Absorption costing, also known as full costing, is an accounting method in which all manufacturing costs — both variable (raw materials, direct labour) and fixed (factory rent, depreciation, supervisory salaries) — are absorbed into the cost of each unit produced, regardless of whether all units are sold in the current period. Under absorption costing, fixed overheads are allocated to inventory based on the production volume — meaning unsold inventory carries a portion of fixed costs on the balance sheet rather than being expensed immediately to the income statement. This distinguishes absorption costing from variable costing (or marginal costing), where only variable costs are attributed to products and all fixed overheads are expensed in the period incurred. In India, absorption costing is the method required under the Companies Act and Indian Accounting Standards (Ind AS) for external financial reporting — ensuring that inventory is valued at its full production cost. For equity investors analysing Indian manufacturing companies, understanding the absorption costing method is important because changes in production volume relative to sales can create counterintuitive effects on reported profit — increasing production (building inventory) under absorption costing can boost reported profit even if sales volumes are unchanged.
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