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.

What Is an Average Collection Period?

Average collection period refers to the amount of time it takes for a business to receive payments owed by its clients in terms of accounts receivable (AR). Companies use the average collection period to make sure they have enough cash on hand to meet their financial obligations. The average collection period is an indicator of the effectiveness of a firm’s AR management practices and is an important metric for companies that rely heavily on receivables for their cash flows.

How Average Collection Periods Work

Accounts receivable is a business term used to describe money that entities owe to a company when they purchase goods and/or services. Companies normally make these sales to their customers on credit. AR is listed on corporations’ balance sheets as current assets and measures their liquidity. As such, they indicate their ability to pay off their short-term debts without the need to rely on additional cash flows.

The average collection period is an accounting metric used to represent the average number of days between a credit sale date and the date when the purchaser remits payment. A company’s average collection period is indicative of the effectiveness of its AR management practices. Businesses must be able to manage their average collection period to operate smoothly.

A lower average collection period is generally more favorable than a higher one. A low average collection period indicates that the organization collects payments faster. However, this may mean that the company’s credit terms are too strict. Customers who don’t find their creditors’ terms very friendly may choose to seek suppliers or service providers with more lenient payment terms.

Formula for Average Collection Period

Average collection period is calculated by dividing a company’s average accounts receivable balance by its net credit sales for a specific period, then multiplying the quotient by 365 days.

Average Collection Period = 365 Days * (Average Accounts Receivables / Net Credit Sales)

Alternatively and more commonly, the average collection period is denoted as the number of days of a period divided by the receivables turnover ratio. The formula below is also used referred to as the days sales receivable ratio.

Average Collection Period = 365 Days / Receivables Turnover Ratio

The average receivables turnover is simply the average accounts receivable balance divided by net credit sales; the formula below is simply a more concise way of writing the formula.

Average Accounts Receivables

For the formulas above, average accounts receivable is calculated by taking the average of the beginning and ending balances of a given period. More sophisticated accounting reporting tools may be able to automate a company’s average accounts receivable over a given period by factoring in daily ending balances.

When analyzing average collection period, be mindful of the seasonality of the accounts receivable balances. For example, analyzing a peak month to a slow month by result in a very inconsistent average accounts receivable balance that may skew the calculated amount.

Net Credit Sales

Average collection period also relies on net credit sales for a period. This metric should exclude cash sales (as those are not made on credit and therefore do not have a collection period).

In addition to being limited to only credit sales, net credit sales exclude residual transactions that impact and often reduce sales amounts. This includes any discounts awarded to customers, product recalls or returns, or items re-issued under warranty.

Importance of Average Collection Period

Average collection period boils down to a single number; however, it has many different uses and communicates a variety of important information.

• It tells how efficiently debts are collected. This is important because a credit sale is not fully completed until the company has been paid. Until cash has been collected, a company is yet to reap the full benefit of the transaction.
• It tells how strict credit terms are. This is important as strict credit terms may scare clients away; on the other hand, credit terms that are too loose may attract customers looking to take advantage of lenient payment terms.
• It tells how competitors are performing. This is important because all figures needed to calculate the average collection period are available for public companies. This gives deeper insight into what other companies are doing and how a company’s operations compare.
• It tells early signals of bad allowances. This is important because as the average collection period increases, more clients are taking longer to pay. This metric can be used to signal to management to review its outstanding receivables at risk of being uncollected to ensure clients are being monitored and communicated with.
• It tells of a company’s short-term financial health. This is important because without cash collections, a company will go insolvent and lack the liquidity to pay its short-term bills.

How to Use Average Collection Period

The average collection period does not hold much value as a stand-alone figure. Instead, you can get more out of its value by using it as a comparative tool.

The best way that a company can benefit is by consistently calculating its average collection period and using it over time to search for trends within its own business. The average collection period may also be used to compare one company with its competitors, either individually or grouped together. Similar companies should produce similar financial metrics, so the average collection period can be used as a benchmark against another company’s performance.

Companies may also compare the average collection period with the credit terms extended to customers. For example, an average collection period of 25 days isn’t as concerning if invoices are issued with a net 30 due date. However, an ongoing evaluation of the outstanding collection period directly affects the organization’s cash flows.

