Do you manufacture a product as part of your business? Then you’re going to need to stay informed on the costs involved in the manufacturing process, if you want your business to grow and thrive. In a recent post, we delved into cost of goods sold or “COGS”, which is one way to look at the cost of creating a product sold by your business. Another way to look at the costs associated with manufacturing goods is by analyzing your absorbed costs.
What are absorbed costs, exactly? And how are they different from COGS? While COGS take into account the direct costs associated with making a product (such as the physical labour and raw materials required to bring a product into existence), absorbed costs include both the direct costs and indirect costs involved in the manufacturing process.
What are indirect costs?
You may be wondering what falls under the umbrella of indirect costs. This would include any overhead required to run your business that has an impact on manufacturing your product, like the cost of rent or property taxes for a building where manufacturing takes place, insurance, and salaries paid to your staff. (For some handy tips on calculating overhead costs for your business, check out this post on our blog.)
While COGS will show up as an expense on your company’s income statement, absorbed costs are not included in expenses. So why should you concern yourself with absorbed costs at all? One reason is that calculating absorbed costs is part of a broader method in accounting called absorption costing, which (when done correctly) can help you make important decisions about the manufacturing of your company’s products. Want to find out more about absorption costing? Read on for a quick and simple overview.
What is absorption costing?
Absorption costing goes by many names: full absorption costing, full costing, full absorption method. It’s part of the generally accepted accounting principles (GAAP), and is something you will need when it comes to preparing financial statements for external financial reporting (as well as income tax reporting). Simply put, absorption costing is an accounting method that is used to take into account all costs associated with manufacturing a product, whether they be direct or indirect costs.
You can think of this method as a way for all of the manufacturing costs that come into play to create a product being absorbed by the finished product in your inventory. This can be contrasted with variable costing (also called direct costing or marginal costing), where fixed costs (those that don’t tend to change over time, like insurance or property tax) are not absorbed by the finished product; in this case, only variable costs (those that fluctuate depending on how much product is being produced, like labour costs) are taken into consideration.
Pros and cons of absorption costing
We saw earlier that absorption costing is part of GAAP and is required when it comes to reporting your company’s financial statements to outside parties, including income tax reporting. This method of costing can also be useful if you want to paint an accurate and detailed picture of all of the costs associated with manufacturing a particular product. If you want to get a clearer understanding of how much of your costs are being covered by sales income, you’ll need to take into account not just the direct costs of making your product, but also the overhead costs involved, which is where absorbed costs come into play.
Things can get a little tricky when it comes to making an exact calculation of absorbed costs. If all of the variables are not considered carefully (including depreciation and yearly fluctuations in your expenses), it can give you misleading results. Making well-informed financial decisions, including which products you should be making more of and which ones you should consider discontinuing, can be a tough call. Getting input from an accounting professional may be helpful, and having the right accounting software [hyperlink on “right accounting software” to kahoo.com”] is crucial.
Need some guidance on setting up your company’s finances so you can make the best costing decisions for your business? Reach out to us any time at firstname.lastname@example.org!