Absorption Costing

What is Absorption Costing?

Absorption costing is the value of all the costs incurred by the purchase of materials and other overhead costs. It absorbs all the costs of Manufacturing a product. This is a very accurate way of getting a view on how much it costs to produce an inventory.

The costs that are included in the manufacturing of the product included raw material costs, physical labour costs, etc. Overhead costs include utility costs, etc.

Absorption costing means that ending inventory on the balance is sheet is higher, but the expenses on the Income is lower.

Example of Absorption Costing

For instance, XYZ company produces biscuits. For the month of April, XYZ company produced 20,000 biscuit packets of with 19,000 packets were sold. 1000 packets are now in the inventory at the month’s end.

Now, assume each biscuit packet costs Rs. 8 with production rates for the direct materials used. The fixed overhead costs are Rs. 40,000 because of the production Facility.

Therefore, the manufacturers under the Absorption costing method will assign Rs. 2 to each biscuit packet for fixed overhead costs. That means, Rs. 40,000/20,000 biscuit packets for the month.

The absorption costs per biscuit packet are now Rs. 10. That is, Rs. 8 labour and material costs + Rs. 2 overhead costs. Therefore, since 19,000 biscuit packets were sold, the total cost of biscuits sold would be Rs. 10 per unit* 19,000 biscuit packets sold.

This means the total cost of goods is Rs. 1,90,000. Therefore, the ending inventory will have Rs. 10 per unit * 1000 biscuit packets remaining in the inventory. That is Rs. 14,000 worth biscuit packets left.

Absorption Costing Vs. Variable Costing

Absorption Costing and Variable costing differ in their treatment of fixed overhead costs. While absorption costing is about allocating fixed overhead costs.