How do absorption costing methods work?

Absorption costing methods allocate all production costs to the product, including both direct and indirect costs.

Absorption costing, also known as full costing, is a method used in managerial and financial accounting that treats all costs of production as product costs, regardless whether they are variable or fixed. This approach contrasts with variable costing, where only variable costs are assigned to the product and fixed costs are treated as period costs.

The process of absorption costing involves two main stages. First, direct costs such as raw materials and direct labour are assigned to the product. Then, indirect costs such as factory overheads are allocated to each unit of production. This allocation is typically based on the proportion of each product's direct costs to the total direct costs of all products.

The main advantage of absorption costing is that it provides a more comprehensive view of product cost, as it includes all costs associated with production. This can be particularly useful for decision-making purposes, as it allows managers to understand the full cost of producing and selling a product. However, it can also lead to some distortions. For example, if production volume varies significantly from period to period, the amount of fixed overhead allocated to each unit can fluctuate, causing unit product costs to vary as well.

Absorption costing is also the method required for external financial reporting under Generally Accepted Accounting Principles (GAAP). This is because it matches costs with revenues more accurately than variable costing, providing a more accurate picture of a company's profitability.

In summary, absorption costing is a method that assigns all production costs to the product, providing a comprehensive view of product cost. It is useful for decision-making and required for external reporting, but can also lead to distortions in unit product costs.