Absorption Costing – Definition

Cite this article as:"Absorption Costing – Definition," in The Business Professor, updated February 14, 2019, last accessed September 21, 2020, https://thebusinessprofessor.com/lesson/absorption-costing-definition/.

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Absorption Costing Definition

In absorption costing, all costs related to the manufacture of good are engrossed in the units produced. Simply stated, the final cost of a finished good will include all costs related to the production, both variable and fixed overhead. Absorption costing is one of the methods available to businesses to evaluate the fixed costs while evaluating the goods, emphasizing the production process.

A Little More on Absorption Costing or Absorb the Cost

By evaluating fixed and variable costs of production, such as material or labor, the absorption approach allows businesses to anticipate overhead by dividing the overhead by units produced. The business’ inventory is analyzed based on the aforementioned costs and adapted to the overall cost of manufacturing. The items will be sold at a cost that absorbs the cost of manufacturing. This method of accounting is also useful for income tax reporting and other external financial reports in addition to aiding the evaluation of selling prices.

Absorption costing falls under Generally Acceptable Accountable Practices. All costs as previously mentioned will be divided by units produced. This is important to note as units produced is not equal to units sold in all cases which can lead to skewed data.

Some businesses choose to use activity-based costing (ABC) to calculate to calculate the overhead cost. However, this is a time-consuming method. Many prefer to use traditional absorption costing or variable costing.

While absorption costing remains simple when all terms are fixed, a manufacturer knows that is rarely the case. Material and labor, among others, are often a variable. Viable costing is a subcategory of the absorption costing method which considers only the variables, separating costs into variables and fixed. Everything from labor to electricity is considered a variable. Fixed costs include rent among others. Variable costing considers fixed costs as overhead which must be immediately charged to the income statement instead of being absorbed into the inventory as with traditional absorption costing.

With absorption costing, there are some differing difficulties. For examples costs associated with administration and sales must be calculated when they are incurred. As with these costs and others, the overhead cannot be directly traced back to a unit.  Likewise, due to variable costs, the report generated from these methods may result in overinflation of a companies profits.

References for Variable Costing

Academic Research for Variable Costing

  • The implications of absorption cost accounting and production decisions for future firm performance and valuation, Gupta, M., Pevzner, M., & Seethamraju, C. (2010). Contemporary Accounting Research, 27(3), 889-922. In this article, the researchers examine the practicality of using absorption cost accounting in order to make decisions for the future production of goods. The correlation between overproduction and stock market values are used to determine the value of this method, as well.
  • Strategic management accounting for pricing: a case example, Simmonds, K. (1982), Accounting and Business Research, 12(47), 206-214. Simmonds looks at the current methods employed by firms to anticipate and track the impact of pricing changes. Specifically, the research examines the long term effects of price adjustments based on absorption costing.
  • Comparison of accounting systems and heuristics in selecting economic optima, Dickhaut, J. W., & Lere, J. C. (1983), Journal of Accounting Research, 495-513. The study uses real-life examples of accounting practices in order to demonstrate the effectiveness of combing methods in order to both save time and increase accuracy. Using both fixed and variable costing is discussed.
  • Product costing in UK manufacturing organizations, Drury, C., & Tayles, M. (1994), European Accounting Review, 3(3), 443-470. The article evaluates questionnaire data in order to evaluate current views of absorption costing and the relevant usage of absorption costing in businesses. The researchers found that a majority of firms use both fixed and variable costing in cost evaluation.
  • Cost/management accounting–The 21st century paradigm, Ferrara, W. L. (1995), Strategic Finance, 77(6), 30. The study synthesizes historical data in relation to management accounting. This data is utilized to make predictions for twenty-first-century accounting and possible solutions to problems.
  • Accounting for lean manufacturing: another missed opportunity?, Carnes, K., & Hedin, S. (2005), Management Accounting Quarterly, 7(1). The study examines how accountants can adjust their methods to best fit the needs of lean operations. The research revealed that many firms lean on traditional absorption costing. Carnes and Hedin recommend that universities transition to better prepare accountant students for the new demands of lean operations.
  • Product pricing, accounting costs and use of product-costing systems, Hilton, R. W., Swieringa, R. J., & Turner, M. J. (1988), Accounting Review, 195-218. The research examines the typical accounting paradigm where best practices of profit management are not put into practice. Instead, firms rely on absorption costing. This study further builds upon Lere’s theory of product pricing with an empirically-tested experiment.
  • Product pricing based on accounting costs, Lere, J. C. (1986), Accounting Review, 318-324. This study examines the multiple accounting strategies used in the product pricing process. The paper compares three individual methods with a utility-maximizing decision maker. The hypothesis indicates that complete and multifaceted analysis will result in the greatest return.
  • Constraint-based accounting and its impact on organizational performance: a simulation of four common business strategies, Draman, R. H., Lockamy Iii, A., & Cox Iii, J. F. (2002), Integrated Manufacturing Systems, 13(4), 190-200. The study compares traditional absorption costing with Dr. Eli Goldratt’s theory of constraints. The historical data indicates that Goldratt’s theory is more effective. Using a Gedanken experiment, the scholars tested their hypothesis.
  • Comparing US and German cost accounting methods, Krumwiede, K., & Suessmair, A. (2007), Management accounting quarterly, 8(3), 1. The study examines the differences between American and German management accounting. Krumwiede and Suessmair found that German firms focused more heavily on management accounting using RCA methods while American firms focused more heavily on financial reporting. The scholars go into a hypothesis as to why this difference exists and the long-term implications.

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