How Absorption Costing Works

When a company makes products, it needs to know the cost of each item. With absorption costing, companies add up four main costs. First, they count the materials they use directly in the product. Second, they include the wages paid to workers who make the product. Third, they add variable overhead costs that change with production levels. Fourth, they include fixed overhead costs that stay the same no matter how much they produce.

Why Companies Use Absorption Costing

Companies use absorption costing for several reasons. The main reason is that tax rules require reporting inventory on financial statements. It helps companies set prices that will cover all their costs and make a profit. It also gives managers a complete picture of product costs.

Difference from Variable Costing

Variable costing is different from absorption costing. It only includes costs that change with production levels and leaves out fixed overhead costs. This makes variable costing useful for making short-term decisions but less helpful for long-term planning.

Benefits and Drawbacks

Absorption costing gives a complete view of manufacturing costs. It meets accounting rules and helps with long-term pricing decisions. However, it can make it harder to see the relationship between production volume and costs, and some managers find it less useful for daily decisions about production levels.

Using Absorption Costing

Companies start by adding up all their manufacturing costs. Then, they divide these costs by the number of products made, which gives them the cost per unit. They use this number to value their inventory and set prices. They must update these calculations regularly as costs change.

This method helps companies understand their actual costs and make better business decisions. It remains the standard way to calculate product costs in manufacturing.