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What is absorption costing?

Absorption costing is a method used in managerial accounting to allocate all manufacturing costs, both variable and fixed, to the cost of a product. It considers that all costs associated with the production process should be absorbed by the units produced. This method aims to provide a comprehensive view of the total cost of producing a product, including both direct and indirect costs.

Under absorption costing, the direct costs directly attributable to the production of a product, such as direct materials and direct labor, are assigned to the product. In addition, indirect manufacturing costs, also known as overhead costs, are allocated to the product based on a predetermined overhead rate or allocation method. These indirect costs can include items like factory rent, utilities, depreciation, and indirect labor.

The concept behind absorption costing is that each unit of production should bear a portion of the total manufacturing costs. The total cost per unit is calculated by dividing the total manufacturing costs by the number of units produced. This allows for the determination of the cost of goods sold and the valuation of inventory.

Absorption costing is commonly used for external reporting purposes, such as financial statements, as it aligns with generally accepted accounting principles (GAAP) requirements. However, it’s important to note that absorption costing can sometimes lead to distortions in product costs and profitability, especially if production levels fluctuate significantly or there are large fixed overhead costs. Alternative costing methods, such as variable costing, may be employed for internal decision-making purposes, as they focus on the variable costs directly associated with production.