Absorption costing is a cost valuation method within the production process. It is characterized by taking into account both fixed and variable costs.
In the business field and the administration of organizations, costing by absorption is a very widespread system of cost control.
It supposes the inclusion in the calculation of the total unitary cost of all the expenses that a company incurs to offer a certain service or produce a good.
Compared to other alternatives, this costing method is characterized by including both direct and indirect costs, as well as fixed and variable costs, together in the total cost of a product.
In other words, through the absorption modality, all costs derived both directly and indirectly when developing a specific production process are taken into account.
It is common to find this concept called absorbent costing, although it is also common to know it as total or integral costing given the previous description.
The method of costing through absorption stands out in the administration of companies for fulfilling a series of particular conditions:
- Consistent sale price. The price at which the developed product will be put up for sale must be consistent with a cost volume close to reality. Its creation supposes the incursion in diverse types of costs.
- Heterogeneity in costing. As indicated, all types of costs are included when valuing a good or service, regardless of whether they are direct or indirect.
- Adaptability. Often the companies that use this cost valuation system do so according to their own nature and conditions. The main ones are the different costs that they incur and in what proportion.
Taking these points into account, this absorption calculation covers the sum of costs related to the raw material used, technical resources, related labor costs or the transport necessary in the process. Among many other types.
The main existing alternative to this model is variable costing: in this, those costs considered as direct and related to manufacturing and product development are taken into account for the calculation.
Conditions derived from absorption costing
The adoption by an organization dedicated to the production or offering of services has aspects to take into account compared to other existing options.
Accounting monitoring is more exhaustive by recording all cost items together. This is noteworthy for companies that require more continuous inventory or stock monitoring (shops, warehouses, etc.)
In this sense, in terms of profitability, it is usually a recommended model since it avoids the appearance of previously unestimated economic inputs. This facilitates the design of better calculated budgets and business plans.
Basically this happens because this system makes it possible to know more effectively the real margin originated in each unit produced.
Alternatively, there are less positive aspects from the point of view of the producer, mainly due to the fact that this cost calculation model presents more difficulty.
In addition, it requires a more exhaustive and specialized administrative control given the volume of costs registered.
Absorption Costing Method Example
Taking the above into account, we can delimit a simple example of what the application of this modality implies. This is the case of the manufacture of pianos for a manufacturer.
This piano producer has estimated variable costs for the production of each unit in the amount of €5,000. It takes into account specific materials for it and its set-up.
However, it takes into account other fixed costs, based mainly on the necessary energy supplies and the hiring of labor. Annually they amount to €250,000.
If your business plan calls for the manufacture of 500 pianos per year, the fixed cost for each one of them is €500. That is, €250,000 per year / 500 pianos = €500 per year per piano produced.
Using the absorption costing method, the producer will estimate that the unit manufacturing cost of one of its products is the sum of variable and fixed costs already taken into account: €5000 + €500 = €5,500.
This system is very widespread in the hotel sector, where cost scandals are constantly being carried out.