Absorption costing: Definition, formula, and how it works

Knowing how much it costs to make your products is key to running a profitable manufacturing business. Absorption costing is a method that can be used to figure this out. It’s the standard approach for external financial reporting under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) because it ensures fixed costs, like factory rent, are accounted for in product costs. 

With 86% of businesses focused on increasing revenue and profitability, according to a QuickBooks Business Solutions Survey, understanding absorption costing can help you accurately track profitability and make smarter pricing decisions. 

This guide explains how it works, the costs, and why businesses use it.

Jump to:

• How absorption costing works
• Key cost components in absorption costing
• Absorption costing formula
• Absorption costing example
• When to use absorption costing
• Absorption costing vs. variable costing
• How Intuit Enterprise Suite can help with absorption costing
• Boost productivity and enhance profitability

How absorption costing works

Absorption costing includes all manufacturing costs in the value of your inventory. 

1. Add up all manufacturing costs

To follow this approach, you’ll add up all your manufacturing costs for that period, then divide that total cost pool by the number of units you produced during the same time. The result is the cost assigned to each individual unit.  

2. Allocate costs to unsold inventory

Now, what happens if you produce items but don't sell them right away? 

With absorption costing, the costs calculated for those unsold units (including their share of fixed costs like factory rent) remain attached. They appear as a current asset under “Inventory” on your company's balance sheet.  

That cost only moves from the balance sheet to the income statement when your business actually sells the product. 

3. Move costs to cost of goods sold upon sale

When you make a sale, the cost becomes part of the cost of goods sold (COGS), an expense that reduces your reported profit. This method helps match the expense of making a product with the revenue earned from selling it in the same accounting period, which aligns with the matching principle of accounting. 

Understanding this timing difference between incurring costs and recognizing the expense is important for accurate cash flow analysis.

Key cost components in absorption costing

Absorption costing pulls together all the costs directly related to manufacturing your products. These are the specific expenses that get allocated to the items you produce. Effective cost accounting systems are designed to track these components accurately.

Remember that costs incurred outside the factory setting, like marketing expenses, sales team salaries, or administrative office rent, are handled differently. These nonmanufacturing costs are treated as period expenses, meaning they hit your income statement in the period they occur, rather than being attached to inventory.

The manufacturing costs included under absorption costing are:

Direct materials

Let's start with direct materials. These are the fundamental raw materials and purchased components that physically become part of the finished product. 

An important aspect is that you can directly trace these materials and their costs to the specific units being produced. Efficient procurement management ensures these materials are acquired cost-effectively.

For instance, if your company manufactures commercial jetliners, the direct materials are substantial and varied:

• Large quantities of specialized aluminum alloys and composites that engineers use for the fuselage, wings, and structural components
• Powerful jet engines from engine manufacturers
• Avionics systems, navigation equipment, and communication suites that engineers installed in the cockpit
• Individual components like wiring harnesses, seats, interior panels, and landing gear assemblies

Direct labor

This cost category covers the wages and benefits paid to employees who are directly involved in converting raw materials into finished goods. This human effort physically creates the product, including operating machinery, assembling components, and performing tasks essential to production. 

But direct labor isn't just about simple assembly lines; it includes any worker spending time directly on manufacturing operations for specific products. Think about a company that manufactures sophisticated medical imaging equipment, like MRI machines. 

The direct labor costs would include:

• Wages for the highly skilled technicians who assemble and calibrate the sensitive magnetic coils and detectors
• Salaries for the engineers who perform final testing and quality assurance procedures on each machine before shipment
• Pay for workers involved in constructing the patient table and gantry structures. Their work is directly applied to building and finishing the individual MRI units

Variable manufacturing overhead (MOH)

These are costs associated with running the factory that are not direct materials or direct labor, and they change in approximate proportion to your production volume. 

When the factory produces more units, these costs tend to increase, and when production slows down, they generally decrease. They indirectly support the manufacturing process rather than becoming part of the product.

Consider a large chemical processing plant producing industrial solvents. As they increase production batches to meet customer orders, their variable MOH costs might include:

• Higher electricity consumption to power mixers, reactors, and distillation columns, plus water for cooling processes
• Increased usage of indirect materials such as filters, catalysts (if consumed based on volume), protective gear for workers, and cleaning agents for equipment between batches
• Costs for disposing of waste materials generated during production, which typically increase with output
• Certain maintenance activities are triggered by machine operating hours or production cycles

Fixed manufacturing overhead (MOH)

These are also indirect factory-related costs, but unlike variable overhead, they remain relatively stable each period, even if your production volume fluctuates significantly. 

