Carrying over inventories and overhead costs is reflected in the ending inventory balances at the end of the production period, which become the beginning inventory balances at the start of the next period. It is anticipated that the units that were carried over will be sold in the next period. If the units are not sold, the costs will continue to be included in the costs of producing the units until they are sold. This treatment is based on the expense recognition principle, which is one of the cornerstones of accrual accounting and is why the absorption method follows GAAP. The principle states that expenses should be recognized in the period in which revenues are incurred.
Thus, absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing costs. Indirect costs are those costs that cannot be directly traced to a specific product or service. These costs are also known as overhead expenses and include things like utilities, rent, and insurance.
Variable Costing Versus Absorption Costing Methods
Many accountants claim that administrative, fixed manufacturing, and marketing and distribution overheads are period costs. They have little long-term value and therefore should avoid including in the product’s pricing. Companies with a consistent demand for products benefits from absorption costing. It provides a straightforward and rigorous costing tool for active enterprises.
It also takes into account fluctuating turnover because costs have been allocated to the items. Period costs include all overheads related to the organization, sales, and distribution. As a result, profits get subtracted from the time in which they take place. In February, Higgins produced 60,000 widgets, so it allocated $120,000 of overhead. The actual amount of manufacturing overhead that the company incurred in that month was $109,000. Calculating usage involves determining the amount of usage of whatever activity measure is used to assign overhead costs, such as machine hours or direct labor hours used.
Advantages and Disadvantages of the Absorption Costing Method
Over the year, the company sold 50,000 units and produced 60,000 units, with a unit selling price of $100 per unit. The difference between the methods is attributable to the fixed overhead. Therefore, the methods can be reconciled with each other, as shown in Figure 6.17. Absorption costing can be difficult to work with compared to other accounting methods. One of the best benefits of absorption costing is that it removes any guesswork from your company’s financials.
By allocating fixed costs to inventory, absorption costing provides a fuller assessment of profitability. Furthermore, absorption costing is essential to submit other formal reporting and file taxes. Every production expense is allocated to all items, regardless of whether every made good is sold. Absorption costing (also known as traditional costing, full costing, or conventional costing) is a costing technique that accounts for all manufacturing costs (both fixed and variable) as production cost. It is then utilized to calculate the cost of products produced and inventories. Since absorption costing requires the allocation of what may be a considerable amount of overhead costs to products, a large proportion of a product’s costs may not be directly traceable to the product.
