• Direct Materials - These are the raw materials such as wood, metal, bricks, etc that are used in order to create a finished usable good which will be demanded by the market.
• Direct Labor - Direct Labor is the manwork and total factory hours put behind assembling the raw materials, creating the finished good, etc.
• Fixed Manufacturing Overhead - This includes expenses such as rent of factory where the raw materials are turned into finished goods, amortization of factory building, utilities, etc.
• Variable Manufacturing Overhead - These are the general and administrative expenses in the manufacturing process.

Absorption costing is different from the other costing methods because it takes into account fixed manufacturing overhead (includes expenses such as factory rent, amortization, utilities). It is hard to factor in the fixed manufacturing overhead expenses into calculating the per unit price of goods, therefore other methods such as Variable Costing do not take it into account.

One drawback of absorption costing is that managers can increase production levels without taking into account total sales (whether there is enough demand for all the goods they are producing). With higher production levels, this year's expenses can be deferred to next year, thus lowering this year's costs. What does this mean? The managers get a fat bonus and pay raises thanks to more "profits."

Inventory Production & Absorption Costing

When beginning inventory and ending inventory levels are different, profit calculations using the Absorption costing can be difficult. Here are the effects of fluctuating inventory levels:

• If Beginning Inventory = Ending Inventory, then Absorption Costing = Variable Costing
• If Inventory Levels = Low, then Variable Costing Profit > Absorption Costing Profit
• If Inventory Levels = High, then Absorption Costing Profit >Variable Costing Profit