Absorption Costing

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Definition of 'Absorption Costing'

Absorption costing is a method of inventory costing in which all manufacturing costs, including fixed and variable costs, are assigned to products. This means that the cost of producing a product includes not only the direct materials and direct labor costs, but also the indirect manufacturing costs, such as factory overhead.

Absorption costing is often used by manufacturers because it provides a more accurate picture of the total cost of producing a product. This is important for pricing decisions, as well as for determining the profitability of different products.

However, absorption costing can also lead to distortions in product costing, as it does not take into account the fact that some fixed costs are not directly related to the production of a particular product. For example, the cost of a factory's heating and lighting system would be the same regardless of how many products are produced.

As a result, absorption costing can sometimes overstate the cost of products that are produced in large quantities, and understate the cost of products that are produced in small quantities. This can make it difficult for managers to make accurate pricing decisions.

There are a number of alternative methods of inventory costing, such as variable costing and direct costing. These methods can provide a more accurate picture of the variable costs of producing a product, but they do not take into account all of the fixed costs.

The choice of which inventory costing method to use depends on the specific needs of the company. If accurate product costing is important, then absorption costing may be the best choice. However, if managers are more concerned with making accurate pricing decisions, then variable costing or direct costing may be a better option.

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