Absorption Costing
A costing method that includes all manufacturing costs — fixed and variable — in the cost of each unit produced.
What is Absorption Costing?
Absorption costing, also called full costing, assigns all manufacturing costs — direct materials, direct labor, variable overhead, and fixed overhead — to each unit produced. Unlike variable costing, which treats fixed overhead as a period expense, absorption costing allocates fixed overhead to inventory and recognizes it only when the goods are sold. This method is required by GAAP for external financial reporting and by the IRS for tax purposes. A key limitation is that increasing production lowers the fixed cost per unit, which can inflate reported income even when sales volume remains unchanged — a distortion managers must recognize when using absorption costing for internal decisions.
Example
A manufacturer produces 10,000 units with $100,000 in fixed overhead. Under absorption costing, each unit absorbs $10 of fixed overhead. If 8,000 units are sold, $80,000 flows through cost of goods sold while $20,000 remains in ending inventory — a key distinction from variable costing, where all $100,000 would be expensed in the current period.