Absorption costing is a managerial accounting method that assigns all manufacturing costs, direct materials, direct labor, and overhead to each unit you produce. Unlike variable costing, which only includes costs that change with output, absorption costing folds in fixed expenses like factory rent and equipment depreciation, too.
For Philippine businesses, this matters beyond theory. PFRS and GAAP both require absorption costing for external financial statements, and the BIR expects your inventory valuations to reflect full production costs when you file. Getting this wrong can lead to misstated income and compliance headaches.
Below, you’ll find the formula, a worked example using Philippine pesos, the pros and cons, and a quick framework for deciding when absorption costing is the right fit for your operations.
Key Takeaways
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What is Absorption Costing?
Absorption costing, sometimes called “full costing”, is an accounting method where every production-related expense is allocated to each unit manufactured. That includes the obvious stuff (raw materials, factory labor) and the not-so-obvious (factory rent, insurance, equipment depreciation).
The key difference from full costing and how it’s calculated is in how fixed overhead gets treated. With variable costing, fixed overhead shows up as a period expense on your income statement regardless of how many units you made. With absorption costing, those fixed costs get spread across every unit sold or not. So if you produced 10,000 units but only sold 8,000, the fixed costs tied to those 2,000 unsold units stay on your balance sheet as inventory rather than hitting your income statement.
This distinction has real consequences for reported profit, tax computations, and how outsiders (investors, lenders, the BIR) evaluate your company’s financial health.
The Formula and How to Calculate It
The formula is straightforward:
Absorption cost per unit = (DL + DM + VO + FO) / Units produced
Here’s what each piece means in practice:
- Direct Materials (DM) — Raw inputs that go directly into the product (fabric for garments, steel for parts, ingredients for food products).
- Direct Labor (DL) — Wages, overtime, and benefits for workers directly assembling or manufacturing.
- Variable Overhead (VO) — Costs that rise and fall with production volume: electricity on the factory floor, machine maintenance, and packaging supplies.
- Fixed Overhead (FO) — Costs that stay the same regardless of output: factory rent, insurance premiums, equipment depreciation, and salaried supervisors.
Once you’ve calculated the per-unit cost, multiply it by unsold units to get the inventory value on your balance sheet. The cost of units actually sold becomes your Cost of Goods Sold (COGS) on the income statement.
When you’re doing this calculation, accuracy matters, especially if you’re tracking costs across multiple product lines. Many businesses find that keeping a well-structured chart of accounts mapped to cost categories makes overhead allocation much smoother during month-end.
Why Businesses Use Absorption Costing
The main reason? Compliance. Both GAAP and the Philippine Financial Reporting Standards (PFRS) require absorption costing for external financial statements. If you’re filing with the SEC or preparing audited financials, this isn’t optional.
Beyond compliance, absorption costing matches production costs against revenue in the same period, which gives a more accurate picture of per-product profitability, especially useful when you’re setting prices or evaluating product lines. It also simplifies things: you don’t need to separate fixed and variable overhead for reporting purposes, which saves time during month-end closing.
There’s a financial reporting benefit, too. Because fixed overhead on unsold inventory gets parked on the balance sheet, reported net income tends to be higher during periods when you’re building stock. That can look favorable on a financial statement, though it cuts both ways (more on the downsides next).
The Downsides You Should Know
Absorption costing isn’t perfect, and ignoring its blind spots can lead to bad decisions.
The biggest issue is profit distortion. Because fixed overhead sticks to unsold inventory, a company can boost reported income just by overproducing, even if nobody’s buying. The costs don’t hit the income statement until those units actually sell. For PH manufacturers with seasonal demand swings, this can create misleading quarter-over-quarter profit trends.
It also makes internal cost analysis tricky. When production goes up, per-unit costs drop (fixed costs get spread across more units). That might make a product look more profitable than it really is. If you’re using absorption cost data to decide whether to expand a product line, you could get a distorted signal.
Finally, absorption costing doesn’t help much with short-term operational decisions, things like whether to accept a special order at a discount or which product to prioritize when capacity is limited. For those situations, variable costing gives you cleaner data because it isolates the costs that actually change with your decisions. Businesses that need tighter control over what they’re actually spending versus what they planned often pair this with a solid budgeting and forecasting process.
