What is Absorption Costing?

Absorption costing is a method for accumulating the costs associated with a production process and apportioning them to individual products. This type of costing is required by the accounting standards to create an inventory valuation that is stated in an organization's balance sheet. A product may absorb a broad range of fixed costs and variable costs. These costs are not recognized as expenses in the month when an entity pays for them. Instead, they remain in inventory as an asset until such time as the inventory is sold; at that point, they are charged to the cost of goods sold.

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The Components of Absorption Costing

The key costs assigned to products under an absorption costing system are noted below.

Direct materials. Direct materials are materials that are included in a finished product.
Direct labor. Direct labor includes the factory labor costs required to construct a product.
Variable manufacturing overhead. Variable manufacturing overhead includes the costs to operate a manufacturing facility, which vary with production volume. Examples are supplies and electricity for production equipment.
Fixed manufacturing overhead. Fixed manufacturing overhead includes the costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.

What Not to Include in an Absorption Costing System

You should charge sales and administrative costs to expense in the period incurred; do not assign them to inventory, since these items are not related to goods produced, but rather to the period in which they were incurred.

Activity-Based Costing

It is possible to use activity-based costing (ABC) to allocate overhead costs for inventory valuation purposes under the absorption costing methodology. However, ABC is a time-consuming and expensive system to implement and maintain, and so is not very cost-effective when all you want to do is allocate costs to be in accordance with GAAP or IFRS.

Absorption Costing Steps

The steps required to complete a periodic assignment of costs to produced goods is noted below.

Step 1. Assign Costs to Cost Pools

The assignment of costs to cost pools is comprised of a standard set of accounts that are always included in cost pools, and which should rarely be changed.

Step 2. Calculate Usage

Calculating usage involves determining the amount of usage of whatever activity measure is used to assign overhead costs, such as machine hours or direct labor hours used.

Step 3. Assign Costs

Assigning costs involves dividing the usage measure into the total costs in the cost pools to arrive at the allocation rate per unit of activity, and assigning overhead costs to produced goods based on this usage rate.

Overhead Absorption

Absorbed overhead is manufacturing overhead that has been applied to products or other cost objects. Overhead is usually applied based on a predetermined overhead allocation rate. Overhead is overabsorbed when the amount allocated to a product or other cost object is higher than the actual amount of overhead, while the amount is underabsorbed when the amount allocated is lower than the actual amount of overhead.

Example of Overhead Absorption

Higgins Corporation budgets for a monthly manufacturing overhead cost of $100,000, which it plans to apply to its planned monthly production volume of 50,000 widgets at the rate of $2 per widget. In January, Higgins only produced 45,000 widgets, so it allocated just $90,000. The actual amount of manufacturing overhead that the company incurred in that month was $98,000. Therefore, Higgins experienced $8,000 of underabsorbed overhead.

In February, Higgins produced 60,000 widgets, so it allocated $120,000 of overhead. The actual amount of manufacturing overhead that the company incurred in that month was $109,000. Therefore, Higgins experienced $11,000 of overabsorbed overhead.

Disadvantages of Absorption Costing

While absorption costing can be quite useful in certain circumstances, there are also several problems associated with it. Here are the chief concerns:

Overstates profit when inventory increases. Absorption costing allocates fixed overhead to each unit of production, whether sold or not. This means that if a company produces more than it sells, some fixed costs are "hidden" in unsold inventory, making profits look higher than they really are. It can mislead managers and stakeholders into thinking the business is more profitable than it truly is during periods of rising inventory.
Not ideal for decision-making. Absorption costing does not clearly separate fixed and variable costs, which are essential for evaluating decisions like pricing, budgeting, or cost control. Without knowing how costs behave with production volume, it’s harder for managers to make informed short-term decisions. As a result, it can lead to less effective strategic planning or operational choices.
Encourages overproduction. Since producing more units spreads fixed overhead over a larger number of products, managers might be tempted to overproduce just to lower per-unit costs and boost reported profits. This can lead to excess inventory, higher storage costs, and waste. It promotes inefficient use of resources and goes against lean or just-in-time production principles.