When all the overhead costs for manufacturing a product are reported in one sum rather than individual items. This is used to show all the costs associated with producing a product.
Absorbed Cost Details
Absorbed Costs include anything that is a direct cost for producing a product and fixed overhead charges. It doesn't matter if the product was sold or not by the end of the reporting period. We've listed some of those potential costs below:
- Wages for people physically working on the product
- Raw materials for the product
- All overhead costs
When recording financials, absorbed costs will be in two separate categories. One is the fixed overhead costs of goods sold and the other is costs of goods still in inventory. Because of this, the inventory on the balance sheet will be higher while expenses on the income statement are lower.
The cost in inventory is then carried into the next reporting company period. However, the cost is listed as an asset on the balance sheet. Generally, standard accounting practices require accounts of absorbed costs when you're reporting externally.
Example of Absorbed Cost
XYZ, Inc. produced 10,000 chocolate cake mixes in the month of January. By the end of January 8,000 are sold while 2,000 remain in inventory. Each cake mix costs $5 in labor and materials needed to make the product. On top of that, it costs $20,000 in fixed overhead costs for each month the facility operates.
Using the absorbed cost method the company will add $2 to each cake mix for fixed overhead costs ($20,000 total for the 10,000 cake mixes produced in January). The total absorbed cost per cake mix is $7 ($5 in labor and materials plus $2 in fixed overhead costs). The total cost of goods sold is $56,000 ($7 total cost per cake mix by 8,000 cake mixes sold). If you take the $7 total cost per cake mix and multiply it by the 2,000 cake mixes still in inventory, the ending inventory will be $14,000.
Absorbed Cost vs Variable Cost
You can tell that absorbed cost is different from variable cost because the former will split the fixed overhead costs across all the product units made in the reporting period. This split means that the overhead cost is broken down into a per-unit amount. The absorbed cost is reported in two different categories: cost of goods sold and goods still in inventory.
On the other hand, the variable cost lumps all the fixed overhead costs together. This results in no per-unit amount and the fixed overhead costs are combined into one line item on reports.
Pros and Cons of Absorbed Cost
Absorbed cost assures more accurate accounting for inventory at the end of the reporting period. This is because the expenses associated with the inventory are connected to the full cost of the inventory still on hand. Also, more expenses are included in unsold products. That means the expenses reported in the current period on the income statement are lower.
Absorbed cost is not a good method to use when trying to determine changes in pricing. In addition, absorbed cost creates the false image that simply producing more will increase net income. Fixed costs are spread over all the units produced. As your production volume increases, the fixed overhead cost will go down and the net income goes up.