What Is Absorption Rate?

Absorption rate most commonly refers to a metric used in the real estate market to evaluate the rate at which available homes are sold in a specific market during a given time period. It is calculated by dividing the number of homes sold in the allotted time period by the total number of available homes. This equation can also be reversed to identify the amount of time it would take for the supply to be sold.

Absorption rate is also a key part of the accounting industry. In this context, absorption rate refers to the way in which businesses calculate their overhead costs.

Understanding Absorption Rate

Absorption rate provides insight into how quickly or slowly houses are selling in the real estate market. Absorption rate does not take into account additional homes that enter the market at various times. While an absorption rate calculation can be projected, it’s most commonly used based on current available data and actual inventory.

A high absorption rate may indicate that the supply of available homes will shrink rapidly. A homeowner is typically able to sell their property faster during periods of high absorption. However, the time period associated with an absorption rate calculation is important to consider.

Traditionally, an absorption rate above 20% signaled a seller’s market in which homes are sold quickly. An absorption rate below 15% is an indicator of a buyer’s market in which homes are not being sold as fast.

Influence in the Real Estate Market

In market conditions with low absorption rates, a real estate agent may be forced to reduce a listing price to entice a sale. Alternatively, the agent can increase the price without sacrificing demand for the home if the market has a high absorption rate. The absorption rate is also important for buyers and sellers to follow as they make decisions on the timing of purchases and sales.

The absorption rate is also a signal for developers to start building new homes, though developers often use long lead times to forecast periods of higher absorption. During market conditions with a high absorption rate, demand may be high enough to warrant the further development of properties. Meanwhile, periods with lower absorption rates indicate a cooling period for construction.

Appraisers use the absorption rate to determine the value of a property. Some procedures require an addendum showing that absorption rates were considered in appraisal calculations. In general, appraisers are responsible for analyzing market conditions and maintaining an awareness of the absorption rates for all types of appraisal values.

Most appraisers include this data metric in the neighborhood section of the appraisal forms. The current valuation of a home would be reduced during periods of decreased absorption rates and increased when absorption rates are high.

Lenders and banking institutions will also consider market conditions when evaluating loan and credit terms. During periods of low absorption, banks may feel tempted to entice clients to borrow money with more favorable loan terms. Alternatively, lenders can be more selective during high absorption periods as they are more likely to have a broader portfolio of prospective borrowers.

Example of the Absorption Rate

Suppose a city has 1,000 homes currently on the market to be sold. If buyers purchase 100 homes per month, the absorption rate is 10% (100 homes sold per month divided by 1,000 homes available for sale). This also indicates that the supply of homes will be exhausted in 10 months (1,000 homes divided by 100 homes sold/month).

Absorption Rate in Accounting

Absorption rate is also used in an entirely different manner in accounting.

In accounting, absorption rate (or the rate of absorption) is the rate at which companies calculate and allocate their overhead expenses. These are the costs associated with providing goods and services to their customers, though these expenses aren’t directly traceable to end products. As such, it’s also often called an overhead absorption rate.

Companies often have to use estimates to determine their overhead costs. That’s because they don’t know what the actual costs are until they come in. In order to determine their overhead, companies divide the total budgeted overhead costs divided by the total budgeted production base. This requires an adjustment at the end of the accounting period to make up for any difference between the predicted and actual costs.

Alternatively, a company may know its actual overhead costs but not know how to trace those costs to final products or services. To overcome this hurdle, companies use estimated cost drivers to guess what non-financial measures cause changes in financial measures.

This can be problematic, especially when companies use very conservative estimates to predict their costs. Doing so may throw off their balance sheets because the actual costs may be higher at the end of the reporting period or if costs fluctuate. However, this practice has the benefit of making sure all costs including estimated amounts and estimated allocations are included when evaluating their products.

The Bottom Line

The absorption rate is a very important metric used in the real estate and accounting.

Realtors use it to determine how many homes are sold in a particular area at any given time. These professionals can also use the rate to determine the kind of market they are facing, whether that’s a buyer’s, seller’s, or a balanced market. This rate is also important for the construction industry, as it indicates when developers should start buying.

Equally important, absorption rate is used in the accounting field—notably for companies to estimate their overhead. Absorption costing entails estimating overhead costs, determining overhead cost drivers, and having products absorb these untraceable costs.

What Is Absorption Costing?

Absorption costing, sometimes called “full costing,” is a managerial accounting method for capturing all costs associated with manufacturing a particular product. All direct and indirect costs, such as direct materials, direct labor, rent, and insurance, are accounted for when using this method.

Under generally accepted accounting principles (GAAP), U.S. companies may use absorption costing for external reporting, however variable costing is disallowed.

Understanding Absorption Costing

Absorption costing includes anything that is a direct cost in producing a good in its cost base. Absorption costing also includes fixed overhead charges as part of the product costs. Some of the costs associated with manufacturing a product include wages for employees physically working on the product, the raw materials used in producing the product, and all of the overhead costs (such as all utility costs) used in production.

In contrast to the variable costing method, every expense is allocated to manufactured products, whether or not they are sold by the end of the period.

