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The
Absorption Costing method (also: Full Costing) is an
inventory valuation / costing model that includes all manufacturing costs:
-
direct materials (those materials that become an integral part of a
finished product and can be conveniently traced into it)
-
direct labor (those factory labor costs
that can be easily traced to individual units of product. Also called
touch labor)
-
both variable and fixed
manufacturing overhead
in the cost of a unit of product. As a
result, under absorption costing, fixed overhead is a product cost until
sold.
Absorption
costing is also referred to as the full cost method.
Should Fixed Manufacturing Costs be Included in Inventories?
Advocates of Absorption Costing say it should, because all of the
production costs are needed to create the products. Thus, they have
"future economic benefits."
Advocates of Variable Costing argue that in order for a fixed
manufacturing cost to be an asset, it has to meet a "future cost
avoidance" criteria much the same way as prepaid insurance. In the case
of fixed manufacturing costs, they do not meet this criteria because
they are incurred each time the production line opens. Thus, they need
to be expenses in that period and only variance expenses inventoried.
Problems with absorption costing also include potential manipulations by
plant managers, such as increasing production regardless of sales levels
to defer costs to the next year, and show a higher current profit for the
sake of bonuses and promotions.
Consequences of using Absorption Costing for Profit calculation
The difference is important for calculating profit when a beginning and
ending inventory levels are different:
- If beginning & ending inventory levels are equal: absorption costing
profit = variable costing profit;
- If inventory levels are run down over the period: variable costing
profit will be higher than absorption costing profit;
- If inventory levels are increased over the period: absorption costing
profit will be higher than variable costing profit.
Compare with Absorption Costing: Variable
Costing | Activity Based
Costing
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