Absorption Costing Meaning, Difference and Features

What is Absorption Costing?

The absorption costing technique is also termed the Traditional or Full Cost Method. This method calculates a product’s cost by considering both variable and fixed costs. Variable costs, like direct labour and materials, directly apply to the products. Conversely, we distribute fixed costs among the different products produced over a specific period using an appropriate method. Absorption costing associates all costs with the manufactured products.

The CIMA Terminology describes absorption costing as: “A principle whereby fixed as well as variable costs are allotted to cost units and total overheads are absorbed according to activity level”.

Absorption costing allocates both fixed and variable costs to specific cost centres using predetermined absorption rates. This approach guarantees that the selling price of a product or service covers all incurred expenses.

Absorption Costing Meaning

Absorption costing is the prescribed method for external reporting as per generally accepted accounting principles (GAAP). All manufacturing costs, whether fixed or variable, should be considered product costs and included in the inventory value on the balance sheet until the product is sold. It is selling the product results in us expensing its cost under the “cost of goods sold” on the income statement. The absorption costing method involves the allocation of fixed factory overhead to the finished goods inventory account, and it becomes an expense in the cost of goods sold when we sell the product.

The alternative names for Absorption costing include Overhead absorption, Recovery, and Application of overheads. It means charging an equitable proportion of the total factory overheads to each unit of production. Sometimes referred to as ‘applied factory overheads’. It is the last step in the distribution plan of overheads. The total factory overheads are first distributed to the production department by allocating departmental costs, apportioning common costs over different production and service departments and redistributing service department costs to production departments. The output of each production department bears an equitable allocation of the department’s total overheads.

For managers within a company, it is also useful to prepare an income statement in a different format that separates the expenses that truly vary directly with revenues.

Difference between marginal costing and absorption costing

Basis of Difference	Marginal Costing	Absorption Costing
Product Cost	Only variable costs are considered product costs and are, therefore, allocated to products, processes, or operations.	All variable manufacturing costs and fixed production overheads are treated as product costs and hence, are charged to products, processes or operations.
Period costs	All fixed costs are considered period costs, and, therefore, they are deducted from profits in the period when they occur.	All administration, selling and distribution overheads are treated as period costs and hence, are written off against the profits in the period in which they arise.
Value of stock	The value of closing stock comprises only variable costs.	The value of closing stock includes fixed production overheads.
Under recovery	The question of under recovery of fixed overheads does not arise.	Under recovery of fixed overheads generally arises.
Decisions	Managerial decisions are based on contribution i.e., excess of sales revenue over variable costs.	Managerial decisions are based on total profit i.e., excess of total sales revenue over total costs
Objective	To highlight the importance of the contribution towards the overall product cost.	To demonstrate fairness and accuracy in the treatment of product costs.
Nature of overheads	Fixed costs and variable costs	The value of closing stock comprises only variable costs.

Stages of Absorption Costing

This costing comprises three stages:

cost allocation;
cost apportionment;
cost absorption.

Overhead Allocation

Allocation involves the direct assignment of whole cost items to particular cost centres or cost units. Allocating the following costs to their respective cost centres is the next step:-

Direct labour costs will be allocated to the production cost centre.
The cost of warehouse security will be allocated to the warehouse cost centre.
Costs such as canteen are charged directly to the various overhead cost centres.

Overhead Apportionment

Apportionment of overhead is the distribution of overheads to more than one cost centre on some equitable basis.

The allocation of indirect costs among multiple cost centres necessitates a fair and equitable distribution to each centre. For example, the expenditure on general repair and maintenance of a department can be allocated to that department but has to be apportioned to various machines (Cost Centres) in the department. Allocating the complete maintenance and repair costs of a department to a single product is feasible when the department exclusively manufactures that product.

Overhead Absorption

Absorption of overheads is the charging of overheads from cost centres to products or services using absorption rates.

The CIMA definition of overhead absorption is: “The charging of overhead to cost units by means of rates separately calculated for each cost centre”.

In other words, the concept of overhead absorption in product costing refers to the percentage of total overhead costs that we allocate to a specific product.

Various methods exist for absorbing overhead costs into product costs, but the two primary methods are as follows:

By the use of percentages;
By rates based on time

Features of Absorption Costing

The following are the features of absorption costing:

1) All costs are classified on a functional basis as production costs, administration costs, selling costs, and distribution costs.

2) Product costs include all variable manufacturing costs and fixed production overheads, which we charge to operations, processes, or products.

3) All administration, selling and distribution overheads are treated as period costs and hence, are written off against the profits in the period in which they arise.