Going-in Cap Rate Calculations for Multi-Family Real Estate Modeling

When analyzing a potential multi-family acquisition, knowing all your going-in cap rates helps inform purchase price. It may mean more wiggle room in negotiations and generally gives the purchaser a better understanding of the opportunities, especially with value-add. It also may be relevant if you plan to have key changes to ongoing expenses.

General Explainer for Absorption Cost Accounting Method

Absorption costing, sometimes referred to as “full costing,” is a method of cost accounting in which all costs related to the manufacturing of a product are included in its overall cost. This includes both variable costs (like raw materials and direct labor) and fixed manufacturing overhead costs (such as facility rent, utilities allocated to production, and factory depreciation). Below is a comprehensive look at absorption costing—its general aspects, industries where it applies, nuances in calculation, and its necessity.

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If you want to try this out for yourself, download this absorption costing template built in Excel.

1. General Aspects of Absorption Costing

1. Definition

   • Absorption costing assigns all manufacturing costs to the product. These costs typically include:

     • Direct Materials (raw materials that become part of the finished product)

     • Direct Labor (costs of wages for the personnel directly involved in production)

     • Variable Manufacturing Overhead (indirect costs that vary with production, such as utilities for running machines or machine maintenance)

     • Fixed Manufacturing Overhead (indirect costs that do not vary directly with production, such as depreciation of equipment, factory rent, production manager’s salary)

2. Purpose

   • To capture the full cost of producing an item. By including both variable and fixed manufacturing overhead costs, absorption costing meets external financial reporting requirements and helps companies see the total cost structure.

3. Treatment of Costs

   • Costs are allocated or “absorbed” by the units produced. In contrast, under variable costing, only variable manufacturing costs are assigned to units; fixed overhead is treated as a period expense. In absorption costing, fixed overhead is spread out across all units produced (i.e., it’s capitalized in inventory until the product is sold).

4. Financial Reporting

   • Absorption costing is required by GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) for external reporting. The rationale is that fixed production costs are necessary for manufacturing, so they should be included in the valuation of inventory on the balance sheet.

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2. Industries That Use Absorption Costing

1. Manufacturing (most common)

   • Automobile manufacturing: Where large overhead costs (machinery, factory costs) must be distributed among thousands of vehicles.

   • Consumer goods production: Companies producing packaged foods, beverages, household items, etc.

   • Electronics manufacturers: Where factories and assembly lines constitute significant fixed costs.

2. Process Industries

   • Industries like chemicals, steel, petroleum refining, and plastics. These have high overhead that must be captured in product costs.

3. Pharmaceuticals

   • High research and development spend may not all be allocated under manufacturing overhead, but once the product is in production, there is significant manufacturing overhead (facilities, specialized equipment, and quality control) that is spread across output.

4. Any Industry with Tangible Product Output

   • If a company is required to maintain inventory (physical goods), absorption costing often applies for external reporting. Even custom manufacturing (e.g., custom machine parts) may have overhead costs that need to be absorbed into the final product cost.

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3. Nuances in the Calculations

1. Allocation of Fixed Overhead

   • Predetermined Overhead Rate: A common approach is to establish a predetermined overhead rate (POR) at the beginning of a period. For example:

     $$\text{POR} = \frac{\text{Budgeted Fixed Overhead}}{\text{Budgeted Units of Production or Machine Hours or Labor Hours}}$$

   • This rate is then multiplied by the actual activity (units produced or machine hours used) to calculate the overhead cost allocated to each product.

2. Inventory Valuation Impact

   • Under absorption costing, unsold inventory carries some portion of fixed overhead as an asset on the balance sheet. This can:

     • Increase reported profits if production exceeds sales (because some fixed overhead is deferred in unsold inventory).

     • Decrease reported profits if sales exceed production (because more overhead costs from previous periods are recognized in the cost of goods sold).

3. Over-/Under-Applied Overhead

   • At the end of the accounting period, the actual overhead costs may differ from what was applied to the products (via the predetermined rate). This leads to:

     • Over-applied overhead: Applied overhead > Actual overhead.

     • Under-applied overhead: Applied overhead < Actual overhead.

   • Companies typically adjust these differences via the cost of goods sold or through an allocation to inventory and COGS.

