Absorption Costing

Under absorption costing, each unit carries a share of fixed production overheads, such as factory rent and supervisors' salaries, as well as direct materials, direct labour and variable overheads. It is also called full costing.

For example, a factory makes 1,000 units with variable costs of 10 per unit and fixed overheads of 5,000. Each unit absorbs 5 of fixed overhead, giving a full cost of 15 per unit. If 800 units are sold, 200 remain in inventory at 15 each, or 3,000.

Absorption costing is required for external financial reporting under IFRS and US GAAP, because inventory must include all production costs.

A key feature is that profit can rise simply by producing more than is sold, because some fixed overhead is carried forward in inventory rather than expensed. In the example, profit is 1,000 higher than under variable costing, because 1,000 of fixed overhead sits in closing inventory. This can encourage overproduction, which is one reason managers also use variable costing internally.