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Understanding Absorption Costing

written by: Alice Rovney•edited by: Linda Richter•updated: 9/13/2010

Absorption costing, often referred to as a traditional costing method, is most often used to prepare financial statements for external use. Absorption costing is important for determining the costs of products.

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    Absorption Costing is Like a Sponge

    Absorption Costing (2) Just what is absorption costing? Although not as gorgeous as the picture to the left, absorption costing is very much like a sponge. In this traditional costing method, the aim is to soak up all the costs involved with generating a product. Absorption costing is most often used in the official financial reports for external reporting purposes.

    Managers tend to lean toward another form of costing, called variable costing, for internal evaluation. Absorption costing is not compared to a sponge for no reason. It includes all costs involved with production, such as direct materials, direct labor, plus variable and fixed manufacturing overhead. All these types of costs are treated as product costs.

    This may cause a little confusion, but you should recall that product costs are all the direct costs associated with manufacturing. Variable costs are dependent on the number of units produced and fixed costs always remain the same; they are not dependent on the number of units produced. Following are some examples:

    All of these costs are included in normal absorption costing:

    1. Nails, wood, silicon, and plastic are used - raw materials that are variable costs and product costs.
    2. Jimmy works on the production line - direct labor is a variable cost and a product cost.
    3. Factory space rent is a direct fixed cost and a product cost. It is also considered manufacturing overhead.

    Get the picture? Now that the basic concept is under the belt, let's dig a little deeper.

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    Absorption Costing: Plunging into Deeper Waters

    Two main types, often referred to as extremes that are each on their own end of the line, are project costing and process costing. The details of these two types of absorption costing methods are explained in the next article in this series. For now a simple--well, fairly simple--introduction is all that is necessary. Actually, understanding the differences between the two types is fairly simple.

    Process costing is typically used in manufacturing companies that produce mass amounts of one type of product over a long period of time. Confused yet? Try thinking aluminum foil, Saran wrap, standard 3" binders, Coke, and so on.

    Job order costing is used, you got it, when the product line varies more. In this system the manufacturer might be producing items of clothing that vary in size, color, fashion, and so on. It's called job order costing because like items are processed in batches. For example, an order for 500 small red t-shirts is called a batch or a job.

    Believe it or not, job costing is also used in the service industry. So your friendly neighborhood accountant has probably used the job costing method a time or two. Besides the accountant it's used in service industries such as hospitals and lawyers. While each industry may vary slightly in applying the job costing system, it's all relatively the same thing.

    Credits:

    Photo courtesy of aa7ae, on Flickr.