Absorption costing is a costing technique in which all of the costs associated with the production of a good or service are accounted for. This is in contrast with variable costing, which only includes certain types of associated costs. This type of costing is also known as full costing or full absorption costing, and it is used in a variety of ways by companies which wish to create a complete picture of their financial situation, including in the calculation of taxes and sales reports.
With absorption costing, the variable manufacturing costs, being raw materials and labor, are only one part of the cost. This technique also considers variable and fixed overhead to be part of the overall cost of the product or service being offered. To put it bluntly: if making a widget requires X in raw materials and Y in labor, the widget couldn't be made without the overhead necessitated by the widget factory in which is it made, which is where absorption costing comes into play.
One way in which absorption costing can be helpful is when a company wants to make sure that a retail price accurately reflects the costs involved in the production of a good. This can be especially critical with small companies which lack financial reserves, and therefore cannot afford to take a loss or to sell products without accounting for overhead. For example, a garment manufacturer might think not just about the cost of wool and labor for making a sweater, but also the costs of knitting machines, the factory where the machines are installed, the cost of running the machines, insurance, and other types of overhead costs.
In our widget example about, absorption costing would require the company to determine overall fixed and variable overhead, and to figure out how much overhead was involved in the production of a particular widget. The absorption costing would include this number along with X and Y. The more widgets a factory can make, the lower the per-widget cost becomes, in terms of overhead, and if the company also starts making gadgets and doo-dads, it can distribute the cost of overhead even further, cutting down on the costs associated with the production of its products.
When people start throwing costing numbers around, it is important to determine which costing method was used, and to make sure that the method use remains consistent throughout a report, unless there is a good reason for changing methods. Clever manipulation of costs can be accomplished by changing costing methods, creating misleading information which may confuse people.