what is absorption costing 
absorption costing sometimes called full costing is a managerial accounting method for capturing all costs associated with manufacturing a particular product all direct and indirect costs such as direct materials direct labor rent and insurance are accounted for when using this method under generally accepted accounting principles gaap u s companies may use absorption costing for external reporting however variable costing is disallowed investopedia michela buttignolunderstanding absorption costingabsorption costing includes anything that is a direct cost in producing a good in its cost base absorption costing also includes fixed overhead charges as part of the product costs some of the costs associated with manufacturing a product include wages for employees physically working on the product the raw materials used in producing the product and all of the overhead costs such as all utility costs used in production 1in contrast to the variable costing method every expense is allocated to manufactured products whether or not they are sold by the end of the period absorption costing means that ending inventory on the balance sheet is higher while expenses on the income statement are lower components of absorption costingthe components of absorption costing include both direct costs and indirect costs direct costs are those costs that can be directly traced to a specific product or service these costs include raw materials labor and any other direct expenses that are incurred in the production process indirect costs are those costs that cannot be directly traced to a specific product or service these costs are also known as overhead expenses and include things like utilities rent and insurance 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 in absorption costing both direct and indirect costs are included in the cost of a product this means that the cost of each unit of a product includes not only the direct costs of producing that unit but also a portion of the indirect costs that were incurred in the production process the total manufacturing costs are then divided by the number of units produced to determine the cost of each unit the formula for absorption costing can be written as follows 2absorption costing vs variable costingabsorption costing and variable costing are two different methods of costing that are used to calculate the cost of a product or service while both methods are used to calculate the cost of a product they differ in the types of costs that are included and the purposes for which they are used the differences between absorption costing and variable costing lie in how fixed overhead costs are treated under absorption costing all manufacturing costs both direct and indirect are included in the cost of a product this means that the cost of each unit of a product includes not only the direct costs of producing that unit such as raw materials and labor but also a portion of the indirect costs that were incurred in the production process such as overhead expenses absorption costing is typically used for external reporting purposes such as calculating the cost of goods sold for financial statements variable costing on the other hand only includes direct costs in the cost of a product indirect costs or overhead expenses are not included in the cost of the product under variable costing instead they are treated as a period expense and are recorded in the income statement in the period in which they are incurred variable costing is typically used for management decision making and planning purposes as it provides a more accurate representation of the incremental costs associated with producing an additional unit of a product variable costing does not determine a per unit cost of fixed overheads while absorption costing does variable costing will yield one lump sum expense line item for fixed overhead costs when calculating net income on the income statement absorption costing will result in two categories of fixed overhead costs those attributable to the cost of goods sold and those attributable to inventory image by sabrina jiang investopedia 2021absorption costing results in a higher net income compared with variable costing advantages and disadvantages of absorption costingassets such as inventory remain on the entity s balance sheet at the end of the period because absorption costing allocates fixed overhead costs to both cost of goods sold and inventory the costs associated with items still in ending inventory will not be captured in the expenses on the current period s income statement absorption costing reflects more fixed costs attributable to ending inventory absorption costing ensures more accurate accounting for ending inventory because the expenses associated with that inventory are linked to the full cost of the inventory still on hand in addition more expenses are accounted for in unsold products which reduces actual expenses reported in the current period on the income statement this results in a higher net income calculation compared with variable costing calculations because absorption costing includes fixed overhead costs in the cost of its products it is unfavorable compared with variable costing when management is making internal incremental pricing decisions this is because variable costing will only include the extra costs of producing the next incremental unit of a product in addition the use of absorption costing generates a situation in which simply manufacturing more items that go unsold by the end of the period will increase net income because fixed costs are spread across all units manufactured the unit fixed cost will decrease as more items are produced therefore as production increases net income naturally rises because the fixed cost portion of the cost of goods sold will decrease provides a more complete picture of the total cost of a product by including both direct and indirect costs helps in determining the total actual cost of goods sold and the cost of inventory on the balance sheet allows a company to understand the full cost of each product or service it provides may not accurately reflect the incremental costs associated with producing an additional unit of a product as it includes fixed overhead costs that do not vary with production volume can lead to distorted cost data if there are significant changes in production volume may not provide as much information for management decision making as variable costing example of absorption costingassume that abc company makes widgets in january it makes 10 000 widgets of which 8 000 are sold by the end of the month leaving 2 000 still in inventory each widget uses 5 of labor and materials directly attributable to the item in addition there are 20 000 of fixed overhead costs each month associated with the production facility under the absorption costing method abc will assign an additional 2 to each widget for fixed overhead costs 20 000 total 10 000 widgets produced in the month the absorption cost per unit is 7 5 labor and materials 2 fixed overhead costs as 8 000 widgets were sold the total cost of goods sold is 56 000 7 total cost per unit 8 000 widgets sold the ending inventory will include 14 000 worth of widgets 7 total cost per unit 2 000 widgets still in ending inventory 