What is Absorption Costing?

The absorption costing method, also called integral costing, is used by companies in order to consider all production costs, whether direct or indirect, fixed or variable.

In addition to considering costs directly related to products, such as raw materials, absorption costing also apportions other production costs – such as renting the property where the products are manufactured and maintaining the machines, for example. This allows to establish the total unit cost of the products.

As it also considers fixed costs, absorption costing allows to verify the impact of productivity on the cost of a product or service. This means that the higher the production, the lower the unit cost of a product calculated using this method.

A characteristic of absorption costing is that it is in line with accounting principles. For this reason, it is the only costing system accepted by Brazilian legislation for the production of accounting reports, such as the Statement of Income for the Year (DRE), and for the calculation of taxes.

This costing method derives from a German system known as RKW (Reichskuratorium für Wirtschaftlichkeit).

How to calculate absorption costing?

To know how to calculate absorption costing, you need to know the difference between costs and expenses. Generally speaking, costs are expenses that are directly related to the production or acquisition of inventories. Expenses, on the other hand, are not linked to the core activity, gathering expenses arising from secondary activities of the company, such as sale, administration and promotion.

Thus, the concept of cost encompasses, for example, raw material, goods purchased for resale, the wages of workers on a production line, the energy spent to make machinery work on the shop floor, the depreciation of machines and equipment, among others.

Some of these costs are fixed, that is, they remain at the same level regardless of the volume of production. Variable costs, on the other hand, correspond to expenses that increase or decrease proportionally to the level of activity – as is the case with raw materials, since the greater the quantity produced, the more inputs will be needed.

Examples

Let’s assume that a shoe factory spends US $ 10 on raw materials per pair of shoes produced. This industry has a fixed monthly cost of US $ 100 thousand – including labor, energy and other accounts – and manages to produce 20 thousand pairs of shoes per month. Using the absorption costing method, its unit cost is as follows:

  • Raw material per unit = US $ 10
  • Apportionment of fixed cost = US $ 100,000 ÷ 20,000 = US $ 5
  • Unit cost = US $ 10 + US $ 5 = US $ 15

If this company increases its production to 25 thousand pairs per month without changing its fixed cost, the calculation of its cost will be:

  • Raw material per unit = US $ 10
  • Fixed cost apportionment = US $ 100,000 ÷ 25,000 = US $ 4
  • Unit cost = US $ 10 + US $ 4 = US $ 14

This example is a simplified calculation, as it considers that this company produces only one model of pair of shoes. However, if we were talking about an industry with a varied range of products, the ideal would be for the apportionment of the fixed cost to use some weighting criterion, a costing “driver”. The most common criterion for weighting fixed costs is production time.

Going back to the case of the shoe factory, let’s imagine that it has two models. The high-heeled shoe spends US $ 10 of raw material per unit and takes 30 minutes to produce. The sandal, on the other hand, uses US $ 8 of raw materials and takes 20 minutes to produce. Let’s consider that the company produces 10,000 units of each model per month and that its fixed monthly cost is still US $ 100 thousand.

Before calculating the cost, it is necessary to know how to weigh the difference in the production time of these items in order to distribute the company’s fixed cost more fairly.

Shoe

  • Unit production time = 30 minutes
  • Total production time = 10,000 pairs x 30 minutes = 300,000 minutes

Sandal

  • Unit production time = 20 minutes
  • Total production time = 10,000 pairs x 20 minutes = 200,000 minutes

Total factory production time = 300,000 minutes (shoes) + 200,000 minutes (sandals) = 500,000 minutes

After applying the rule of three, we know that the shoe’s manufacturing time represents 60% of the factory’s activity, and the sandal’s, 40%.

The company’s fixed cost must respect these proportions when calculating the unit cost of each of these products, as follows:

  • Total fixed cost = US $ 100,000
  • Fixed cost to assign to shoes = US $ 60,000
  • Fixed cost to allocate for sandals = US $ 40,000

Thus, the unit cost of each product will be:

Shoe

  • Raw material per unit = US $ 10
  • Apportionment of fixed cost = US $ 60,000 ÷ 10,000 = US $ 6
  • Unit cost = US $ 10 + US $ 6 = US $ 16

Sandal

  • Raw material per unit = US $ 8
  • Fixed cost apportionment = US $ 40,000 ÷ 10,000 = US $ 4
  • Unit cost = US $ 8 + US $ 4 = US $ 12

Advantages and disadvantages of absorption costing

The main advantage of adopting absorption costing, instead of other costing methods, is that it complies with the legislation. It is also simpler to implement, because it does not require the separation of production costs by type, since it encompasses all of them.

Among the disadvantages is the fact that, by this method, fixed costs are distributed on the basis of an assessment that can be arbitrary. It does not allow to know the real margin of the products and, since the fixed cost of the company depends on the volume of production, the cost of a product may be affected by the reduction in the production of another item.

Difference between absorption cost and variable cost

Although absorption costing is the only method accepted by law, for management purposes, the company’s accounting can use other costing systems.

Among the complementary methods is variable costing, also called direct cost or direct costing. Unlike absorption costing, variable costing considers only the variable costs of a product, that is, those whose total increases proportionally in the event of growth in production or sales.

In the direct costing method, product costs are measured more objectively, without an arbitrary distribution of the fixed cost. This system also allows you to calculate the contribution margin for each product. However, it shows only the partial cost of the product, as it does not consider fixed costs.