Absorbing Absorption Costing with Seekho

What Is Absorption Costing?

The Absorption costing definition can be mentioned as an accounting method where all the costs related to the production of any item are included. Both the direct and indirect costs of manufacturing are considered in this form of accounting. Some examples of direct costs include direct material, and direct labor, and indirect costs are insurance, depreciation, interest expenses, and others.

All the companies are required to determine absorption costing as per the Generally Accepted Accounting Principles (GAAP) (1). This method of costing is required for external reporting purposes. In absorption costing the fixed overhead of a product is allocated to that particular product even if it has not been sold during the period. This means that more cost is included in the closing inventory which gets carried over as opening inventory in the beginning of the year. 

Benefits of Absorption Costing

With the help of absorption costing, it is possible to get an accurate accounting of closing inventory. This is because the expenses associated with closing inventory are included in the cost of the inventory. Moreover, in this costing system, more expenses are allocated to the unsold products which reduces the expenses of the current period at the end of the year. It is said that absorption costing provides a better idea about the profitability of the organization than variable costing. 

This is truer when all the products of the company are not sold at the same accounting period. Another advantage of this accounting method is that it does not impact the operational efficiency of the companies. However, there are also many disadvantages of full costing. One disadvantage is that this costing method always does not showcase the true picture of the financial position of the organization. Sometimes, this method can increase the profit more than it actually is. It can also inflate the profits of the company. This can create a false idea about the company and its financial performance.  

Example of Absorption Costing

Suppose a company produces 10000 of its units in a month. Out of these 10000 units, only 8000 were sold and 2000 were left in the inventory. Each of these materials required Rs 5 as direct material and labor. Along with this, the fixed overhead expenses incurred by the company were Rs 20,000. Here, the company uses absorption costing to determine its fixed overhead. It has been calculated that Rs 2 of fixed overhead costs has been calculated by dividing the total fixed overhead by the total number of units. 

Fixed overhead per unit = 20,000/10000 = Rs 2

Another example of Full costing can be given. Let say that in the month of January, a company produces 10,000 widgets, out of which 8000 at the end of the month. This means there are still 2000 units left in the inventory. each widget requires Rs 6 as direct labor and direct material expenses. Along with this, fixed overhead costs amounting to Rs 20,000 is also charged on the products. This means the average fixed overhead per unit is (20,000/10,000) Rs 2. This means the initial absorption cost per unit is (6+2) = Rs 8 per unit. The total cost of all the units sold is = (8000*8) = Rs 64000. Thus, the closing inventory of this company is 2000 units and the cost of this closing inventory is = Rs (2000*8) = Rs 16000. Thus, it can be clearly understood that absorption costing takes into account all the different costs associated with the manufacturing of a product and it also includes the same for calculating the value of closing inventory. 

Absorption Costing vs. Variable Costing

Variable costing (2) is an accounting method where only variable costs are included in the product cost. However, in absorption costing or full costing, all costs associated with the production of material are included. Variable costs include direct material, direct labor and other variable costs whereas absorption costs include direct material, and direct labor cost along with fixed overhead expenses and variable overhead expenses. 

Another important difference between absorption costing and variable costing is that variable costing helps in comparing the results of different product lines whereas absorption costing helps in calculating the per unit cost of a different product line without focusing on profitability. However, in the variable costing method, profits can be easily determined and monitored. But, in absorption costing, profit cannot be easily calculated. This is because, in absorption costing, changes in sales are very difficult to predict.  

Seekho: Why Choose Us?

Seekho is India's vernacular online learning platform which uses short videos to teach relevant topics. Some of the courses provided by this platform are digital marketing, productivity tools, product management courses, supply chain management, HR Management, consulting, & more. Others include personal development, analytics and data science, entrepreneurship, and so many others. This application hires industry experts to teach the customers. In the case of finance, concepts like absorption costing, marginal costing, variable costing and others are taught with care. 

Each of these courses is affordable and highly relevant in today's highly competitive external market. So, this is where you skill yourself about finance, marketing and many other topics. For example, learning courses on Finances and getting to know about concepts like variable costing, absorption costing and others can open up opportunities for different positions. Thus, this application can definitely help in improving the career prospects of these individuals by providing them with relevant knowledge which can be used to gain a higher competitive advantage in the market.