What Is the Absorption Method Also Known As?

October 26, 2025 •

3 min read

According to the Corporate Finance Institute, the absorption method is also referred to as full costing. This accounting technique captures all manufacturing costs related to producing a product, including both fixed and variable overheads.

Quick Summary

The absorption method, or full costing, is an accounting approach that assigns all production costs, including both fixed and variable overhead, to a product. It is required by GAAP for external reporting and inventory valuation.

Key Points

Full Costing: The absorption method is also known as full costing, as it assigns both fixed and variable manufacturing overhead to products.
GAAP Compliance: This method is required by Generally Accepted Accounting Principles (GAAP) for external financial reporting and tax purposes.
Cost Components: It includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead in the cost of a product.
Inventory Valuation: Absorption costing values inventory higher than variable costing because it includes an allocated portion of fixed overhead.
Profit Manipulation: Because fixed costs are held in inventory until products are sold, absorption costing can distort reported profits when production levels exceed sales.
Decision-Making: While useful for external reporting and long-term pricing, the absorption method is less effective for short-term managerial decisions compared to variable costing.

What is the absorption method also known as?

The absorption method is an accounting technique also known as full costing or full absorption costing. This method assigns all manufacturing costs, both fixed and variable, to the units produced. This differs from methods that treat fixed overhead separately, as full costing ensures each product unit "absorbs" a portion of all production-related expenses, leading to a comprehensive cost per unit.

Absorption costing is required for external financial reporting under Generally Accepted Accounting Principles (GAAP) in the United States and other international standards. It's a standard for most public companies and for tax reporting. Knowing what's included in the full cost is vital for accurate inventory valuation and determining a product's true production cost for long-term pricing.

The components of full costing

Full costing includes four main components of manufacturing costs:

Direct Materials: Raw materials directly traceable to the finished product.
Direct Labor: Wages and benefits for employees directly involved in manufacturing.
Variable Manufacturing Overhead: Indirect manufacturing costs that change with production volume, like factory electricity.
Fixed Manufacturing Overhead: Indirect manufacturing costs that remain constant regardless of production volume, such as factory rent. A portion of these fixed costs is allocated to each unit produced.

How absorption costing differs from variable costing

A key difference between absorption costing and variable costing (marginal costing) is the treatment of fixed manufacturing overhead.


Feature	Absorption Costing (Full Costing)	Variable Costing (Marginal Costing)
Fixed Overhead	Treated as a product cost, allocated to each unit of inventory.	Treated as a period cost, expensed in full in the period incurred.
Inventory Valuation	Higher, as it includes both fixed and variable manufacturing costs.	Lower, as it only includes variable manufacturing costs.
Net Profit	Can be higher when production exceeds sales.	Fluctuates directly with sales volume.
GAAP Compliance	Required for external financial reporting.	Not compliant with GAAP for external reporting.

This distinction impacts financial reporting. When production exceeds sales, absorption costing reports higher net income because fixed overhead is capitalized in unsold inventory, unlike variable costing where it's expensed immediately.

Key advantages of using the absorption method

Absorption costing offers several benefits:

GAAP Compliance: Necessary for external reporting and tax purposes.
Matches Costs to Revenue: Aligns with the matching principle, expensing production costs when related revenue is recognized.
Accurate Inventory Valuation: Provides a complete inventory value by including fixed and variable costs.
Better Long-Term Pricing Decisions: Helps set accurate long-term prices by considering full production cost.
Simplicity for Certain Businesses: Can be straightforward for businesses with simple product lines.

Potential drawbacks and considerations

Absorption costing also has limitations:

Can Skew Profitability: May inflate profits when production is high but sales are low, potentially misleading management.
Not Ideal for Short-Term Decisions: Less useful for decisions like special order pricing where only variable costs are relevant.
Incentive to Overproduce: Can incentivize managers to increase production to boost short-term profits.
Complexity: Allocating fixed overhead can be complex for businesses with diverse products.
Under/Over-absorption: Using predetermined rates can lead to imbalances requiring adjustments.

Conclusion

The absorption method, known as full costing, is a core accounting technique for assigning all manufacturing costs to a product. It's crucial for external financial reporting, ensuring compliance with standards like GAAP (Generally Accepted Accounting Principles), and provides a complete view of production cost. While beneficial for long-term decisions and inventory valuation, its treatment of fixed overhead makes it less suitable for short-term managerial analysis compared to variable costing. Understanding its components, pros, and cons helps businesses use full costing for compliance and other metrics for internal strategy.

Frequently Asked Questions

The primary alternative to the absorption method is variable costing, also known as marginal costing. The key difference is how fixed manufacturing overhead is treated: as a period cost in variable costing versus a product cost in absorption costing.

GAAP requires absorption costing because it adheres to the matching principle, which ensures that all costs associated with producing an item are expensed in the same period that the revenue from its sale is recognized. It provides a more complete picture of inventory value for financial reporting.

Absorption costing results in a higher valuation of ending inventory compared to variable costing. This is because it includes a portion of fixed manufacturing overhead in the cost of each unit, which is carried on the balance sheet until the product is sold.

While it can be used, absorption costing is often less useful for internal decision-making, such as setting short-term pricing or evaluating product lines. Variable costing is typically preferred for these purposes as it provides a clearer picture of marginal costs.

If production increases and not all goods are sold, absorption costing can temporarily inflate net income. This is because a portion of fixed manufacturing costs is held in unsold inventory on the balance sheet rather than being expensed, delaying its impact on profit.

The formula for absorption cost per unit is the sum of Direct Materials + Direct Labor + Variable Manufacturing Overhead + Fixed Manufacturing Overhead, all divided by the number of units produced in the period.

The main drawback is that it can distort a company's true profitability by holding fixed costs in inventory. This can potentially mislead management and investors, especially if production levels fluctuate or are intentionally manipulated.