# Absorption Costing

Absorption costing is a method in which cost of units produced is calculated as the sum of both the variable manufacturing costs incurred and the fixed manufacturing costs allocated to those units. It is also called full absorption costing or full costing, because all product costs (including the fixed manufacturing overheads) are included in the cost of units produced and carried forward to future periods, instead of being charged wholly to income statement in a single period.

While direct costs (such as direct materials, direct labor and variable manufacturing overheads) are traceable to different units, indirect costs such as fixed manufacturing overheads require allocation to different units on some reasonable basis. Depending on whether fixed manufacturing costs are assigned to units or not, there are two possible approaches to finding cost of units produced, namely absorption costing and variable costing (also called marginal costing). In absorption costing, fixed manufacturing costs are assigned to units while in variable costing (also called marginal costing), fixed manufacturing costs are not assigned to units but are subtracted from sales in the period in which they are incurred.

## Absorption costing income statement

Net income under absorption costing is calculated as follows:

 Sales Less Cost of goods sold Equals Gross margin Less Selling & admin expenses Equals Net income

Cost of goods sold is calculated as follows:

 Opening inventories balance Add Manufacturing cost for the period Less Closing inventories balance Equals Cost of goods sold

Manufacturing cost for the period
= direct materials
+ direct labor

Cost of inventories depends on which cost flow assumption is used. Under the FIFO method, cost of closing inventories = manufacturing cost for the period/units produced × units in closing inventories.

## Example

XYZ Inc. manufactures wallets. Information for the financial year ended 31 March 2015 is given below.

 Units in opening inventories 3,000 Units produced during the year 22,000 Units in closing inventories 4,000 Direct materials 2,000 Direct labor 3,000 Variable manufacturing overheads 1,000 Fixed manufacturing overheads 1,500 Total cost of opening inventories 7,500 Direct materials for the period 16,100 Direct labor for the period 22,000 Variable manufacturing overheads for the period 11,000 Fixed manufacturing overheads for the period 13,200 Total manufacturing cost for the period 62,300 Variable selling & administrative expenses for the period 4,400 Fixed selling & administrative expenses for the period 10,000

If price per unit sold is $4.5, calculate net income under the absorption costing and reconcile it with variable costing net income which comes out to be$20,727.

Solution

Number of units sold = 3,000 + 22,000 - 4,000 = 21,000

Sales revenue = 21,000 × $4.5 =$94,500

Cost of closing inventories = $62,300/22,000 × 4,000 =$11,327

Cost of goods sold = $7,500 +$94,500 - $11,327 =$58,473

Gross profit = $94,500 -$58,473 = $36,027 Net income =$36,027 - $4,400 -$10,000 = $21,627 ## Reconciliation between absorption costing and variable costing Net income under absorption costing can be reconciled with net income under variable costing by (a) subtracting the manufacturing overheads carried forward (absorbed by closing inventories) and (b) adding the manufacturing overheads brought in (absorbed by opening inventories).  Net income (absorption costing) Less Fixed manufacturing overheads carried forward (closing inventories) Add Fixed manufacturing overheads brought in (opening inventories) Equals Net income (variable costing) Fixed manufacturing overheads included in closing inventories =$13,200/22,000 × 4,000 = $2,400 Fixed manufacturing overheads included in opening inventories =$1,500

Net income (variable costing) = $21,627 -$2,400 + 1,500 = \$20,727.