What it means
Direct costs are easy to attribute: the timber in a chair and the wages of the person assembling it clearly belong to that chair. Overheads such as factory rent, supervision, machine maintenance and heating do not attach to any single unit, yet they are unavoidably part of what production costs.
Absorption costing solves this by spreading budgeted overhead across output using an absorption rate, typically per machine hour, per labour hour or per unit. Every unit then carries a slice of overhead, and that full cost sits in inventory on the balance sheet until the unit is sold.
This is why absorption costing is mandatory for statutory accounts under both IFRS and US GAAP. Variable costing, which charges all fixed overhead against the period, is often more useful for internal decisions but is not accepted for published inventory values.
The awkward consequence is that production volume affects reported profit. Building inventory pushes fixed overhead onto the balance sheet rather than the income statement, so a factory that produces more than it sells can report a higher profit without selling a single extra unit.
Because the rate is set on budgeted figures, actual overhead rarely matches overhead absorbed. The difference is called under-absorption or over-absorption and is written off to the profit and loss account at the period end, and a persistent gap is a sign the budget assumptions need revisiting.
In practice
Real-world examples.
Example
A bakery calculates an absorbed cost of $2.40 per loaf, of which $0.55 is overhead and $1.85 is direct cost. When it is offered a supermarket contract at $2.20, the finance manager points out that the deal contributes only $0.35 per loaf towards overhead, well short of the $0.55 the standard cost assumes.
Example
An electronics assembler using a labour hour absorption rate finds the basis is badly wrong after automating a line. Machine hours now drive most of the overhead, so it switches basis and discovers that two products it believed were profitable are being sold below full cost.
Example
A manufacturer builds 20,000 units in a quiet quarter but sells only 14,000. Absorption costing leaves overhead on 6,000 units sitting in inventory, so reported profit looks better than the cash position, and the board asks for a variable costing statement alongside the statutory one.
Formula
Calculation
Overhead absorption rate = budgeted overhead / budgeted activity level
Absorbed cost per unit = direct materials + direct labour + variable overhead + (absorption rate x activity per unit)
A furniture factory budgets $600,000 of fixed production overhead and 30,000 machine hours for the year, giving an absorption rate of $600,000 / 30,000 = $20 per machine hour. A dining table uses 2 machine hours, so it absorbs 2 x $20 = $40 of fixed overhead.
With direct materials of $35, direct labour of $25 and variable overhead of $10, the absorbed cost per table is $35 + $25 + $10 + $40 = $110.
If the factory actually runs only 28,000 machine hours it absorbs 28,000 x $20 = $560,000 against actual overhead of $600,000, leaving $600,000 - $560,000 = $40,000 under-absorbed and charged as an extra expense at the year end.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Ardmore Valves, an invented industrial supplier, absorbed overhead at a single plant-wide rate of $18 per direct labour hour. Its high-volume brass fitting used 0.5 labour hours and therefore carried 0.5 x $18 = $9 of overhead, while a low-volume custom valve used 3 hours and carried 3 x $18 = $54.
The trouble was that most of the overhead came from machine set-ups, quality inspection and engineering support, all of which the custom valve consumed heavily and the fitting barely touched. When the fictional finance team rebuilt the rates around set-ups and inspections, the fitting's absorbed overhead fell to $4 and the custom valve's rose to $96.
Ardmore had been quoting custom work at prices that looked like a 20% margin and were in fact losing money on every order, while turning away fitting business it could have won on price. Repricing the range lifted operating profit by $740,000 the following year with no change in volume at all.
Watch out
Common mistakes.
- Confusing absorbed cost with cash cost, when a large part of the absorbed figure is an allocation rather than money spent on that unit.
- Using a single plant-wide absorption rate in a factory where different products consume overhead in completely different ways.
- Reading a rise in profit as a sales success when it actually came from building inventory and absorbing overhead into the balance sheet.
Questions
People also ask.
Why is absorption costing required for published accounts?
Because accounting standards say inventory must be valued at full production cost, including a fair share of fixed production overhead.
What is the difference between absorbed cost and marginal cost?
Absorbed cost includes a share of fixed overhead, while marginal cost is only the extra cost of making one more unit, so marginal cost is always the lower figure.
What causes under-absorption?
Producing fewer units or working fewer hours than budgeted, or spending more on overhead than planned, and the shortfall is charged against profit at the period end.
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