Definition: Absorption costing is a cost accounting method for valuing inventory. Absorption costing includes or “absorbs” all the costs of manufacturing a product including both fixed and variable costs. That means that all costs including direct, like material costs, and indirect, like overhead costs, are included in the price of inventory. Absorption costing gives a much more comprehensive and accurate view on how much it really costs to produce your inventory then the variable costing method.
What Does Absorption Costing Mean?
What is the definition of absorption costing? Think about it like this. If Apple used full absorption costing when they were valuing their inventory of iPods, the inventory value would include the following: the materials to make the iPods, the money paid to workers to manufacture the iPods, the manufacturing overhead, as well as the fixed overhead for the entire operation. In contrast, variable costing only takes into consideration the first three of these costs or the variable costs.
I think this table might help show the differences between the two inventory valuable methods. The right column shows the absorption costing method. Notice that all the costs are included in the final inventory valuation. Take a look at the two total values of the inventory. Look how much less the variable costing method values your inventory. This could be a major problem when it comes to marketing and pricing your products.
If the management isn’t taking all fixed costs into consideration when valuing the true cost of producing inventory, the sales price might be too low and the company might actually be losing money on every product sold.
Let’s take a look at an example.
|Costs||Variable Costing Method||Absorption Costing Method|
|Cost of iPod Materials||$57.92||$57.92|
|Cost of Hourly Workers per iPod||$18.25||$18.25|
|Cost of Salary Workers per iPod||$0||$22.25|
|Cost of Utilities||$0||$2.75|
|Cost of Shipping Materials||$1.85||$1.85|
As you can see, the AC method assigns the cost of the workers’ wages and the utility expenses to the merchandise being produced. In many ways, this is a more accurate way to account for the true cost of producing the products.
Define Absorption Costing: Absorption costing means a way to value inventory by assigning all fixed and variable manufacturing costs to the merchandise.