Absorption costing is a method of accounting for production costs that assign all direct and indirect costs to the products being produced.
This method is also known as full costing or traditional costing. Under absorption costing, the cost of each product includes the direct materials, direct labour, and both variable and fixed overhead costs associated with manufacturing the product. This means that all of a company’s production costs are included in the inventory cost until the finished product is sold.
Absorption Costing Formula
The absorption costing formula is:
The total cost of a product = Direct materials + Direct labour + Variable overheads + Fixed overheads
Direct materials include any raw materials used in the production process. Direct labour refers to wages paid to workers who are responsible for producing the item. Variable overheads are costs that change based on production levels, such as electricity or machine maintenance expenses. Fixed overheads include expenses that remain constant over time, such as rent or property taxes, or annual salaries of executives.
Advantages of absorption costing
There are many benefits of absorption costing. The following are the main advantages of absorption costing:
Accurate product costing- It appropriately recognises the need to consider fixed manufacturing costs in product cost estimation and defines an appropriate price structure. It avoids separating costs into fixed and variable elements, which cannot be done easily and accurately. In reality, all costs (fixed and variable) associated with production should be charged to the unit of product produced. Prices established based on absorption costing ensure that all costs are covered completely. The market is well-regulated when the full cost is used as a foundation for pricing.
Useful for decision-making: Absorption costing can be useful for decision-making since it takes into account all costs incurred to produce a product.
Compliance with accounting standards – It has been recognised by various bodies as FASB (USA.) ASC (UK) and ASB ( INDIA) to prepare external reports and inventory valuations.
Simple and easy to understand: Absorption costing is a simple method that’s easy to understand by managers and stakeholders alike.
It assists in making managers more accountable for the costs and services supplied to their centres/departments due to the proper allocation and apportionment of fixed manufacturing resources.
In conclusion, while absorption costing ensures closer examination into each unit’s true expense than other approaches like variable or marginal costing which only considers variable expenses typically linked to every unit price; still businesses must recognize its drawbacks fully before settling on this approach for determining their inventory’s true cost at any given period accurately.