Absorption Costing (Full Costing)
Definition:
This method allocates all manufacturing costs to the product, including:
• Direct materials
• Direct labor
• Variable manufacturing overhead
• Fixed manufacturing overhead
Key Features:
• All manufacturing costs are "absorbed" by the product, whether they are fixed or
variable.
• Complies with generally accepted accounting principles (GAAP) and is required for
external financial reporting.
Advantages:
1. Provides a complete picture of product costs, including fixed overhead.
2. Suitable for long-term pricing decisions as it reflects all costs incurred to produce a
product.
Disadvantages:
1. Can result in higher inventory values, leading to higher taxable income if inventory
levels increase.
2. Not ideal for short-term decision-making, as fixed costs might obscure the
contribution margin.
Use Case:
Best for external financial reporting or when you need a full cost analysis of your product.
Scenario:
A small manufacturing firm in the Philippines produces and sells 1,000 units of a product.
• Selling price per unit: ₱500
• Variable costs per unit:
o Direct materials: ₱100
o Direct labor: ₱80
o Variable manufacturing overhead: ₱20
• Fixed manufacturing overhead: ₱100,000 per month
• Fixed selling and administrative costs: ₱50,000 per month
The firm produced 1,200 units during the month but sold only 1,000 units.
Step 1: Calculate Costs
Variable Costs:
• Total variable manufacturing cost per unit:
₱100 + ₱80 + ₱20 = ₱200 per unit
Fixed Costs (for manufacturing):
• Total fixed manufacturing cost: ₱100,000
Fixed Costs Per Unit (for absorption costing):
• Fixed manufacturing overhead allocated per unit:
₱100,000 ÷ 1,200 units = ₱83.33 per unit
Step 2: Inventory Valuation
Cost Component Absorption Costing Variable Costing
Variable manufacturing cost ₱200 ₱200
Fixed manufacturing overhead ₱83.33 ₱0
Total Unit Cost ₱283.33 ₱200
Step 3: Profit Calculations
Sales Revenue:
1,000 units × ₱500 = ₱500,000
Cost of Goods Sold (COGS):
• Absorption Costing:
1,000 units × ₱283.33 = ₱283,330
• Variable Costing:
1,000 units × ₱200 = ₱200,000
Ending Inventory (200 units):
• Absorption Costing:
200 units × ₱283.33 = ₱56,666
• Variable Costing:
200 units × ₱200 = ₱40,000
Fixed Manufacturing Overhead Expensed:
• Absorption Costing: Fixed overhead for unsold units is deferred in inventory.
• Variable Costing: Full ₱100,000 expensed in the current period.
Fixed Selling and Administrative Costs:
• Expensed entirely under both methods = ₱50,000.
Step 4: Income Statement Comparison (Philippine Peso)
Income Statement Item Absorption Costing Variable Costing
Sales Revenue ₱500,000 ₱500,000
COGS ₱283,330 ₱200,000
Gross Profit/Contribution Margin ₱216,670 ₱300,000
Fixed Manufacturing Overhead (expensed) ₱0 (included in COGS) ₱100,000
Income Statement Item Absorption Costing Variable Costing
Fixed Selling/Admin Costs ₱50,000 ₱50,000
Net Income ₱166,670 ₱150,000
Philippine Context Considerations:
1. Tax Reporting:
Absorption costing is required for financial reporting to comply with Philippine
Financial Reporting Standards (PFRS) and the BIR. Inventory valuation under
absorption costing affects taxable income.
2. Management Decision-Making:
Variable costing is not accepted for tax reporting but can be used internally for
decisions like setting prices, determining break-even points, and managing costs.
3. VAT Implications:
If the firm is VAT-registered, output VAT (12% of sales) and input VAT (on purchases)
should also be accounted for in reporting.
4. Philippine Peso Presentation:
Always ensure amounts are in PHP (₱) and align with local formats and standards.
Absorption Costing (Full Costing)
Mechanics:
• Assigns all manufacturing costs (variable + fixed) to the product.
• Fixed manufacturing overhead is distributed across all units produced, regardless of
whether they are sold or remain in inventory.
• Inventory on the balance sheet includes both variable and fixed manufacturing
costs.
Advantages:
1. Full Cost View: Captures the total cost of production, making it useful for setting
prices that ensure all costs are covered.
2. External Reporting Compliance: Aligns with PFRS, making it suitable for
reconciling management and financial reports.
3. Long-Term Decisions: Helps in understanding the total cost structure over
extended periods.
Disadvantages:
1. Obscures Cost Behavior: Fixed costs are spread over units, which can mislead
managers when evaluating short-term profitability.
2. Inventory Build-Up Issue: Managers might overproduce to allocate more fixed
costs to inventory, inflating profits but creating inefficiency.
3. Less Insight for Decision-Making: Does not directly reveal the contribution margin
or variable cost per unit.
Best Use Cases:
• Pricing Strategy: When products are priced based on full cost plus markup.
• Inventory Management: For financial reporting that aligns with Philippine
regulatory requirements.
