Reviewed by Oct 05, 2020| Updated on
Absorption costing refers to a method of costing to account for all the costs of manufacturing. The management uses this method to absorb the costs incurred on a product. The costs include direct costs and indirect costs. Direct costs include materials, labour used in production. Indirect costs include factory rent, administration costs, compliance, and insurance.
The costs observed under absorption costing include variable costs, fixed costs, and semi-variable costs. Variable costs increase or decrease in the proportion of the goods produced. Fixed costs do not alter irrespective of the quantity of production. Semi-variable costs increase or decrease in batches.
Absorption costing is part of accounting methods and procedures. Absorption costing determines the cost of the inventory at the end of an accounting period. The closing inventory also consists of fixed costs, thus increasing the value of the inventory. This method of inventory valuation increases the profit of the company.
Absorption costing is also known as full costing since it includes all the costs associated with production. Variable costs are direct labour and material costs. Fixed costs include rent, security, and insurance expenses. Semi-variable costs include electricity charges for the factory. Thus, under full costing, all the expense are absorbed by the product irrespective of the product being sold.
Absorption costing enables precise accounting for the overall cost of production, unlike in variable costing, which considers only variable costs. The method of absorption costing enables reporting of high profit with a high value of closing inventory. This is because the cost of production is completely absorbed.
The method of absorption costing is specified in the generally accepted accounting principles (GAAP) for reporting of accounts under various statutes. In this method, the fixed cost per unit produced decreases with incremental production. This is contrary to variable costing, where incremental production bears the same variable costs of production. Also, the method of variable costing does not depict a correct picture of the accounting profits or losses.