How to Calculate Ending Inventory Using Absorption Costing

Two methods are commonly employed to value inventory -- variable costing and absorption costing. The difference between the two is in their treatment of operational overhead. Variable costing only takes into account costs directly affected by changes in production volume, whereas absorption costing takes into account all direct and indirect costs of production. Variable costing is typically used internally for budgeting and forecasting, while absorption costing is suited for external financial reporting.

  1. 1.

    Determine includable costs. Direct labor, direct materials and operational overhead are included in the cost of inventory when employing the absorption accounting method. Direct labor costs include actual payroll expenses, as well as federal and state employment taxes, workers’ compensation insurance and employee benefits. Direct material costs include all supplies used to construct inventory items. Operational overhead includes indirect costs that are difficult or impossible to trace to a particular unit or job. This includes costs such as indirect materials and indirect labor, maintenance and repairs on equipment and costs associated with maintaining facilities used in production.

  2. 2.

    Allocate operational overhead. Operational overhead must be allocated across all units produced during a period. If inventory consists of only one product, the unit cost is computed by dividing the sum of includable costs by the number of units produced. When the inventory is not uniform, however, costs must be allocated based on some reasonable allocation base, such as direct-labor hours or machine hours.

  3. 3.

    Compute work-in-process. Work-in-process (WIP) includes inventory items that have started, but not yet completed production at the end of the accounting cycle. It is common for companies to have several stages of production, and each stage requires an input of direct labor, direct material and operational overhead. WIP value is computed in the same manner as completed inventory, but fewer costs are allocated to each unit.

  4. 4.

    Compute ending inventory. Inventory includes raw material, completed products and work-in-process. As no direct labor or operational overhead costs are allocated to raw material, it will be valued at its orginal cost. Completed inventory and WIP produced in the current period is valued at unit cost. As long as the company produces more than it sells, the costs of newly produced units are added to beginning inventory to arrive at ending inventory. When a company sells more than it produces, on the other hand, all units completed in the current period are expensed and beginning inventory is reduced to account for additional units sold. Changes in raw material and WIP are added to or subtracted from the remaining beginning inventory to determine the value of ending inventory.