Absorption costing is a method of costing that includes all costs incurred in the production process, including both fixed and variable costs.
Absorption costing, also known as full costing, is conventional in ascertaining costs. It is the practice of charging all variable and fixed costs to the operation, processes, and products.
It is the oldest and most widely used technique for ascertaining the cost. Under this cost technique, the cost is made up of direct cost plus overhead costs absorbed on some suitable basis. In this technique, the cost per unit (CPU) remains the same only when the output level remains the same. But when the level of output changes, the cost per unit also changes in the presence of fixed cost, which remains constant.
The change in cost per unit with a change in the level of output in an absorption costing technique poses a problem to the management in taking managerial decisions.
Absorption costing is helpful if there is only one product, there is no inventory, and the overhead recovery rate is based o normal capacity instead of the actual activity level. Two distinguishing features of absorption costing is that fixed factory expenses are included in the (i) unit cost and (ii) inventory value.
There are a number of reasons why businesses might choose to use absorption costing. Firstly, it complies with generally accepted accounting principles (GAAP). Secondly, it provides a more accurate picture of the true cost of production and therefore enables better decision-making. Finally, it is easier to calculate than other costing methods.
Treatment of Absorption Costing in Books
Absorption costing divides all the costs into three parts, i.e. manufacturing, administrative and selling & distribution.
In the income statement of the profit and loss account, all the manufacturing costs are subtracted from the gross sales revenue to arrive at the gross margin. From the gross margin, selling and administrative expenses are deducted to find out the net income amount.
It is worth noting that fixed manufacturing overheads are charged to the number of units produced based on per unit fixed manufacturing overhead rate obtained by dividing the standard fixed manufacturing overhead by the normal output level as given below:
= Standard Fixed Manufacturing Overhead / Normal Output (normal capacity)
If the actual production is above or below the normal capacity level adjustments, volume variance must be made.
Absorption costing is applicable for product costing when there is a mix of purchases of long-lived products and short-lived products. It is also applicable for product costing when the product is built or assembled using the skills and resources of a limited number of manufacturers. In absorption costing, the total cost of the product is determined from the material costs of the component parts of the product.
The material cost of the product’s parts is charged separately to the product. The total cost of the product is arrived at by adding the amount of material cost of each part. Each part is the product of the total labour and material costs.