In business, the term “absorption costing” refers to a method of allocating costs to products or services. This includes both direct and indirect costs incurred during the production process.
The main advantage of using absorption costing is that it provides a more accurate picture of the true cost of producing a product or service. This information can be useful in pricing decisions and in evaluating the efficiency of production processes.
However, there are some disadvantages to using absorption costing as well. For example, it can lead to under-valued inventory and overstated expenses in certain situations.
What Is Absorption Costing?
Absorption costing is a method of allocating indirect costs to inventory. In this costing approach, all manufacturing costs—both direct and indirect—are assigned to products. The goal of absorption costing is to create a more accurate picture of the total cost of each product.
The main advantage of absorption costing is that it provides a more comprehensive view of product costs. This information can be helpful in decision-making, particularly when it comes to pricing products.
There are some disadvantages to using absorption costing as well. One is that it can lead to under-costing of products, since not all indirect costs are always allocated to inventory. Additionally, this method can be complex and time-consuming to implement.
Why Use Absorption Costing?
There are a number of reasons why businesses use absorption costing. First, it is generally accepted by accounting standards organizations. Second, it provides a more accurate picture of the true cost of producing a product.
Third, it can be used to generate accurate financial statements. Finally, it can help managers make better decisions about pricing, production levels, and other strategic issues.
Variables That Affect Absorption Costing
There are a few variables that can affect the absorption costing of a product. These include the amount of direct labor involved in production, the amount of overhead costs incurred, and the selling price of the product.
Direct labor costs are usually the largest variable in absorption costing. This is because direct labor is a direct cost of production and is thus included in the absorption costing calculation. Overhead costs, on the other hand, are indirect costs that are not directly related to production. As such, they are not included in the absorption costing calculation.
The selling price of a product can also affect its absorption costing. If a product is sold at a higher price, its absorption costing will be higher as well. Conversely, if a product is sold at a lower price, its absorption costing will be lower.
How to Calculate Absorption Costing in Excel
In order to calculate absorption costing in Excel, you will need to first download the free Absorption Costing template. This template can be found by clicking on the link below.
Once you have downloaded the template, open it in Excel and enter your company’s name and logo in the appropriate cells. Next, enter the names of your products in the first column and the unit prices of each product in the second column. In the third column, enter the number of units of each product sold during the period being covered by the template.
The fourth column is where you will enter the variable costs associated with each unit sold. These costs can include materials, labor, and overhead. The fifth column is where you will enter the fixed costs associated with production. These costs can include rent, utilities, and insurance.
Once you have entered all of the necessary information into the template, click on the “Calculate” button. This will cause Excel to calculate your company’s absorption costing. The results of the calculation will be displayed in the sixth column of the template.
Examples of Absorption Costing
1. Company A manufactures and sells a single product. The company’s absorption costing income statement for the year ended December 31, 2017, is as follows:
2017
Sales $1,200,000
Cost of goods sold $ 800,000
Gross margin $ 400,000
Selling and administrative expenses $ 300,000
Operating income (loss) $ 100,000
Income tax expense (benefit) $ 40,000
Net income (loss) available to common shareholders $ 60,000
2. Company B manufactures two products (Product X and Product Y). The company’s absorption costing income statement for the year ended December 31, 2017, is as follows:
2017
Sales
Product X $ 600,000
Product Y $ 400,000
Total sales $1,000,000
Cost of goods sold
Product X $ 360,000
Product Y $ 240,000
Total cost of goods sold $ 600,000
Gross margin $ 400,000
Selling and administrative expenses $ 300,000
Operating income (loss)
What Is Absorption Costing? – Absorption Costing Financial Definition
Absorption costing is a method of inventory valuation in which all manufacturing costs are assigned to products. This includes both direct costs (such as raw materials and labor) and indirect costs (such as overhead). The goal of absorption costing is to match the cost of goods sold with the revenue generated from selling those goods.
The main advantage of absorption costing is that it provides a more accurate picture of the true cost of goods sold. This information is useful for decision-making purposes, such as pricing products and determining which product lines are profitable.
The main disadvantage of absorption costing is that it can lead to under- or over-absorption of manufacturing costs. This can distort financial statements and make it difficult to compare the profitability of different product lines.
Overhead costs are often the largest component of manufacturing costs, so proper application of absorption costing is essential for accurate financial reporting.
