Today we take a look at the Absorption Costing Method and how it is used to allocate cost to produced goods. Do not forget to download the Excel working file at the end of the article.
What is Absorption Costing?
Absorption Costing is a management accounting method for accumulating all costs associated with production in the value of produced inventory. It is also called ‘full costing’ and is required for the external reporting of a company, for it to be GAAP or IFRS compliant.
Products can absorb a wide variety of Fixed and Variable costs. These are not recognized as expenses in the current period when they’re incurred. Instead, these costs remain in the inventory balances until the products are sold, at which point we charge their cost to COGS (cost of goods sold). Absorption costing is a system used in valuing inventory, which considers the cost of materials and labor, and also the variable and fixed manufacturing overheads.
It is possible to use Activity-based costing (ABC) to allocate production overheads within the application of absorption costing. However, this is too time-consuming and is not very cost-effective when all we want is to allocate costs to be following GAAP/IFRS.
Steps of Absorption Costing
To utilize the Absorption costing method of cost allocation, we need to follow these three steps:
- Assign costs to cost pools – prepare a mapping of sets of accounts to various cost pools; this must be considered thoroughly, as regular changes are not welcome, because they hinder future analysis;
- Calculate the usage based on activity measures, e.g., labor or machine hours;
- Assign costs – calculate the allocation rate and allocate overhead to produced goods.
Components of Absorption Costing
The main parts of product cost under Absorption costing are:
- Direct Materials (DM) – the direct materials used in the production of the unit;
- Direct Labor (DL) – the direct labor spent on the production of the unit, valued at the applicable labor rate;
- Variable Manufacturing Overheads (VMOH) – cost to operate the manufacturing facility which varies with production volume, e.g., electricity, water, etc.;
- Fixed Manufacturing Overheads (FMOH) – cost to operate the facility which does not vary with changes in production volume, e.g., rent, insurance, etc.
Under Absorption Costing, we consider variable and fixed selling & general administrative expenses as period costs, and we expense them in the period they’re incurred; we do not include them in the cost of production.
The various manufacturing or production costs related directly to the produced goods or other cost objects are what we refer to as overheads. These costs are not directly attributable to the products, so they are usually absorbed on a predetermined overhead allocation rate. If the rate is not set correctly, we might have underabsorption or overabsorption, which will hinder future production and inventory balances, as it will either understate or overstate the ending balance value of finished goods.
Absorption Costing vs. Variable Costing
Absorption costing allocates all non-direct manufacturing overheads to produced goods, whether these are sold or not, which is the main difference with variable costing. That way, in absorption costing, fixed production overheads are split in two – attributable to COGS (cost of goods sold) and attributable to inventory (finished goods ending balance).
Absorption Costing formula and process
This formula shows us how to value finished goods cost under the absorption costing method. We need to follow these steps:
- Identify materials used directly in the production of one unit and multiply these by the units produced, to get the total direct materials used (DM);
- Evaluate the direct labor cost, based on hours spent in production, the expertise required and corresponding labor rate, then multiply this by the produced quantity, to get the total direct labor costs (DL);
- Identify variable production overhead costs per unit and multiply these by the manufactured units, to get the total variable manufacturing overheads (VMOH);
- Accumulate all fixed production overhead costs, that do not relate to the volume of production (FMOH);
- Sum these four and divide them by the quantity of produced units, to get the full cost per unit of the product.
Advantages of Absorption Costing
Using the Absorption costing method has the following benefits:
- It gives us a more accurate ending balance of inventory, as costs related to unsold goods are in the balance, and not expensed during the period;
- Absorption costing is GAAP/IFRS compliant and required in financial reporting and inventory valuation;
- This method is more relevant when determining the selling price, as it makes sure we cover all related expenses when setting a selling price;
- Absorption costing results in higher net income, as costs related to unsold goods are not charged to the income statement (as compared to variable costing, where all fixed production overheads are expensed in the same period they are incurred).
Disadvantages of Absorption Costing
When applying the absorption costing method, we also face the following drawbacks:
- This method assumes that fixed costs are allocated equally to units. That way, we create an unusual situation where each additional unit produced decreases allocated fixed overheads and subsequently increases net income when sold. Management can produce more and not sell it, to increase reported net income of the company.
- A significant portion of production costs may not be traceable to the product directly, which can be an issue with incremental pricing decisions, where we only focus on costs related directly to the production of the next item.
Let us take a look at two examples to illustrate how to apply the absorption costing method.
SJP Kits Ltd. is an Austrian company producing hand-made ski clothing. As part of the financial team, we are analyzing the cost of a product, to support management with the decision-making process for the selling price. We have the following data:
Based on this input information and the Absorption Costing formula we discussed above, we know that we should calculate the AC while excluding both the variable and fixed selling & admin costs. That way, we get the following calculation:
Now that we have the Absorption Cost calculated and we know that the management is looking for a mark-up of 35%, we can calculate the selling price.
To facilitate the decision-making process even further, we can prepare a summarized income statement, to showcase the effect this product will have on the gross profit and EBITDA of the company.
SJP Kits also produces ski pants. The sales director has informed us that they have received a quote to provide 12,000 pcs of a ski pant model, for a total contract price of 600,000 euro. As part of the financial team, the sales department asked us if this contract will be profitable for the company.
Let us start by taking a look at our data from past production. So far we have produced 10,000 pcs of this model.
We can use the data we have to calculate the Absorption Cost of the 10,000 pcs we already created.
By also calculating the price per unit in the suggested contract, we can compare it to the Absorption Cost. We notice that the amount offered will not even cover the cost of the products. Therefore this contract is not to be undertaken by the company. We have to either negotiate a higher contract price or look into possible cost optimizations.
To support our conclusion and facilitate the decision-making process of the management, we can present the following summary to showcase the effect on the income statement of the company.
From the perspective of financial analysis, it is critical to understand the concept of the Absorption Costing formula, as it can help the company determine the contribution margin of a specific product and this can further help in the break-even analysis. Also, the application of Absorption Costing in the production of additional units adds to the net profit of the company since there are no more fixed costs to be allocated. And last but not least, Absorption Costing is GAAP and IFRS compliant.
In this article, we explored Absorption Costing. Do not forget to share with friends and colleagues, and download the Excel working for the article below:
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