold. Those costs are passed along to consumers whether or not they buy the product.
2. While absorbing costs is standard for most startup businesses, variable costing is more appropriate if you’re growing slowly (and therefore may be increasing steadily) while charging for goods and services as they’re sold. While it’s normal for startups to absorb some costs over time as they grow, it’s typically more efficient for them to pass along costs with some predictable delay.
3. Absorption costing is the cost of meeting outstanding liabilities while charging fixed costs for variable overhead. In variable costing, costs are variable because they may change over time.
4. Variable costing considers actual costs incurred by suppliers to fulfill your orders, while absorption costing only considers upfront costs such as inventory or fixed hardware/software costs.
5. Absorption costing is more mature and generally accepted in the finance industry, while variable costing occurs more frequently in consumer credit transactions.
6. With absorption costing, you pay only for the goods and services you consume over the product’s lifetime. In contrast, variable costing involves estimating how much each component will cost over time and adjusting the purchase price accordingly.
Example of Absorption Costing
1. let’s say you sell a product for $100, which is your cost for manufacturing and warehousing the product. Then let’s say an outside party buys the product for $110, which is their best guess about what the market will bear (higher or lower than your original price). If you had sold the product for the amount being paid, then your absorption cost would be $101 – $110 = $3
2. For example, if you sell a book at $10, but it took you two weeks to print and ship that $5 book, the cost of absorbing that cost into inventory would be $2 (the time it took to print and ship the book).
4 Components of Absorption Cost
The main components of Absorption costing are:
- Direct Materials (DM)
- Direct Labor (DL)
- Variable Manufacturing Overheads (VMOH)
- Fixed Manufacturing Overheads (FMOH)
Advantages of Absorption Costing
- Absorption costing is GAAP-compliant. GAAP accounting is an essential requirement for any business as it helps to make economic incorporation easy and predictable.
- They can be applied both to products and services and give a better picture of overall costs.
- It can also help evaluate whether your methods are producing a large amount of “real” profit, considering that other potential customers should be getting a similar return on their investment as well.
- Absorption costs have become a popular way to measure accounting profitability. In general, an investment will pay off in less than one year but will require two to three years of working capital to recover your initial investment. Accounting for expenses in this way helps investors gauge if an investment is profitable, and if so, how profitable it is. For a retailer, absorption costs help determine if an investment will yield enough profit to justify continuing operations over time.
Disadvantages of Absorption Costing
- The principal disadvantage of absorption cost is its inability to predict changes in demand. Because the sunk cost is an asset owned by the business, and because it can shift with shifts in demand and market conditions, and investment in absorption cost requires anticipating all eventualities. This may involve imagining scenarios in which the resource in question no longer suits the business’s needs but still serves current demands.
- Absorption Costing is overvalued. It leads to undesirable behaviors when market forces are allowed to set prices for goods or services without regard for competitive effect or consumer welfare.
- Absorption costings reduce the utility of the estimated selling price. This can occur because the valuable real estate is assumed to be fixed in unit costs rather than in usage costs. In addition, if a vendor takes into account only one use when calculating costs, he may include fixed charges for materials or labor in costs because those costs are not estimated for each use by customers.
Absorption cost accounting is used to turn variable costs into costs that can be reflected in the income statement. In this method, the cost of goods sold (COGS) is translated into a single item that represents all profit generated by the business during a given period. Although the number is fixed, it changes over time because of changes in demand for any particular good or service; for example, when consumers buy more aggressively in response to higher prices. It should be noted that this methodology is rarely applied directly to manufacturing activities, which are often closely related to research, development, advertising, quality control, inventory management, etc. Instead, it’s frequently applied when measuring the overall profitability of an organization.