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
+ 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.
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.
Advantages
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.
by Obaidullah Jan, ACA, CFA and last modified on