With more than 1.4 million accounting jobs in 2018, according to the Bureau of Labor Statistics, there are many different uses for accountants and their skills. With the need for accuracy and transparency in private and public accounting, one important concept to explore is absorption, or full costing.
Absorption or full costing is an accounting method that is used by businesses to determine the complete cost of producing products or services.
When it comes to calculating the full cost, there are three main categories taken in account:
- Direct Costs – How much material, labor, machinery, etc. it costs to produce each product.
- Total Amount of Fixed Costs – Examples include monthly rent payments, tax payments, base salaries, etc. These are the types of expenses a company would incur regardless of the level of production.
- Total Amount of Variable Costs – If there’s increased demand for a particular product, companies would incur variable costs to meet that demand. Examples would include additional wage payments, increased electricity bills for extended or additional shifts, etc. Unlike a pre-negotiated rate for a lease, paying overtime or for more staff would vary based on changes in production needs.
It’s important to note that with absorption or full costing, regardless of the accounting period, both variable and fixed selling and administrative costs are not included when calculating cost per item. These costs are accounted for in the accounting time, whenever the expenses actually occurred or on an accrual basis.
Along with being GAAP-compliant (following Generally Accepting Accounting Principles) when it comes to absorption or full costing, the direct material costs, labor costs and variable and fixed overhead expenses are factored into the per-product cost to the point of sale. Once sold, the expenses will then be reflected on the Income Statement within the COGS fields (Costs of Good Sold).
Further Considerations and Differences with Variable Costing
The primary difference between full costing and variable costing can be seen when it comes to fixed overhead manufacturing costs.
For the absorption or full costing approach, fixed manufacturing overhead costs are recognized when the product is sold. With the variable costing method, the fixed manufacturing overhead costs are accounted for when the business incurs the expenses for that product (i.e., during production time).
Whether or not produced items are sold or still part of the business’ inventory, the absorption costing approach assigns all expenses to the inventory. This helps companies calculate their net profit more precisely. The approach to determining net profit is especially helpful if a company’s inventory is unsold after the accounting timeframe when production occurred.
When fixed costs such as insurance, salary, advertising and related expenses add up quickly and to great amounts, this is something to keep in mind when determining private performance and public perception for publicly traded companies.