Absorption Costing: Meaning, Formula, Examples & Accounting Explained

 

Introduction

Absorption Costing is a fundamental accounting concept used in both personal finance and business accounting. It refers to a method of costing in which all manufacturing costs — fixed and variable — are absorbed by the units produced. This principle is especially relevant for business owners, accountants, financial analysts, and tax professionals in India, as it plays a crucial role in product pricing, tax computation, and financial reporting under Indian GAAP and the Income Tax Act.

Understanding absorption costing helps companies comply with Indian tax laws, prepare accurate profit & loss statements, and make better strategic decisions regarding cost control and pricing strategies.

Definition

Absorption Costing (also known as Full Costing) is a costing method where all manufacturing costs (direct materials, direct labor, and both variable and fixed overheads) are assigned to the product units.

Detailed Explanation

✅ 1. Components of Absorption Costing

Absorption costing includes:

Cost Component	Included in Absorption Costing?
Direct Materials	✔ Yes
Direct Labor	✔ Yes
Variable Manufacturing Overheads	✔ Yes
Fixed Manufacturing Overheads	✔ Yes
Selling & Administrative Costs	❌ No (Treated as Period Costs)

✅ 2. How Absorption Costing Works (With Example)

Let’s say a company manufactures 1,000 units of a product in a month.

• Direct Material per unit: ₹100

• Direct Labour per unit: ₹50

• Variable Overhead per unit: ₹30

• Fixed Overhead (Total): ₹200,000

Fixed Overhead Per Unit = ₹200,000 / 1,000 units = ₹200

Total Cost Per Unit = ₹100 + ₹50 + ₹30 + ₹200 = ₹380

So, under absorption costing, each unit is valued at ₹380.

✅ 3. Formula for Absorption Costing

$$\text{Absorption Cost per Unit} = \text{Direct Material} + \text{Direct Labour} + \text{Variable Overheads} + \text{Fixed Overhead per Unit}$$

✅ 4. Journal Entry Example (Accounting Illustration)

Assume 1,000 units are produced, and 800 units are sold.

Dr. Finished Goods Inventory       ₹3,80,000  
     Cr. Work-in-Progress Inventory     ₹3,80,000  

(Recording transfer of goods to inventory)

Dr. Cost of Goods Sold             ₹3,04,000 (800 × ₹380)  
     Cr. Finished Goods Inventory       ₹3,04,000  

(Recording sale of 800 units)

✅ 5. Why Absorption Costing is Important

• Complies with Indian Accounting Standards (AS 2)

• Mandatory for external financial reporting

• Useful in stock valuation for income tax purposes

• Ensures overhead recovery in product costing

• Avoids under-pricing of goods

Tax Implications (India Specific)

• Income Tax: Closing stock valuation under the Income Tax Act, 1961 should follow absorption costing (as per ICDS II guidelines).

• GST Compliance: Accurate cost valuation affects ITC (Input Tax Credit) valuation and helps in correct GST return filing.

• Company Law: Schedule III of the Companies Act, 2013 prescribes cost disclosures that indirectly rely on absorption principles.

Example – Real-Life Scenario

A Noida-based company produces electric fans.

• Monthly production: 2,000 units

• Fixed monthly overheads: ₹4,00,000

• Variable cost per unit: ₹150

Absorption cost per unit = ₹150 + ₹200 (fixed per unit) = ₹350

If the company prices it at ₹500, it earns ₹150 gross profit per unit.

FAQs (with FAQ Schema)

❓ What is the difference between absorption costing and variable costing?

Absorption costing includes all manufacturing costs, while variable costing only includes variable costs, excluding fixed overheads from product cost.

❓ Is absorption costing allowed under Indian Accounting Standards?

Yes, it is mandated under AS-2 and ICDS II for inventory valuation and tax reporting.

❓ How does absorption costing affect income tax filing in India?

It ensures correct profit computation by including fixed overheads in inventory valuation, impacting closing stock and taxable income.

Related Terms

• Variable Costing
• Direct Costing
• Overhead Allocation
• Cost Accounting
• ICDS II – Valuation of Inventory