Absorption costing is defined as a method for accumulating the costs associated with a production process and apportioning them to individual products. This type of costing is required by the accounting standards to create an inventory valuation that is stated in an organization’s balance sheet.
A product may absorb a broad range of fixed and variable costs. These costs are not recognized as expenses in the month when an entity pays for them. Instead, they remain in inventory as an asset until such time as the inventory is sold; at that point, they are charged to the cost of goods sold.
Absorption Costing Components
The key costs assigned to products under an absorption costing system are:
- Direct materials . Those materials that are included in a finished product.
- Direct labor . The factory labor costs required to construct a product.
- Variable manufacturing overhead . The costs to operate a manufacturing facility, which vary with production volume. Examples are supplies and electricity for production equipment.
- Fixed manufacturing overhead . The costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.