Example of Average Collection Period

As noted above, the average collection period is calculated by dividing the average balance of AR by total net credit sales for the period, then multiplying the quotient by the number of days in the period.

Let’s say a company has an average AR balance for the year of $10,000. The total net sales that the company recorded during this period was $100,000. We would use the following average collection period formula to calculate the period:

($10,000 ÷ $100,000) × 365 = Average Collection Period

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The average collection period, therefore, would be 36.5 days. This is not a bad figure, considering most companies collect within 30 days. Collecting its receivables in a relatively short and reasonable period of time gives the company time to pay off its obligations.

If this company’s average collection period was longer—say, more than 60 days— then it would need to adopt a more aggressive collection policy to shorten that time frame. Otherwise, it may find itself falling short when it comes to paying its own debts.

Accounts Receivable (AR) Turnover

The average collection period is closely related to the accounts turnover ratio, which is calculated by dividing total net sales by the average AR balance.

Using the previous example, the AR turnover is 10 ($100,000 ÷ $10,000). The average collection period can also be calculated by dividing the number of days in the period by the AR turnover. In this example, the average collection period is the same as before: 36.5 days.

365 days ÷ 10 = Average Collection Period

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Collections by Industries

Not all businesses deal with credit and cash in the same way. Although cash on hand is important to every business, some rely more on their cash flow than others.

For example, the banking sector relies heavily on receivables because of the loans and mortgages that it offers to consumers. As it relies on income generated from these products, banks must have a short turnaround time for receivables. If they have lax collection procedures and policies in place, then income would drop, causing financial harm.

Real estate and construction companies also rely on steady cash flows to pay for labor, services, and supplies. These industries don’t necessarily generate income as readily as banks, so it’s important that those working in these industries bill at appropriate intervals, as sales and construction take time and may be subject to delays.

The Bottom Line

The average collection period is the average number of days it takes for a credit sale to be collected. During this period, the company is awarding its customer a very short-term “loan”; the sooner the client can collect the loan, the earlier it will have the capital to use to grow its company or pay its invoices. While a shorter average collection period is often better, too strict of credit terms may scare customers away.

What Is Aggregate Demand?

Aggregate demand is a measurement of the total amount of demand for all finished goods and services produced in an economy. Aggregate demand is commonly expressed as the total amount of money exchanged for those goods and services at a specific price level and point in time.

Understanding Aggregate Demand

Aggregate demand is a macroeconomic term and can be compared with the gross domestic product (GDP). GDP represents the total amount of goods and services produced in an economy while aggregate demand is the demand or desire for those goods. Aggregate demand and GDP commonly increase or decrease together.

Aggregate demand equals GDP only in the long run after adjusting for the price level. Short-run aggregate demand measures total output for a single nominal price level without adjusting for inflation. Other variations in calculations can occur depending on the methodologies used and the various components.

Aggregate demand consists of all consumer goods, capital goods, exports, imports, and government spending programs. All variables are considered equal if they trade at the same market value.

Aggregate Demand Components

Aggregate demand is determined by the overall collective spending on products and services by all economic sectors on the procurement of goods and services by four components:

Consumption Spending

Consumer spending represents the demand by individuals and households within the economy. While there are several factors in determining consumer demand, the most important is consumer incomes and the level of taxation.

Investment Spending

Investment spending represents businesses’ investment to support current output and increase production capability. It may include spending on new capital assets such as equipment, facilities, and raw materials.

Government Spending

Government spending represents the demand produced by government programs, such as infrastructure spending and public goods. This does not include services such as Medicare or social security, because these programs simply transfer demand from one group to another.

Net Exports

Net exports represent the demand for foreign goods, as well as the foreign demand for domestic goods. It is calculated by subtracting the total value of a country’s exports from the total value of all imports.

