Absorption Costing: The Daily Definition
What is Absorption Costing?
Absorption costing is the process of assigning value to your inventory that accounts for the costs of each unit of production. In most cases, you can calculate a fixed cost based on units of output. Those units can be based on direct labor hours, machine hours, or cost of materials. In other words, this process divides your fixed overhead cost of operation among all methods of production. You can also refer to this process as “allocation costing.”
In order to calculate this, consider this scenario. Let’s say that parts for item X cost $15. Jim, who gets paid $20 an hour, spends half an hour assembling each item X, so the labor cost for item X is $10. You also factor in shipping these items, which costs $5 each. Add all these factors of production together and you get a total absorption cost of $25.
With absorption costing, you can gather data on your products to run a cost-volume-profit analysis. With this, you’re able to determine what your company needs to do to reach its “break-even point,” or how much product needs to be sold in order to be profitable.
Our two cents:
There’s quite a bit of math involved in absorption costing. It’s an excellent tactic to improve your visibility on spending. While overall revenue figures can help you drive your goals, they’re not granular enough to be used on their own.
With absorption costing, you have the opportunity to assess the value of each unit of your production. You can also assess the amount of time and labor allocated to that individual unit. This process is also required in order to become GAAP compliant, which can help take your business to the next level of professionalism. For more information on becoming GAAP compliant, check out what industry professionals have to say on the subject.