Absorbed Cost

What Is Absorbed Cost?

Absorbed cost, also known as absorption cost, is a managerial accounting method that includes both the variable and fixed overhead costs of producing a particular product. Knowing the full cost of producing each unit enables manufacturers to price their products.

Calculating absorbed costs is part of a broader accounting approach called absorption costing, also referred to as full costing or the full absorption method.

Understanding Absorbed Cost

The absorbed-cost method takes into account and combines — in other words, absorbs — all the manufacturing costs and expenses per unit of a produced item, ones incurred both directly and indirectly. Some accounting systems limit the absorbed cost strictly to fixed expenses, but others include costs that can fluctuate as well.

In general, though, absorption costing has four major components:

1. direct materials, or substances included in a product
2. factory labor costs necessary to produce a product
3. fixed manufacturing overhead
4. variable overhead, which can include costs like a company's rent for property or equipment

As an evaluation mechanism, the absorbed cost goes further than the cost of goods sold (COGS). COGS takes into account the direct costs associated with making a product (such as the physical laborers and raw materials), absorbed costs include both the direct costs and indirect costs involved in the manufacturing process. However, while COGS are included as expenses on a company’s income statement, absorbed costs are not.

Absorbed costs can include expenses like energy costs, equipment rental costs, insurance, leases, and property taxes. These expenses must have some tie-in to the manufacturing process or site, though — they can't include advertising or administrative costs at corporate HQ.

The absorbed cost is a part of generally accepted accounting principles (GAAP), and is required when it comes to reporting your company’s financial statements to outside parties, including income tax reporting.

Pros and Cons of Absorbed Costs

By including overhead, in addition to more direct costs like materials and wages, calculating absorbed cost helps companies determine the overall cost of making and bringing to market a single product line, brand, or item — and which of these are the most profitable.

In corporate lingo, "absorbed costs" often refer to a fixed amount of expenses a company has designated for manufacturing costs for a single brand, line, or product. Absorbed cost allocations for one product produced may be greater or lesser than another.

If you want to get a clearer understanding of how much of your costs are being covered by sales income, you’ll need to take into account not just the actual expenses of making your product, but also the overhead expenses in running your company, which is where absorbed costs come into play.

On the downside, things can get a little tricky when it comes to making an exact calculation of absorbed costs, and knowing how much of them to include. If all of the variables are not considered carefully (including depreciation, administrative expenses, and yearly fluctuations in your expenses), it can give you misleading results.

Absorbed Costs vs. Variable Costs

Absorbed cost gives a much more comprehensive and accurate view of how much it costs to produce your inventory, in comparison to the variable cost method, which does not allocate any of the fixed manufacturing overhead. It breaks down fixed overhead into two categories: costs attributable to the cost of goods sold and those attributable to inventory. Either way, with variable costing (also called direct costing or marginal costing), fixed costs (those that don’t tend to change over time, like insurance or property tax) are not absorbed by the finished product. 

Absorbed cost calculations produce a higher net income figure than variable cost calculations because more expenses are accounted for in unsold products, which reduces actual expenses reported. Also, net income increases as more items are produced, because fixed costs are spread across all units manufactured.

While absorbed costs are needed to prepare financial statements for financial reporting, variable costing is more useful for making internal pricing decisions, because it only includes the extra costs of producing the next incremental unit of a product. Variable costs can be more valuable for short-term decision-making, giving a guide to operating profit if there's a bump-up in production to meet holiday demand, for example.