Absorption costing

Definition

Absorption costing is a method of inventory costing where all manufacturing costs, both fixed and variable, are included in the cost of a product. This approach spreads these costs over all units produced, regardless of their sales status.

5 Must Know Facts For Your Next Test

1. Absorption costing includes direct materials, direct labor, and both variable and fixed manufacturing overhead in product costs.
2. It is required by Generally Accepted Accounting Principles (GAAP) for external financial reporting.
3. Under absorption costing, fixed manufacturing overhead is allocated to each unit of production.
4. This method can result in higher net income compared to variable costing when inventory levels increase.
5. Absorption costing can potentially incentivize overproduction since it spreads fixed costs over more units.

Review Questions

• What costs are included in absorption costing that are not included in variable costing?
• Why is absorption costing required for external financial reporting?
• How does absorption costing affect net income when inventory levels change?

Related terms

Variable Costing: A method where only variable manufacturing costs are included in product costs.

Fixed Manufacturing Overhead: Costs that do not vary with production volume and are allocated to products under absorption costing.

Activity-Based Costing (ABC): A more precise method of allocating overhead by assigning costs to specific activities related to production.