Absorption Costing in Action: A Philippine Manufacturing Example
Let’s work through a realistic example. Say you run a garment factory in Cavite, producing uniform polo shirts for corporate clients.
| Cost Component | Monthly Total | Per Unit (5,000 shirts) |
|---|---|---|
| Direct materials (fabric, buttons, thread) | ₱375,000 | ₱75.00 |
| Direct labor (sewing operators, cutters) | ₱250,000 | ₱50.00 |
| Variable overhead (electricity, machine maintenance) | ₱75,000 | ₱15.00 |
| Fixed overhead (factory rent, depreciation, insurance) | ₱200,000 | ₱40.00 |
| Total absorption cost per unit | ₱900,000 | ₱180.00 |
Now, suppose you only sold 4,000 shirts this month. Here’s how the numbers flow:
- COGS on your income statement: 4,000 × ₱180 = ₱720,000
- Ending inventory on your balance sheet: 1,000 × ₱180 = ₱180,000
Notice what happened: ₱40,000 worth of fixed overhead (1,000 unsold units × ₱40 fixed overhead each) didn’t hit your income statement this month. It’s sitting in inventory. That makes this month’s profit look ₱40,000 higher than it would under variable costing.
This is exactly why it’s important to understand both methods — especially when you’re presenting financials to lenders or investors who may not realize that “profit” includes costs deferred to future periods.
Absorption vs. Variable Costing: Which One When?
The core difference comes down to one question: what do you do with fixed overhead?
| Aspect | Absorption Costing | Variable Costing |
|---|---|---|
| Fixed overhead treatment | Allocated to each unit produced | Expensed entirely in the period incurred |
| Inventory valuation | Higher (includes fixed overhead) | Lower (excludes fixed overhead) |
| Reported profit when inventory builds | Higher | Lower |
| Required for external reporting? | Yes (GAAP, PFRS, BIR) | No, internal use only |
| Best for | Financial statements, tax compliance, and pricing | Break-even analysis, special order decisions, CVP analysis |
Many PH companies use both absorption costing for official financial statements and BIR filings, and variable costing internally for management decisions. There’s no rule saying you can’t run parallel reports, and doing so gives you the best of both worlds.
If you’re required to submit an inventory list to the BIR, your valuations need to follow full-cost allocation, so getting absorption costing right isn’t just good practice; it’s a compliance requirement.
When Should You Use Absorption Costing? A Quick Decision Framework
Not sure if absorption costing is the right approach for your situation? Run through these questions:
| # | Question | If Yes… |
|---|---|---|
| 1 | Are you preparing financial statements for external parties (banks, investors, SEC)? | Absorption costing is required under PFRS/GAAP. No choice here. |
| 2 | Do you need to file inventory valuations with the BIR? | Use absorption costing, the BIR expects full cost allocation for inventory. |
| 3 | Are you trying to decide whether to accept a one-time bulk order at a discount? | Variable costing gives clearer insight for short-term pricing decisions. |
| 4 | Does your production volume fluctuate significantly month to month? | Be cautious with absorption costing; it can make high-production months look artificially profitable. |
Bottom line: use absorption costing for anything external-facing, and consider supplementing it with variable costing for internal planning and short-term decisions.
Simplify Full Cost Allocation with Accounting Software
Tracking all these cost components manually, especially across multiple product lines or branches, gets complicated fast. That’s where accounting software helps. A system that automates overhead allocation, tracks inventory valuation in real time, and generates reports aligned with PFRS standards can save your finance team hours of spreadsheet work each month.
If your business is BIR-registered and required to use a Computerized Accounting System (CAS), it’s worth evaluating software that’s already BIR-accredited. We’ve put together a comparison of the best accounting tools options in the Philippines, including features, pricing considerations, and which ones support automated cost allocation, so you can find the right fit without starting from scratch.
Conclusion
Absorption costing gives you the full picture of what each product truly costs to make — and it’s the method Philippine regulators and international standards expect to see on your financial statements. The tradeoff is that it can mask profitability issues when inventory builds up, so it’s worth pairing with variable costing for internal analysis.
For PH manufacturers and MSMEs, the practical takeaway is this: make sure your accounting system can handle proper overhead allocation and inventory valuation. Whether you use spreadsheets or dedicated software, getting absorption costing right protects you from compliance issues and gives you reliable data for pricing decisions.
