Definition of Absorption Costing
Absorption costing (also known as full absorption costing) indicates that all of the manufacturing costs have been assigned to (absorbed by) the units of goods produced. In other words, the cost of a finished product includes the following costs:
- direct materials
- direct labor
- variable manufacturing overhead
- fixed manufacturing overhead
Absorption costing is required for external financial reporting and for income tax reporting.
Another method of costing (known as direct costing or variable costing) does not assign the fixed manufacturing overhead costs to products. Therefore, direct costing is not acceptable for external financial and income tax accounting, but it can be valuable for managing the company.