What is absorption costing?

Absorption costing is a method of costing that treats all manufacturing costs, both fixed and variable, as product costs. This means that the total cost of producing a product includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. As a result, when a product is sold, the costs associated with manufacturing it are fully absorbed into the product's cost, which can be useful for inventory valuation and financial reporting purposes.

This approach contrasts with methods that only include variable costs in product costs, which are typically used in variable costing. Absorption costing provides a more comprehensive view of the costs associated with production and aligns with Generally Accepted Accounting Principles (GAAP) for external financial reporting.

The focus on manufacturing costs distinguishes absorption costing from other approaches, such as a pricing strategy that might ignore these costs or a cost allocation method exclusive to service industries, which is not relevant in the context of manufacturing. Thus, absorption costing is vital in helping businesses understand their overall cost structure and profitability related to production.