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.
Absorption Costing
Definition: Absorption costing, sometimes referred to as “full costing,” is a managerial accounting method used to capture all costs associated with manufacturing a specific product. Under this method, all direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are included.
Origin: The origin of absorption costing can be traced back to the early 20th century, during the Industrial Revolution, which spurred large-scale production and complex manufacturing processes. To allocate costs more accurately, businesses began adopting this method. Over time, absorption costing became widely accepted and is now part of Generally Accepted Accounting Principles (GAAP).
Categories and Characteristics: Absorption costing is mainly divided into two categories: full absorption costing and partial absorption costing.
- Full Absorption Costing: All direct and indirect costs are allocated to the product. The advantage of this method is that it fully reflects the total cost of the product, but the disadvantage is that it may lead to cost overestimation.
- Partial Absorption Costing: Only a portion of the indirect costs, usually those directly related to production, are allocated. The advantage of this method is that it simplifies the cost allocation process, but the disadvantage is that it may not be comprehensive enough.
Specific Cases:
- Case One: A manufacturing company produces Product A and uses absorption costing to calculate costs. The direct material cost is $100, direct labor cost is $50, and indirect costs such as factory rent and insurance are $30. The total cost is $180, and these costs are all allocated to Product A.
- Case Two: Another company produces Product B, with a direct material cost of $200, direct labor cost of $100, and indirect costs of $50. Using absorption costing, the total cost is $350. These costs help the company price and evaluate profits more accurately.
Common Questions:
- Question One: Why is absorption costing widely used in external reporting?
Answer: Because absorption costing fully reflects the total cost of the product and complies with Generally Accepted Accounting Principles (GAAP), it is widely used in external reporting. - Question Two: What is the main disadvantage of absorption costing?
Answer: The main disadvantage is that it may lead to cost overestimation, especially when indirect costs are high.