Aggregate Demand Formula

The equation for aggregate demand adds the amount of consumer spending, investment spending, government spending, and the net of exports and imports. The formula is shown as follows:

$\begin{aligned} &\text{Aggregate Demand} = \text{C} + \text{I} + \text{G} + \text{Nx} \\ &\textbf{where:}\\ &\text{C} = \text{Consumer spending on goods and services} \\ &\text{I} = \text{Private investment and corporate spending on} \\ &\text{non-final capital goods (factories, equipment, etc.)} \\ &\text{G} = \text{Government spending on public goods and social} \\ &\text{services (infrastructure, Medicare, etc.)} \\ &\text{Nx} = \text{Net exports (exports minus imports)} \\ \end{aligned}$​Aggregate Demand=C+I+G+Nxwhere:C=Consumer spending on goods and servicesI=Private investment and corporate spending onnon-final capital goods (factories, equipment, etc.)G=Government spending on public goods and socialservices (infrastructure, Medicare, etc.)Nx=Net exports (exports minus imports)​

The aggregate demand formula above is also used by the Bureau of Economic Analysis to measure GDP in the U.S.

What Affects Aggregate Demand?

Interest Rates

Interest rates affect decisions made by consumers and businesses. Lower interest rates will lower the borrowing costs for big-ticket items such as appliances, vehicles, and homes and companies will be able to borrow at lower rates, often leading to capital spending increases. Higher interest rates increase the cost of borrowing for consumers and companies and spending tends to decline or grow at a slower pace.

Income and Wealth

As household wealth increases, aggregate demand typically increases. Conversely, a decline in wealth usually leads to lower aggregate demand. When consumers are feeling good about the economy, they tend to spend more and save less.

Inflation Expectations

Consumers who anticipate that inflation will increase or prices will rise tend to make immediate purchases leading to rises in aggregate demand. But if consumers believe prices will fall in the future, aggregate demand typically falls.

Currency Exchange Rates

When the value of the U.S. dollar falls, foreign goods will become more expensive. Meanwhile, goods manufactured in the U.S. will become cheaper for foreign markets. Aggregate demand will, therefore, increase. When the value of the dollar increases, foreign goods are cheaper and U.S. goods become more expensive to foreign markets, and aggregate demand decreases.

Economic Conditions and Aggregate Demand

Economic conditions can impact aggregate demand whether those conditions originated domestically or internationally. The financial crisis of 2007-08, sparked by massive amounts of mortgage loan defaults, and the ensuing Great Recession, offer a good example of a decline in aggregate demand due to economic conditions.

With businesses suffering from less access to capital and fewer sales, they began to lay off workers and GDP growth contracted in 2008 and 2009, resulting in a total production contraction in the economy during that period. A poor-performing economy and rising unemployment led to a decline in personal consumption or consumer spending. Personal savings also surged as consumers held onto cash due to an uncertain future and instability in the banking system.

In 2020, the COVID-19 pandemic caused reductions in both aggregate supply or production, and aggregate demand or spending. Social distancing measures and concerns about the spread of the virus caused a significant decrease in consumer spending, particularly in services as many businesses closed. These dynamics lowered aggregate demand in the economy. As aggregate demand fell, businesses either laid off part of their workforces or otherwise slowed production as employees contracted COVID-19 at high rates.

Aggregate Demand vs. Aggregate Supply

In times of economic crises, economists often debate as to whether aggregate demand slowed, leading to lower growth, or GDP contracted, leading to less aggregate demand. Whether demand leads to growth or vice versa is economists’ version of the age-old question of what came first—the chicken or the egg.

Boosting aggregate demand also boosts the size of the economy regarding measured GDP. However, this does not prove that an increase in aggregate demand creates economic growth. Since GDP and aggregate demand share the same calculation, it only indicates that they increase concurrently. The equation does not show which is the cause and which is the effect.

Early economic theories hypothesized that production is the source of demand. The 18th-century French classical liberal economist Jean-Baptiste Say stated that consumption is limited to productive capacity and that social demands are essentially limitless, a theory referred to as Say’s Law of Markets.

Say’s law, the basis of supply-side economics, ruled until the 1930s and the advent of the theories of British economist John Maynard Keynes. By arguing that demand drives supply, Keynes placed total demand in the driver’s seat. Keynesian macroeconomists have since believed that stimulating aggregate demand will increase real future output and the total level of output in the economy is driven by the demand for goods and services and propelled by money spent on those goods and services.