These costs represent the essential infrastructure, equipment, and core personnel required to keep the factory operational, regardless of the specific number of units produced day-to-day. 

Including these fixed costs as part of the product cost is the key characteristic of absorption costing that distinguishes it from variable costing.

Imagine a large-scale commercial construction project like a new high-rise office tower. Its fixed manufacturing overhead represents significant upfront investments and ongoing costs, such as:

• Depreciation expenses on heavy machinery and equipment like cranes, excavators, and concrete mixers, which are often owned or leased for the project's duration.
• Site office rent and utilities for the project management team remain consistent throughout the construction period, regardless of daily progress.
• Salaries for core project management staff, including the project manager, site superintendent, and administrative personnel, who are essential to overseeing the entire operation.
• Insurance premiums for the construction site, equipment, and general liability, which are typically fixed for the project's duration.
• Costs associated with maintaining site infrastructure, like temporary roads, security fencing, and initial site preparation, which are necessary even on days with lower construction activity.

Absorption costing formula

Now that we've identified the key manufacturing costs involved, let's put them together. The absorption costing formula calculates the cost assigned to each unit produced. 

It works by totaling all the manufacturing costs for a period and dividing that sum by the total number of units manufactured during that same time frame.  

Here’s the formula: Absorption cost per unit = (Total Direct Materials + Total Direct Labor + Total Variable MOH + Total Fixed MOH​) ÷ Total Units Produced

In simple terms, you combine every manufacturing expense incurred, from direct materials and labor to variable overhead and fixed overhead, and then spread that total cost evenly across all the units made in that period.  

The result of this calculation gives you the absorption cost for one unit. 

This per-unit figure is critical for two key accounting tasks:

1. Valuing the units that haven't been sold yet (Ending Inventory) on your balance sheet
2. Determining the COGS expense on your income statement when units are eventually sold

Absorption costing example

To make absorption costing clearer, let's look at a practical example. We'll use a fictional motor company, "Precision Motors Ltd.," for the month of July.

Here are the company's figures for July:

• Units produced: 2,000 motors
• Units sold: 1,500 motors

And the total costs incurred: 

• Direct materials: $40,000
• Direct labor: $60,000
• Variable MOH: $20,000
• Fixed MOH: $80,000

Now, we can walk through the calculations step-by-step using the absorption costing method:

1. First, add up all the manufacturing costs Precision Motors incurred during July. 

• $40,000 (direct materials) + $60,000 (direct labor) + $20,000 (variable MOH) + $80,000 (fixed MOH) = $200,000

2. Next, divide the total manufacturing cost by the number of motors produced in July using the formula we discussed. 

• $200,000 (total manufacturing cost) / 2,000 (units produced) = $100 per motor

3. Now, calculate the number of units left in inventory, then multiply by the absorption cost per unit. 

• Units remaining = 2,000 units produced - 1,500 units sold = 500 motors
• Ending inventory value = $100 (absorption cost per unit) * 500 (units remaining) = $50,000 
• This $50,000 is the value of the unsold inventory that Precision Motors will report on its balance sheet at the end of July. This figure directly impacts metrics related to working capital.

4. Finally, to find the COGS, multiply the absorption cost per unit by the number of motors sold during the month. 

• $100 (absorption cost per unit) * 1,500 (units sold) = $150,000 
• This $150,000 is the expense reported on the income statement (as COGS) for the cost of the motors sold in July.

When to use absorption costing

Absorption costing is a common method used by manufacturing businesses for several important reasons. These often relate to accounting rules and getting a complete view of production expenses.

External reporting compliance

Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) require that inventory reported on external financial statements include all manufacturing costs. 

This means direct materials, direct labor, and both variable and fixed manufacturing overhead should be part of the inventory cost. 

Absorption costing meets this requirement, making it suitable for reports shared with investors, lenders, and the public.

Tax compliance

Tax authorities, such as the IRS in the US, typically require inventory costs for tax filings to include both direct costs and a share of indirect costs, including fixed overhead. 

Rules like the Uniform Capitalization (UNICAP) rules specify how to treat these costs. Using absorption costing (or a similar full costing method) helps businesses comply with these tax regulations, ensuring that businesses deduct costs appropriately when selling inventory.

Matching principle

Absorption costing aligns with the matching principle used in accrual accounting. 

Keeping fixed manufacturing overhead costs attached to the inventory until the products are sold helps match the total expense of producing those goods (recorded as COGS) with the revenue earned from selling them in the same accounting period. 

This works alongside the revenue recognition principle to ensure income is reported accurately over time.

