Absorption costing is typically required for financial and income tax reporting purposes. Activity-based costing, also known as ABC, is an accounting method that identifies a company’s activities and assigns costs to units produced by the company based on the number of activities used by each unit. Absorption costing recognizes the significance of factoring in fixed production expenses when evaluating product costs and pricing strategies. All production-related expenses (both fixed and variable) ought to be billed to the units produced. The Administrative and variable selling costs and Fixed Selling and administrative costs are regarded as period costs under ABS costing and are not included in the cost of a product.

When we include fixed overheads in the product costs, absorption costing provides a clear picture of the amount of resources consumed by the organization. The variable costing technique considers fixed overheads as period costs rather than spreading them out to the produced units. Absorption costing is an easy and simple way of dealing with fixed overhead production costs. It is assuming that all cost types can allocate base on one overhead absorption rate. The absorption rate is usually calculating in of overhead cost per labor hour or machine hour. The products that consume the same labor/machine hour will have the same cost of overhead.

The Components of Absorption Costing

Indirect costs are typically allocated to products or services based on some measure of activity, such as the number of units produced or the number of direct labor hours required to produce the product. The variable cost per unit is $22 (the total of direct material, direct labor, and variable overhead). The absorption cost per unit is the variable cost ($22) plus the per-unit cost of $7 ($49,000/7,000 units) for the fixed overhead, for a total of $29.

The principle states that expenses should be recognized in the period in which revenues are incurred. Including fixed overhead as a cost of the product ensures the fixed overhead is expensed (as part of cost of goods sold) when the sale is reported. In addition, absorption costing takes into account all costs of production, such as fixed costs of operation, factory rent, and cost of utilities in the factory. It includes direct costs such as direct materials or direct labor and indirect costs such as plant manager’s salary or property taxes. The example exhibits the absorption costing technique, where it assigns the product costs to units produced and sold.

External Reporting

Figure 6.11 shows the cost to produce the 10,000 units using absorption and variable costing. Carrying over inventories and overhead costs is reflected in the ending inventory balances at the end of the production period, which become the beginning inventory balances at the start of the next period. It is anticipated that the units that were carried over will be sold in the next period.

The costs here include raw materials and labor directly tied to production, variable, and fixed overheads. 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. 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.

What Is Absorption Costing?

Also, this allocation of fixed overheads across the produced units can also lead to over or under-absorption of the overheads. Maybe calculating the Production Overhead Cost is the most difficult part of the absorption costing method. The following is the step-by-step calculation and explanation of absorbed overhead in applying to Absorption Costing. Absorption costing is not as well understood as variable costing because of its financial statement limitations. See the Strategic CFO forum on Absorption Cost Accounting that helps managers understand its uses to learn more.