Components of Absorption Costing

The components of absorption costing include both direct costs and indirect costs. Direct costs are those costs that can be directly traced to a specific product or service. These costs include raw materials, labor, and any other direct expenses that are incurred in the production process.

Indirect costs are those costs that cannot be directly traced to a specific product or service. These costs are also known as overhead expenses and include things like utilities, rent, and insurance. Indirect costs are typically allocated to products or services based on some measure of activity, such as the number of units produced or the number of direct labor hours required to produce the product.

In absorption costing, both direct and indirect costs are included in the cost of a product. This means that the cost of each unit of a product includes not only the direct costs of producing that unit, but also a portion of the indirect costs that were incurred in the production process. The total manufacturing costs are then divided by the number of units produced to determine the cost of each unit. The formula for absorption costing can be written as follows:

Absorption cost = (Direct labor costs + Direct material costs + Variable manufacturing overhead costs + Fixed manufacturing overhead) / Number of units produced.

Absorption Costing vs. Variable Costing

Absorption costing and variable costing are two different methods of costing that are used to calculate the cost of a product or service. While both methods are used to calculate the cost of a product, they differ in the types of costs that are included and the purposes for which they are used. The differences between absorption costing and variable costing lie in how fixed overhead costs are treated.

Under absorption costing, all manufacturing costs, both direct and indirect, are included in the cost of a product. This means that the cost of each unit of a product includes not only the direct costs of producing that unit, such as raw materials and labor, but also a portion of the indirect costs that were incurred in the production process, such as overhead expenses. Absorption costing is typically used for external reporting purposes, such as calculating the cost of goods sold for financial statements.

Variable costing, on the other hand, only includes direct costs in the cost of a product. Indirect costs, or overhead expenses, are not included in the cost of the product under variable costing. Instead, they are treated as a period expense and are recorded in the income statement in the period in which they are incurred. Variable costing is typically used for management decision-making and planning purposes, as it provides a more accurate representation of the incremental costs associated with producing an additional unit of a product.

Variable costing does not determine a per-unit cost of fixed overheads, while absorption costing does. Variable costing will yield one lump-sum expense line item for fixed overhead costs when calculating net income on the income statement. Absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold, and those attributable to inventory.

Advantages and Disadvantages of Absorption Costing

Assets, such as inventory, remain on the entity’s balance sheet at the end of the period. Because absorption costing allocates fixed overhead costs to both cost of goods sold and inventory, the costs associated with items still in ending inventory will not be captured in the expenses on the current period’s income statement. Absorption costing reflects more fixed costs attributable to ending inventory.

Absorption costing ensures more accurate accounting for ending inventory because the expenses associated with that inventory are linked to the full cost of the inventory still on hand. In addition, more expenses are accounted for in unsold products, which reduces actual expenses reported in the current period on the income statement. This results in a higher net income calculation compared with variable costing calculations.

Because absorption costing includes fixed overhead costs in the cost of its products, it is unfavorable compared with variable costing when management is making internal incremental pricing decisions. This is because variable costing will only include the extra costs of producing the next incremental unit of a product.

In addition, the use of absorption costing generates a situation in which simply manufacturing more items that go unsold by the end of the period will increase net income. Because fixed costs are spread across all units manufactured, the unit fixed cost will decrease as more items are produced. Therefore, as production increases, net income naturally rises, because the fixed-cost portion of the cost of goods sold will decrease.

Example of Absorption Costing

Assume that ABC Company makes widgets. In January, it makes 10,000 widgets, of which 8,000 are sold by the end of the month, leaving 2,000 still in inventory. Each widget uses $5 of labor and materials directly attributable to the item. In addition, there are $20,000 of fixed overhead costs each month associated with the production facility. Under the absorption costing method, ABC will assign an additional $2 to each widget for fixed overhead costs ($20,000 total ÷ 10,000 widgets produced in the month).

The absorption cost per unit is $7 ($5 labor and materials + $2 fixed overhead costs). As 8,000 widgets were sold, the total cost of goods sold is $56,000 ($7 total cost per unit × 8,000 widgets sold). The ending inventory will include $14,000 worth of widgets ($7 total cost per unit × 2,000 widgets still in ending inventory).

The Bottom Line

Absorption costing is a method of costing that includes all manufacturing costs, both fixed and variable, in the cost of a product. It is also known as full costing or full absorption costing. Absorption costing is used to determine the cost of goods sold and ending inventory balances on the income statement and balance sheet, respectively. It is also used to calculate the profit margin on each unit of product and to determine the selling price of the product.

Under absorption costing, the fixed manufacturing overhead costs are included in the cost of a product as an indirect cost. These costs are not directly traceable to a specific product but are incurred in the process of manufacturing the product. The fixed manufacturing overhead costs are allocated to each unit of product based on a predetermined overhead allocation rate, which is calculated by dividing the total estimated fixed manufacturing overhead costs by the total number of units that are expected to be produced. In addition to the fixed manufacturing overhead costs, absorption costing also includes the variable manufacturing costs in the cost of a product. These costs are directly traceable to a specific product and include direct materials, direct labor, and variable overhead.