Full cost visibility

This method captures the entire cost of manufacturing a product, including the resources used for fixed overhead like factory space and equipment depreciation. 

Having this full cost per unit can help businesses set long-term sales prices and evaluate the overall profitability of different product lines. 

This insight is also valuable input for demand planning, helping align production forecasts with cost structures.

Inventory valuation

Using absorption costing means the inventory value shown on the balance sheet reflects the complete manufacturing cost invested in those goods.

This presents a more comprehensive picture of the company's assets, showing the full cost tied up in products that are waiting to be sold. 

Effectively managing and reporting these crucial inventory asset values, consistent with external financial reporting standards, often relies on integrated ERP systems.

Absorption costing vs. variable costing

The fundamental difference between absorption costing and variable costing lies in how they treat one specific cost: fixed manufacturing overhead. This single difference changes how inventory is valued, how income statements are structured, and how profit can behave relative to production and sales.  

Absorption costing: Fixed manufacturing

Let's look at absorption costing first. Because it treats fixed manufacturing overhead as a product cost:

• Inventory cost includes all manufacturing costs, reflecting the full investment on the balance sheet. 
• The income statement calculates gross profit, with COGS including fixed overhead for sold units.
• It's required for external reporting (GAAP/IFRS) as it reflects full inventory cost and matches costs to revenue.  
• Reported profit can increase if production exceeds sales, as some fixed costs are deferred in inventory.

Variable costing: Fixed manufacturing

Now, let's contrast this with variable costing. Because it treats fixed manufacturing overhead as a period cost:

• Inventory includes only variable manufacturing costs, resulting in lower balance sheet values.
• The income statement highlights contribution margin, showing funds available to cover fixed costs and contribute to profit.  
• It's generally not used for external reports as it excludes fixed overhead from inventory cost.
• Managers often prefer it internally for clearer cost-volume-profit analysis, such as performing a break-even analysis, as profit tends to track sales volume more directly.

Choosing between absorption and variable costing depends largely on the purpose; external reporting typically requires absorption costing, while variable costing often provides clearer insights for internal management decisions. 

How Intuit Enterprise Suite can help with absorption costing

Handling absorption costing means you need to accurately track all your manufacturing costs and allocate overhead correctly. This takes careful organization, especially with fixed overhead. Using accounting software built for this complexity, like Intuit Enterprise Suite, can make the whole process run more smoothly and provide clearer financial insights.

Streamline cost capture for accuracy

A key part of absorption costing is gathering reliable cost numbers for your materials, labor, and factory overhead. 

With the Enterprise Suite, you can bring this information together more easily. 

For example, integrated payroll tools help you accurately assign labor costs to production. Leveraging workforce automation within these tools can further improve efficiency. 

You can also streamline how you record and approve supplier bills for materials and other factory expenses, ensuring those costs are captured consistently with less manual data entry. This represents a significant business process improvement for many manufacturing finance teams, helping build a trustworthy base for your cost calculations.

Gain clear reporting insights

Once you have the costs, you need to see the results in your financial reports according to absorption costing rules. This means seeing inventory valued correctly—including that allocated fixed overhead—and understanding your true COGS. 

The reporting tools within the Enterprise Suite are flexible, letting you organize information in detail. You can generate the standard financial statements you need, plus custom reports that clearly reflect your costs based on absorption costing rules. This gives you a better view of profitability based on the full costs of production.

Ensure consistency across entities

Does your business run multiple factories or have separate divisions? 

Keeping your absorption costing method consistent across all of them is important for accurate overall reporting. 

The Enterprise Suite includes tools specifically for managing multiple entities. 

This allows you to oversee finances for different locations from one place, apply the same accounting rules everywhere, and easily combine results into reliable consolidated reports, offering capabilities often associated with a custom ERP solution but integrated within the suite.

Improve planning and forecasting

Ultimately, getting absorption costing right leads to more dependable information for running your business. 

When your product costs accurately reflect all manufacturing expenses, you have a stronger basis for planning. 

This cost data, managed within the Enterprise Suite, helps you create better budgets and forecasts, supporting effective financial planning and analysis. This leads to more informed decisions about pricing, production, and strategy.

Boost productivity and enhance profitability

Understanding absorption costing helps manufacturers who need accurate financial reports that are compliant with GAAP/IFRS by allocating all manufacturing costs, including fixed overhead, to products. 

Accurately calculating absorption costs, especially allocating overhead, can be complex as your business scales. If you're looking for tools to simplify these processes and gain better control over your product costing, consider exploring the Intuit Enterprise Suite. Learn how it can support your manufacturing accounting needs.