What is Absorption Costing?

Inventory valuation / costing including all manufacturing costs. Explanation of Absorption Costing.

The Absorption Costing method (also: Full Costing) is an inventory valuation and costing model that includes all manufacturing costs:

• Direct materials. Those materials that become an integral part of a finished product, and which can be easily traced back into the finished product.
• Direct labor. Those factory labor costs that can be easily traced back to individual units of product. Also known as touch labor.
• Both variable and fixed manufacturing overhead.

in the cost of a unit of product. As a result, under absorption costing, fixed overhead is a product cost until the products are sold.

Absorption costing is also known as the full cost method.

Should Fixed Manufacturing Costs be Included in Inventories?

Advocates of Absorption Costing say that it should, because all of the production costs are needed to create the products. Thus, they have "future economic benefits."

Advocates of Variable Costing argue that for a fixed manufacturing-cost to be an asset, it has to meet a future cost avoidance criterion. Much in the same way as prepaid insurance. In the case of fixed manufacturing costs, they do not meet this criterion because they are incurred each time the production line opens. Thus, they should be regarded as expenses in that period, and only the variances in expenses should be inventoried.

Problems with absorption costing also include potential manipulations by plant managers, such as increasing production regardless of sales levels. In this way costs can be deferred to the next year, and a higher current profit can be shown for the sake of bonuses and promotions.

Consequences of using Absorption Costing for Profit calculation

The difference is important for calculating profit when the beginning inventory level and the ending inventory level are different:

• If beginning & ending inventory levels are equal: absorption costing profit = variable costing profit;
• If inventory levels are run down over the period: variable costing profit will be higher than absorption costing profit;
• If inventory levels are increased over the period: absorption costing profit will be higher than variable costing profit.