Absorption costing is a method of allocating all manufacturing costs, both variable and fixed, to the cost of a product. This includes direct costs, such as direct materials and direct labor, as well as indirect manufacturing overhead costs. Absorption costing is also known as full costing.

Key points about absorption costing include:

1. **Variable and Fixed Costs:** In absorption costing, both variable and fixed manufacturing costs are assigned to products. Variable costs are costs that vary with the level of production, while fixed costs remain constant regardless of the production volume.

2. **Product Cost Calculation:** The total product cost under absorption costing is the sum of direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. This total cost is then divided by the number of units produced to determine the per-unit cost.

3. **Treatment of Fixed Costs:** One distinctive feature of absorption costing is the treatment of fixed manufacturing overhead costs. These costs are allocated to units produced, and they become part of the product cost. This is in contrast to variable costing, where fixed manufacturing overhead costs are treated as period costs and are not assigned to individual units.

4. **Income Statement Presentation:** Absorption costing is often required for external financial reporting purposes, as it aligns with Generally Accepted Accounting Principles (GAAP). The fixed manufacturing overhead costs allocated to units in inventory are expensed when the units are sold.

5. **Matching Principle:** Absorption costing adheres to the matching principle, which requires that costs be matched with revenues in the period when the revenues are earned. This is achieved by allocating fixed manufacturing overhead costs to units produced and then expensing them when the units are sold.

6. **Criticism:** One criticism of absorption costing is that it can result in fluctuations in reported profits based on changes in inventory levels. When production exceeds sales, more fixed manufacturing overhead costs are allocated to inventory, potentially inflating profits. Conversely, when sales exceed production, fewer fixed manufacturing overhead costs are allocated to inventory, potentially understating profits.

7. **Comparison with Variable Costing:** Absorption costing is often contrasted with variable costing, where only variable manufacturing costs are assigned to products, and fixed manufacturing overhead costs are treated as period costs. Both methods can result in different reported profits, especially when inventory levels change.

While absorption costing is widely used for external reporting, businesses may also use variable costing for internal decision-making and performance evaluation. It’s important for users of financial information to be aware of the costing method used and understand how it may impact reported financial results.