Meaning
Cost accounting methodology assigns all manufacturing costs, including fixed factory overheads, directly to the inventory cost of manufactured goods. Fixed and variable costs attach to units produced during a specific financial period. Under absorption accounting, standard operating statements classify fixed manufacturing expenses as asset values until product sales occur.
Non-manufacturing costs, such as administrative salaries and selling expenses, remain period costs deducted immediately from revenue.
Allocation Mechanism
Direct labour hours or machine hours distribute plant fixed overhead across physical output. When production runs below planned capacity, absorption accounting leaves unallocated overhead as an immediate expense on the income statement. Overhead rates calculated during pilot runs often understate unit costs when full production schedules experience unexpected downtime.
Cost Recovery
Capital tied up in unsold inventory carries fixed overhead forward into subsequent reporting cycles. Holding finished inventory temporarily increases short-term operating profit by deferring overhead recognition. Operating margins collapse when inventory clears during periods of lower production volume.
Volume Variance
Manufacturing plants running at peak capacity spread fixed charges across maximum unit volume to reduce per-unit expense. Higher volume decreases unit cost under absorption accounting, creating an incentive to overproduce goods regardless of end-customer demand. Volume variances quantify the difference between budgeted factory overhead and actual overhead absorbed into product inventory.
