Absorption costing is a costing method in which fixed manufacturing overhead — rent on the factory, depreciation on equipment, salaries of production supervisors — is allocated to, or “absorbed” by, the units manufactured, alongside direct materials, direct labor, and variable overhead. Under this method every unit produced carries a share of fixed factory costs as part of its inventory value, not just its variable costs.
How costs are absorbed into units
A predetermined overhead rate, usually fixed overhead divided by an expected level of production activity such as machine hours or units, is calculated in advance and then applied to each unit as it moves through production. If a factory budgets $500,000 of fixed overhead for 100,000 expected units, each unit absorbs $5 of fixed overhead regardless of what the actual volume produced turns out to be, in addition to its direct materials, direct labor and variable overhead.
Why GAAP and IFRS require it
Absorption costing is the only method permitted for external financial statements under US GAAP and IFRS, because it treats fixed manufacturing cost as a true product cost that belongs on the balance sheet inside inventory until the related units are actually sold, rather than expensing it immediately regardless of whether production was sold. Its competing alternative, direct costing (also called variable costing), expenses all fixed manufacturing overhead in the period incurred and is acceptable only for internal management reporting.
The effect on reported profit
Because fixed overhead rides along with unsold inventory under absorption costing, a company that produces more units than it sells in a period defers some of that period's fixed overhead into ending inventory, which can make reported profit higher than it would be under variable costing in the same period — and the reverse happens when a company sells more than it produces, drawing down inventory and releasing previously deferred fixed costs back onto the income statement. This mechanical quirk is well known to analysts and is one reason earnings can sometimes be managed, intentionally or not, simply by ramping production up or down near a reporting date.
Absorption costing versus direct costing in practice
Most manufacturers keep both views available: absorption costing for the audited financial statements that satisfy external reporting rules, and direct or variable costing internally, since stripping out fixed overhead makes it far easier for managers to see how contribution margin and profitability change with volume, a question absorption costing's blended per-unit cost tends to obscure. Reconciling the two views is a routine part of management reporting at companies that rely heavily on internal volume-based decision-making, and finance teams typically maintain a standard bridge schedule that converts one view into the other so that external and internal reports can always be traced back to the same underlying transactions.
A simple worked comparison
Suppose a factory produces 10,000 units in a period and sells 8,000, with $4 of variable cost per unit and $40,000 of fixed overhead for the period, giving a $4 fixed overhead rate per unit. Under absorption costing, each of the 8,000 units sold carries $8 of total manufacturing cost ($4 variable plus $4 fixed), so $32,000 of fixed overhead flows to cost of goods sold while the remaining $8,000 tied to the 2,000 unsold units stays on the balance sheet in ending inventory. Under variable costing, the full $40,000 of fixed overhead is expensed immediately regardless of how many units were actually sold, which is exactly why absorption costing reports $8,000 more profit in this period — the amount still sitting in inventory rather than hitting the income statement.