Absorption costing, also called full costing or the full absorption method, is the product costing method that puts every manufacturing cost into the cost of a unit, direct materials, direct labor, variable manufacturing overhead and fixed manufacturing overhead. Because fixed manufacturing overhead attaches to the unit, it sits in inventory on the balance sheet until that unit is sold, and is released into cost of goods sold only then. Spending outside production stays out: selling expenses form no part of inventory cost, and general and administrative expenses are period charges except for the portion clearly related to production.
What Goes Into a Unit’s Cost
The figure is built in four layers.
Absorption cost per unit = direct materials
+ direct labor
+ variable manufacturing overhead per unit
+ fixed manufacturing overhead per unitMaterials and labor are traced to the unit. The two overhead layers are not, so a rate has to put them there, and building that rate belongs to costing overheads and the predetermined overhead rate.
The fourth layer is the one that defines the method. Absorption costing makes fixed manufacturing overhead a product cost, so it waits in inventory instead of hitting the period that incurred it, and the attachment test behind that is in period vs product cost and period cost.
The Standard That Requires It
For US external reporting the method is not a preference. Fixed production overhead has to be allocated to the costs of conversion, on the basis of the normal capacity of the production facilities, and the exclusion of all overheads from inventory costs does not constitute an accepted accounting procedure (Accounting Research Bulletin No. 43, Chapter 4, paragraphs 5 and 5A, as amended by FASB Statement No. 151). Together they leave a full absorption basis as the only acceptable one for the inventory figure. The standard defines normal capacity as a range of production levels, the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. Actual production may be used when it approximates that range, so the denominator is a normal-volume figure rather than this period’s budget or this period’s output.
The tax rules name the method outright rather than describing it. Under the full absorption method of inventory costing both direct and indirect production costs must be taken into account in computing inventoriable costs, and those production costs must be allocated to goods produced during the taxable year, whether sold during the taxable year or in inventory at the close of the taxable year (Treasury Regulation 1.471-11(a)). That allocation rule is the deferral in regulatory form, because a cost allocated to a unit still sitting in inventory has not yet reached the return. The same paragraph also points past itself, to sections 1.263A-1 and 1.263A-2, for production costs incurred in taxable years beginning after December 31, 1993, so a producer reading 1.471-11 alone is reading only part of the current rule. What counts as a production cost is in production costs, and the wider set the uniform capitalization rules pull in is in costing overheads.
Why Reported Income Moves With Production Volume
Under absorption costing the fixed manufacturing overhead a period charges against income depends on how many units were made, not only on how many were sold. Produce more than you sell and part of the period’s fixed overhead leaves the income statement and waits in ending inventory. Produce less than you sell and overhead deferred earlier comes back out on top of what this period incurred.
The same standard bounds it. The fixed overhead each unit carries is not increased as a consequence of abnormally low production or idle plant, and whatever the units never absorb is recognized as an expense in the period in which it was incurred (Accounting Research Bulletin No. 43, Chapter 4, paragraphs 5 and 5A, as amended by FASB Statement No. 151). So the rate cannot climb to rescue a thin quarter. What counts as abnormally low, and what the gap does to a volume variance, is in 2-way variance analysis.
A Worked Example
Say a manufacturer makes one product for a year, sells the same quantity in both cases, and varies only how much it produces.
Fixed manufacturing overhead for the year $300,000
Normal capacity 30,000 units
Fixed overhead per unit 300,000 / 30,000 = $10.00
Variable manufacturing cost per unit $22.00
Absorption cost per unit 22.00 + 10.00 = $32.00
Units sold, both cases 24,000 units
Case A, produce 30,000 units
Cost of goods sold 24,000 x 32.00 = $768,000
Charged against income = $768,000
Fixed overhead sitting in the 6,000 unsold units = $60,000
Case B, produce 24,000 units
Cost of goods sold 24,000 x 32.00 = $768,000
Fixed overhead absorbed 24,000 x 10.00 = $240,000
Unallocated fixed overhead 300,000 - 240,000 = $60,000
Charged against income 768,000 + 60,000 = $828,000Both cases sell the same units at the same unit cost and still report different costs for the year. Case A parks the difference in the unsold units and hands it to next year’s cost of goods sold. Case B cannot, because production ran below normal capacity, so the unabsorbed amount is expensed where it was incurred. The lever moves the timing of fixed overhead, never the amount, and the two cases converge once the inventory clears.
What Absorption Costing Is Confused With
Variable Costing, Called Marginal Costing
Variable costing puts only the variable manufacturing costs into unit cost and charges the whole of fixed manufacturing overhead to the period. It is the same data sorted differently, so the two methods agree whenever production equals sales and part company when it does not. UK and Commonwealth material calls it marginal costing, and the per-unit measure behind that name is marginal cost. Only the absorption basis satisfies the inventory standard, so variable costing stays a management view rather than a basis for the external figure. The layouts that go with the two methods, traditional against contribution format, are in the contribution margin income statement.
Activity Based Costing and Differential Costing
Neither is an alternative on this question. Activity based costing changes how overhead is assigned, not whether fixed manufacturing overhead belongs in unit cost, and differential costing compares alternatives on what changes between them, which usually makes a fully absorbed unit cost the wrong input.
What Are the Disadvantages of Absorption Costing?
Reported operating income moves with production volume, so a period can read stronger because more was made rather than because more was sold, and a reviewer comparing two periods has to check output before crediting the improvement.
A fully absorbed unit cost is also only true at the volume its fixed overhead rate was computed on, and the fixed layer inside it is an allocation rather than a cost the unit caused, so quoting a short-run price off it carries into the decision a cost that will not change with it. What one more unit would actually cost is marginal cost.
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