Absorption costing

What it means

Absorption costing assigns all production costs to a product: direct materials and labour, plus a share of production overheads such as energy, machine depreciation or the supervisor's salary. The result is the full production cost per unit.

Overheads are spread across products using a chosen allocation base, such as labour hours or machine time. The method is set out in the company's costing formula.

The opposite is variable costing, which assigns only variable costs to the product. Both methods are correct but answer different questions.

How it works in practice

In Slovak accounting the absorption approach matters when valuing own-produced inventory and work in progress. Own production cost includes direct costs and may include part of indirect production costs, but not administration or selling costs.

For pricing, absorption costing shows what price a product needs in the long run to cover all production costs. It is therefore the usual starting point when bidding for large orders.

When a company produces more than it sells, part of fixed overhead stays in inventory and the period's profit looks better. Managers need to know this, or they may read rising profit as success when it is only rising stock.

What to watch out for

The biggest risk is an unsuitable allocation base. Spreading overhead by direct wages in automated production inflates the cost of hand-made products and understates machine-made ones, leading to wrong prices.

For short-term decisions, such as whether to accept an extra order at a lower price, absorption costing can mislead. Fixed overhead is incurred either way, so the contribution margin is the better guide.