Keynes considered unemployment to be a byproduct of insufficient aggregate demand because wage levels would not adjust downward fast enough to compensate for reduced spending. He believed the government could spend money and increase aggregate demand until idle economic resources, including laborers, were redeployed.

Other schools of thought, notably the Austrian School and real business cycle theorists stress consumption is only possible after production. This means an increase in output drives an increase in consumption, not the other way around. Any attempt to increase spending rather than sustainable production only causes maldistribution of wealth or higher prices, or both.

As a demand-side economist, Keynes further argued that individuals could end up damaging production by limiting current expenditures—by hoarding money, for example. Other economists argue that hoarding can impact prices but does not necessarily change capital accumulation, production, or future output. In other words, the effect of an individual’s saving money—more capital available for business—does not disappear on account of a lack of spending.

The Bottom Line

Aggregate demand is a concept of macroeconomics that represents the total demand within an economy for all kinds of goods and services at a certain price point. In the long term, aggregate demand is indistinguishable from GDP. However, aggregate demand is not a perfect metric and it is the subject of debate among economists.

What Is Adjusted Present Value (APV)?

The adjusted present value is the net present value (NPV) of a project or company if financed solely by equity plus the present value (PV) of any financing benefits, which are the additional effects of debt. By taking into account financing benefits, APV includes tax shields such as those provided by deductible interest.

The Formula for APV Is


$\begin{aligned} &\text{Adjusted Present Value = Unlevered Firm Value + NE}\\ &\textbf{where:}\\ &\text{NE = Net effect of debt}\\ \end{aligned}$​Adjusted Present Value = Unlevered Firm Value + NEwhere:NE = Net effect of debt​

The net effect of debt includes tax benefits that are created when the interest on a company’s debt is tax-deductible. This benefit is calculated as the interest expense times the tax rate, and it only applies to one year of interest and tax. The present value of the interest tax shield is therefore calculated as: (tax rate * debt load * interest rate) / interest rate.

How to Calculate Adjusted Present Value (APV)

To determine the adjusted present value:

1. Find the value of the un-levered firm.
2. Calculate the net value of debt financing.
3. Sum the value of the un-levered project or company and the net value of the debt financing.

How to Calculate APV in Excel

An investor can use Excel to build out a model to calculate the net present value of the firm and the present value of the debt.

What Does Adjusted Present Value Tell You?

The adjusted present value helps to show an investor the benefits of tax shields resulting from one or more tax deductions of interest payments or a subsidized loan at below-market rates. For leveraged transactions, APV is preferred. In particular, leveraged buyout situations are the most effective situations in which to use the adjusted present value methodology.

The value of a debt-financed project can be higher than just an equity-financed project, as the cost of capital falls when leverage is used. Using debt can actually turn a negative NPV project into one that’s positive. NPV uses the weighted average cost of capital as the discount rate, while APV uses the cost of equity as the discount rate.

Example of How to Use Adjusted Present Value (APV)

In a financial projection where a base-case NPV is calculated, the sum of the present value of the interest tax shield is added to obtain the adjusted present value.

For example, assume a multi-year projection calculation finds that the present value of Company ABC’s free cash flow (FCF) plus terminal value is $100,000. The tax rate for the company is 30% and the interest rate is 7%. Its $50,000 debt load has an interest tax shield of $15,000, or ($50,000 * 30% * 7%) / 7%. Thus, the adjusted present value is $115,000, or $100,000 + $15,000.

The Difference Between APV and Discounted Cash Flow (DCF)

While the adjusted present value method is similar to the discounted cash flow (DCF) methodology, adjusted present cash flow does not capture taxes or other financing effects in a weighted average cost of capital (WACC) or other adjusted discount rates. Unlike WACC used in discounted cash flow, the adjusted present value seeks to value the effects of the cost of equity and cost of debt separately. The adjusted present value isn’t as prevalent as the discounted cash flow method.

Limitations of Using Adjusted Present Value (APV)

In practice, the adjusted present value is not used as much as the discounted cash flow method. It is more of an academic calculation but is often considered to result in more accurate valuations.

Learn More About Adjusted Present Value (APV)

To dig deeper into calculating the adjusted present value, check out Investopedia’s guide to calculating net present value.