What is absorption costing?
Absorption costing is a way of costing that gives every job a share of the business's overheads, such as rent, admin and insurance, on top of its direct costs. In a fabrication shop, overheads are usually absorbed through the machine hourly rate, so each hour of cutting carries part of them.
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What does absorption costing mean in fabrication?
Every shop has costs that don't belong to any one job: rent, office staff, insurance, software, the forklift. Absorption costing spreads them across the work with an overhead absorption rate:
- overhead absorption rate = budgeted overheads for the year ÷ budgeted machine hours for the year
Each job then carries overheads in proportion to the machine hours it uses. Some businesses absorb overheads by labour hours instead. For laser cutting, machine hours fit better, because the machine is what every job runs through.
How is absorption costing used?
Shops use it to set the hourly rate, which combines three parts:
- direct machine costs: depreciation or finance, power, gas, consumables and maintenance
- direct labour: the operator
- absorbed overheads: the overhead absorption rate
The total is the full cost of a machine hour. Add profit and it becomes the rate the shop quotes from. Shops with several machines and a press brake split overheads between them, so each machine's rate carries its own share.
Why does absorption costing matter?
Without it, a shop can price every job above its direct costs and still lose money. If quotes cover the machine and the operator but not the rent and the office, the overheads come out of profit.
The weak point is the budgeted hours. If the machine cuts fewer hours than planned, part of the overheads is never charged to any job. That shortfall is under-absorption, and it's the same problem as an hourly rate built on optimistic machine utilisation.
Absorption costing vs marginal costing
Marginal costing prices a job on its variable costs only: material, gas, power and consumables. Anything charged above those contributes to fixed costs and profit. It answers one question well: whether to take filler work at a lower price in a quiet week.
The risk is letting marginal prices become normal prices. Price enough work to cover only variable costs and the overheads go unpaid. Most shops quote on absorption costing and treat marginal pricing as a deliberate exception.
Absorption costing and quoting
Overheads only reach the customer through the rate in the quote. Build them into the hourly rate once, then apply that rate on every quote, so no estimator leaves them out. Tempus Tools' guide to setting laser cutting prices works through an absorption costing example step by step.
Further reading: Laser cutting hourly rate: what should be included?
Related terms
Set prices that cover every cost
Our free guide to setting laser cutting prices works through absorption costing, utilisation and margin, and pairs with the hourly rate calculator.
FAQs
What is absorption costing in simple terms?
It's costing that makes every job pay a share of the overheads as well as its own direct costs. A fabrication shop usually does it through its machine hourly rate: the year's overheads are divided by the year's machine hours, and that amount is added to every hour quoted.
How do you calculate an overhead absorption rate?
Divide the overheads you expect for the year by the machine hours you expect to cut. If the machine cuts fewer hours than budgeted, the rate is too low and some overheads go unrecovered, so base the hours on measured utilisation, not shift time.
What is the difference between absorption and marginal costing?
Absorption costing gives every job a share of fixed overheads. Marginal costing charges only variable costs and treats anything above them as a contribution to overheads and profit. Marginal pricing can justify filler work in a quiet period, but quoting everything that way leaves overheads unpaid.
What is under-absorption?
Under-absorption is when a business recovers less overhead than it spent, because it worked fewer hours than it budgeted for. In a laser shop it shows up when the hourly rate assumed more cutting hours than the machine actually ran.