4. Choosing an Activity Base

   • Companies may allocate overhead based on:

     • Direct Labor Hours

     • Machine Hours

     • Number of Units Produced

   • Selecting the appropriate base is important to reflect the cause-and-effect relationship between overhead consumption and production.

5. Complexity in Multi-Product Scenarios

   • If multiple products are being produced in the same facility, the overhead allocation can become more complex. Cost accountants may use:

     • Multiple Overhead Rates (department-specific or activity-specific)

     • Activity-Based Costing (ABC) if overhead is very high and products consume overhead in different proportions.

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4. Why Absorption Costing Is Necessary

1. Compliance with Accounting Standards

   • Absorption costing is required by GAAP and IFRS for external financial statements. It ensures that financial statements reflect all the manufacturing costs tied to the products that remain in inventory.

2. More Complete Profit Measurement

   • By including both variable and fixed costs in product costs, absorption costing can provide a comprehensive picture of a product’s profitability in the long run. While variable costing is beneficial for internal decision-making (such as short-term pricing or contribution margin analysis), absorption costing is needed for an all-inclusive profitability view.

3. Inventory Valuation

   • For companies that carry significant inventory, absorption costing aligns the cost of the product with its level of completion and ensures that some portion of fixed costs is recognized when (and only when) the product is sold.

4. Misleading Profit Signals Under Other Methods

   • If a company only used variable costing in external reports, products still in inventory wouldn’t include any portion of the fixed manufacturing costs. This can understate inventory on the balance sheet and distort actual net income from a regulatory standpoint.

5. Matching Principle

   • Absorption costing upholds the matching principle (expenses should be recognized in the same period as the revenue they help to generate). By putting some manufacturing overhead into the value of the product, the expense of that overhead is recognized when the product is sold, rather than when the costs are incurred.

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5. Practical Considerations and Caveats

1. Short-Term Decision-Making

   • Internally, managers often prefer to use variable costing or contribution margin analysis for short-term decisions (e.g., special orders, capacity considerations) because it can clarify how changes in volume affect profits. However, for long-term pricing or capacity planning, absorption costing helps ensure the company covers the full spectrum of costs.

2. Potential for Overproduction

   • One critique of absorption costing is that it can encourage overproduction in the short run. When more units are produced than sold, some of the fixed overhead is “trapped” in inventory on the balance sheet, which can inflate operating income temporarily.

3. Implementation Complexity

   • With multiple products, production lines, or a wide variety of costs, allocating overhead requires thorough data collection, activity measurement, and constant updating of overhead rates (particularly in dynamic production environments).

4. Regulatory Scrutiny

   • Because absorption costing is required for external reporting, regulators and auditors will scrutinize how overhead rates are determined and whether the methodology is consistent, transparent, and adheres to applicable guidelines.

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Summary

• Absorption costing is a foundational accounting method where all manufacturing costs (variable and fixed) are allocated to products, aligning expenses with revenues under the matching principle.

• It’s necessary for external reporting to comply with GAAP and IFRS, as it provides a more comprehensive long-term view of product costs and profitability.

• While many industries (especially manufacturing and process industries) adopt this approach, its nuances in allocating overhead and the potential for over-/under-applied overhead are important considerations for accurate financial reporting and inventory valuation.

• Although it has the downside of potentially incentivizing overproduction, absorption costing remains integral to both meeting accounting standards and providing complete product cost information for decision-makers.

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Article found in Accounting and Finance.

Manufacturing Financial Model Update: Adding Direct Labor and Variable Manufacturing Overhead Costs per Unit Sections

I had a client ask me how to enter direct labor costs into the made-to-order manufacturing model and the only answer I could give was to manually input the labor costs into the fixed overhead sections and adjust the costs each year according to the expected unit volumes. This was not ideal so there has been an update to the default version of this template.

Accounting Template for Absorption Costing

This template was built primarily for manufacturers to better understand their unit costs. In the default version of the spreadsheet, I included many slots for each section for maximum flexibility. It is easy to add or delete rows if you don't need that much space and it won't break the model. Absorption costing is a way to account for every single cost that relates to producing a single finished product (all direct variable and fixed costs).