Which of the following costs is inventoried when using absorption costing?
Understanding Absorption Costing
When studying managerial accounting, one of the most frequently tested concepts is absorption costing (also known as full costing). If you are asked, "Which of the following costs is inventoried when using absorption costing?", the short answer is: all manufacturing costs, both variable and fixed.
Unlike variable costing—which treats fixed manufacturing overhead as a period expense—absorption costing "absorbs" all costs associated with production and ties them directly to the product. These costs sit on the balance sheet as inventory until the product is eventually sold.
Definitions of Inventoried Costs
To fully understand what gets trapped inside the inventory asset account under absorption costing, we must break down the components of manufacturing costs:
- Direct Materials ( DM ): The raw materials and components that go directly into the physical creation of the product (e.g., steel used to manufacture a car).
- Direct Labor ( DL ): The wages and benefits paid to workers who physically touch and assemble the product (e.g., the assembly line worker's salary).
- Variable Manufacturing Overhead ( VMOH ): Factory costs that fluctuate in total with the volume of production (e.g., electricity used to run manufacturing machinery).
- Fixed Manufacturing Overhead ( FMOH ): Factory costs that remain constant regardless of production volume during a period (e.g., factory rent, property taxes, and depreciation on manufacturing equipment).
Quick Reference Table: Absorption vs. Variable Costing
To make the distinction crystal clear, let's compare how different types of costs are treated under absorption costing versus variable costing.
| Cost Category | Inventoried Under Absorption Costing? | Treated as Period Expense Under Variable Costing? |
|---|---|---|
| Direct Materials | Yes | No (Inventoried) |
| Direct Labor | Yes | No (Inventoried) |
| Variable Manufacturing Overhead | Yes | No (Inventoried) |
| Fixed Manufacturing Overhead | Yes | Yes (Expensed immediately) |
| Selling & Administrative Costs | No (Always a period cost) | No (Always a period cost) |
Real-World Examples
Imagine you own a company that manufactures premium leather backpacks. During the month of January, you incur the following costs:
- $10,000 for leather and zippers (Direct Materials)
- $5,000 for factory workers' wages (Direct Labor)
- $2,000 for factory utility bills (Variable Manufacturing Overhead)
- $8,000 for the monthly lease on the factory building (Fixed Manufacturing Overhead)
- $4,000 for corporate marketing and CEO salaries (Selling & Administrative Costs)
When calculating the value of your inventory using absorption costing, you will inventory items 1, 2, 3, and 4. Your total inventoried cost for the month is $25,000. The marketing and CEO salaries ($4,000) are never inventoried because they are non-manufacturing period costs.
Common Pitfalls
Students often make a few classic mistakes when answering this question on exams:
- Confusing Manufacturing with Non-Manufacturing: Students sometimes mistakenly include Selling & Administrative expenses in inventory. Remember: inventory only captures factory/production costs.
- Forgetting Fixed Overhead: If a multiple-choice question asks which method inventories fixed overhead, the answer is always absorption costing. Variable costing explicitly excludes fixed overhead from inventory.
- Assuming All Costs are Assets: Non-manufacturing costs (like advertising or shipping) are expensed immediately on the income statement, regardless of whether you are using absorption or variable costing.