Take All Costs into Account with Absorption Costing
Absorption costing (sometimes also called full costing) is the predominant method for costing goods the companies manufacture and sell. United States Generally Accepted Accounting Principles (GAAP) require all U.S. companies to use absorption costing in their financial statements. International accounting standards have similar requirements worldwide.
Absorption costs include all product costs — the costs of making products. Product costs include a variable component that increases and decreases with volume and a fixed component that doesn’t change regardless of how much or how little you produce.
The costs of direct materials, raw materials that you can directly trace to the manufactured product, are variable. After all, the more units you make, the more direct materials you need to make them. The same goes for direct labor, the cost of paying employees to make your products.
Overhead costs, such as the miscellaneous costs of running a factory, usually consist of a mixture of fixed and variable costs. Absorption costing requires you to spread out the fixed costs over all units produced.
Suppose your factory makes T-shirts. Each T-shirt requires $8 worth of variable costs (direct materials, direct labor, and variable overhead), and your factory pays $100,000 for fixed costs each year for rent and utilities. This year, you plan to make 50,000 T-shirts. How much will each T-shirt cost?
According to absorption costing, the cost of a T-shirt includes both variable and fixed components. You know that the variable component per shirt is $8.
The fixed component of $100,000 applies to all the shirts, however, so you need to spread it out among them. Divide the total fixed costs of $100,000 by the number of units you plan to produce (50,000) to get a fixed cost per unit of $2. Therefore, each T-shirt includes $8 worth of variable costs and $2 worth of fixed costs, resulting in total cost per unit of $10.
Businesses use total cost per unit to report the value of inventory on their balance sheets and cost of goods sold on their income statements.