What is absorption costing
Absorption costing assigns all manufacturing costs to the product: direct and indirect, fixed and variable. Direct costs are traced to the product; indirect costs are allocated using a base such as direct labor hours or machine hours. Selling and administrative expenses are excluded and go straight to the period's result.
It is the method required to value inventory on the balance sheet and for tax, so it is the starting point for the unit production cost.
Visual map of absorption costing
The map shows the allocation step by step, the two-product example and the comparison with variable costing.
Which costs are included and how to allocate
- Direct costs: raw material, components and direct labor, assigned to the product without allocation.
- Manufacturing overhead: plant rent, energy, depreciation, supervision, maintenance and tooling, which serve several products.
- Outside product cost: sales commissions, outbound freight, administrative salaries.
Allocation follows four steps:
- Add up the period's overhead.
- Choose the base that best explains consumption (direct labor hours, machine hours, labor cost, units).
- Calculate the overhead rate.
- Apply the rate to each product's consumption and add it to the direct costs.
Overhead rate formula
Overhead rate = period overhead ÷ total of the base
Unit cost = direct material + direct labor + (rate × base consumed per unit)
Example: two products, $36,000 of overhead
Fictional one-month example: product A and product B share the same plant.
| Data | Product A | Product B |
|---|---|---|
| Production (units) | 1,000 | 500 |
| Raw material ($/unit) | 30.00 | 45.00 |
| Direct labor ($/unit) | 12.00 | 20.00 |
| Direct labor hours per unit | 0.5 | 1.0 |
| Direct labor hours in the month | 500 | 500 |
Monthly overhead: $36,000. Base: direct labor hours (500 + 500 = 1,000 h). Rate = 36,000 ÷ 1,000 = $36.00 per hour.
| Unit cost ($) | Product A | Product B |
|---|---|---|
| Raw material | 30.00 | 45.00 |
| Direct labor | 12.00 | 20.00 |
| Allocated overhead (36 × hours) | 18.00 | 36.00 |
| Total cost per unit | 60.00 | 101.00 |
Check: 1,000 × 60 + 500 × 101 = 110,500 = 36,000 overhead + 74,500 direct costs. All overhead was absorbed.
If the base were direct labor cost ($12,000 + $10,000 = $22,000), the rate would be 36,000 ÷ 22,000 = 163.6% and the costs would change:
| Allocation base | Cost of A | Cost of B |
|---|---|---|
| Direct labor hours | $60.00 | $101.00 |
| Direct labor cost | $61.64 | $97.73 |
The choice of base shifts cost between products without changing the total. When a single base distorts the result, activity-based costing is the alternative.
Effect on profit: absorption vs variable
In the month, the company sold 800 units of A at $90.00 and 400 of B at $150.00. 200 units of A and 100 of B remained in inventory.
| Item ($) | Absorption | Variable |
|---|---|---|
| Revenue (72,000 + 60,000) | 132,000 | 132,000 |
| Cost of goods sold | 88,400 (800 × 60 + 400 × 101) | 59,600 (800 × 42 + 400 × 65) |
| Margin | 43,600 (gross profit) | 72,400 (contribution margin) |
| Fixed costs of the period | already in the products | 36,000 |
| Result | 43,600 | 36,400 |
| Ending inventory | 22,100 | 14,900 |
The $7,200 difference is the fixed overhead that stayed in inventory: 200 × 18 + 100 × 36. Under absorption, producing more than you sell raises the period's profit; under variable costing it does not. This connects to the contribution margin, the better guide for short-term decisions.
When to use it
- Balance sheet and tax: inventory valuation and cost of goods sold follow absorption (IAS 2 and local equivalents).
- Long-term pricing: the price must also cover the fixed structure, the basis of markup.
- Standard cost: standard costs are usually built on absorption.
- Machine rates: the machine-hour rate is a more accurate allocation base than labor hours in automated processes.
For short-term decisions (accepting an order, dropping an item, setting the mix), prefer contribution margin. For the volume needed to cover fixed costs, see the break-even point.
Mistakes and limitations
- One base for everything: products with very different resource consumption end up with distorted costs.
- Idle capacity buried in the product: if actual output falls, the rate rises and the unit cost goes up. With output of 600 units of A and 300 of B (600 h) and the $36.00 rate set at normal capacity, 21,600 is absorbed and $14,400 of overhead is under-absorbed, which should go to the period's result and not to the product.
- Short-term decisions on full cost: dropping a product for a low gross margin can worsen the result, because fixed overhead does not disappear.
- Profit that depends on inventory: building inventory improves book profit without selling more.
- Inventory valuation: mixing the cost method with FIFO, LIFO and average cost without a standard creates inconsistency.
Frequently asked questions
What is absorption costing?
The method that assigns all manufacturing costs to the product, direct and indirect, fixed and variable, with indirect costs allocated.
How does it differ from variable costing?
Variable costing assigns only variable costs to the product and expenses fixed costs in the period. In the example, profit was 43,600 under absorption and 36,400 under variable costing.
How is the overhead rate calculated?
Divide the period's overhead by the total of the base. In the example: 36,000 ÷ 1,000 hours = $36.00 per hour.
Do administrative expenses go into product cost?
No. Selling and administrative expenses are period costs; only manufacturing costs go into the product.
Is absorption costing mandatory?
For financial and tax reporting, yes: inventory valuation includes manufacturing overhead. For internal management, other methods can complement it.
Which allocation base should I choose?
The one that best explains the consumption of the indirect cost: machine hours in automated processes, labor hours in manual ones.
Sources
- HORNGREN, C. T.; DATAR, S. M.; RAJAN, M. V. Cost Accounting: A Managerial Emphasis. Pearson.
- GARRISON, R. H.; NOREEN, E. W.; BREWER, P. C. Managerial Accounting. McGraw-Hill.
- IAS 2 – Inventories. IFRS Foundation.
Keep studying: trusted sources and links
- Sebrae: gestão, custos e finanças para empresas (in Portuguese)
- CFC: Conselho Federal de Contabilidade (in Portuguese)
- Wikipedia: Cost accounting
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About the author
Lean Manufacturing & Behavioral Management Specialist
Over 20 years in the automotive and metalworking industries (GM and Dana), Lean Manufacturing practitioner since 2006. SENAI instructor and mentor in Brazil’s Brasil Mais Produtivo program, delivering consulting, training and audits for 50+ companies, combining quality, productivity and people development.