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:

LessCost of goods sold
EqualsGross margin
LessSelling & admin expenses
EqualsNet income

Cost of goods sold is calculated as follows:

Opening inventories balance
AddManufacturing cost for the period
LessClosing inventories balance
EqualsCost of goods sold

Manufacturing cost for the period
= direct materials
+ direct labor
+ variable manufacturing overheads
+ fixed manufacturing overheads

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.


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

Units in opening inventories3,000
Units produced during the year22,000
Units in closing inventories4,000
Direct materials2,000
Direct labor3,000
Variable manufacturing overheads1,000
Fixed manufacturing overheads1,500
Total cost of opening inventories7,500
Direct materials for the period16,100
Direct labor for the period22,000
Variable manufacturing overheads for the period11,000
Fixed manufacturing overheads for the period13,200
Total manufacturing cost for the period62,300
Variable selling & administrative expenses for the period4,400
Fixed selling & administrative expenses for the period10,000

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.


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)
LessFixed manufacturing overheads carried forward (closing inventories)
AddFixed manufacturing overheads brought in (opening inventories)
EqualsNet 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.


Absorption costing is the costing method used for financial accounting and tax purposes because it reflects a more comprehensive net income on income statement and a more complete cost of inventories on balance sheet by shifting costs between different periods in accordance with the matching concept.

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork