Absorption costs are to be used in management accounting. Its use applies to identifying expenses that relate to the production of products. This is important because data related to absorption costs will usually be required when you present an external report on your company.
On the other hand, it is a useful tool for inventory valuation. To understand the importance of this data, you need to know that it will represent all the costs involved in manufacturing. Therefore, it will include charges such as raw materials, labor, fixed costs, and variable costs.
How absorption costs are formed
When an absorption cost accounting is carried out, basic elements are included, such as:
- Direct labor: is where the influence of the direct labor cost consumed in the product’s manufacture is noted.
- Direct materials: this section includes the cost of materials used directly in the production of the product. May contains the valuation of the applicable labor rate.
- Fixed manufacturing costs: this covers the costs of operating the facility that will not change regardless of the quantity of product produced. For example, depreciation of plant property, insurance, etc.
- Variable manufacturing costs: this section includes expenses that impact production but are irregular. Examples could be the cost of electricity, water, etc.
How an absorption cost estimate is created
Although we can do it in different ways, three steps are basic to absorption costs:
- Assigning cost groups: generally, we will do it by creating various group records per cost typology. This is important as changing these groups can affect future calculations.
- Determining the metrics: Determining the metrics is also very relevant. For example, the amount of time, the use of machinery, the amount of labor, etc., must be determined.
- Distribution of costs: In this section, the overhead costs related to the factory properties will be distributed. This distribution establishes the relationship between these costs and production.
Things to bear in mind
The first thing to be clear is that an absorption cost income statement is generated from absorption costs. This may seem obvious, but it is not so obvious, as it is possible to make the mistake of not dividing the product cost with the period determined to calculate such a statement.
Here, an absorption cost will indicate that each product will have a fixed overall price. This cost will be independent of sales during the given period in which the study is established.
In a way, this means that all costs are included after an inventory: something that is usually reported as a balance sheet asset.
What advantages and disadvantages does it offer?
There is no single advantage. Note that absorption cost does point to some advantages over other account formats, but the benefits of absorption costs are more important:
- Tracking of returns made in the accounting period. That is very important as it will consider all production costs and not just direct costs.
- Summary of the fixed costs that are associated with ending inventories.
- Profit control: providing more accurate data in accounting periods as it brings together all manufacturing expenses and fixed costs rather than just the primary ones.
- More precise assessment of selling prices
- Better calculation of net profit as it will reduce the actual payment reported in the income statements
However, it also has some disadvantages. The most well-known are the following:
- It is not efficient when you want to make concrete product decisions.
- It is not straightforward: this is an important aspect as it is not always easy to evaluate and understand. Incremental costs can be complex to analyze.
- Can generate false pictures of profits: not all fixed costs will be accounted for and deducted from the company’s revenues. Therefore, it may raise the expectation and not be entirely real.
- In the case of manufactured products not marketed after the accounting period, it may result in a gain on net income.
In short, it is very useful but not always easy to use the tool. It is often incorporated in the best accounting software. You can also find it in virtually all corporate financial management services.
Due to its usefulness for the financial reports required by the State, it is a tool that you should consider in your company.