Absorption Costing

Absorption Costing

Absorption costing is a method of accounting that records cost of goods sold as part of cost of goods sold rather than as separate expenses. This method is commonly used in situations where a company manufactures or assembles its own products.

Key Principles of Absorption Costing:

• Costs are absorbed into cost of goods sold: All costs associated with the acquisition and production of goods are added to the cost of goods sold. This includes raw materials, labor, factory overhead, and depreciation.
• Cost of goods sold is a single figure: The cost of goods sold is calculated by adding all costs associated with the production or acquisition of goods.
• Factory overhead is not separately disclosed: Factory overhead costs are absorbed into cost of goods sold. They are not disclosed separately.
• Depreciation is included in cost of goods sold: Depreciation on assets used in production is included in cost of goods sold.

Advantages:

• Simplicity: Absorption costing is simpler to administer than other costing methods.
• Consistency: Absorption costing ensures that costs are consistently accounted for in the same period.
• Full disclosure: All costs associated with the production or acquisition of goods are disclosed in the cost of goods sold.

Disadvantages:

• Lack of transparency: The true cost of production may not be fully visible under absorption costing.
• Misleading financial statements: Absorption costing can present financial statements in a way that may be misleading to investors.
• Cost allocation difficulties: It can be difficult to allocate costs to different products or departments accurately.

Examples:

• A company manufacturing a car will include all costs associated with the production of the car (raw materials, labor, factory overhead) in the cost of goods sold.
• A company assembling furniture will include all costs associated with the assembly of the furniture (purchasing the components, labor, shipping) in the cost of goods sold.

Conclusion:

Absorption costing is a commonly used costing method for manufacturers and assemblers. It simplifies accounting, but it can also be less transparent than other costing methods. It is important to weigh the advantages and disadvantages of absorption costing before deciding whether it is the best method for a particular company.