What is absorption costing? Simply put, it is a method that assigns costs from cost items to finished products. This method is particularly helpful for small organizations without adequate financial reserves, as they cannot afford losses or sales without an accurate understanding of their overhead costs. For example, a clothing manufacturer would consider the costs of knitting machines, a factory, insurance, and other expenses, which are usually not included in the final product’s price.
The primary advantage of variable costing over absorption costing is the ability to perform contribution margin analysis (CVP) using the costs of fixed overhead. This approach allows managers to determine break-even points and contribution margin ratios, and to perform sensitivity analysis. It also meets U.S. GAAP standards, but is not useful for internal decision-making. Absorption costing may seem like an obvious choice, but it actually has several advantages.
The main advantage of absorption costing is that it recognises the fixed costs of manufacturing a product, which helps frame a reasonable pricing policy. The fixed cost of production is charged to each unit manufactured, and the profit calculation is accurate. In addition to allowing for the correct profit calculation, it helps to conform to concepts such as matching and accrual costing. The disadvantages of absorption costing include a lack of flexibility in preparing a flexible budget.
The benefits of absorption costing are many. First, it can help you determine the relative importance of fixed and variable costs in the production process. It is also recognized by the Inland Revenue as a standard method for financial accounting. With absorption costing, the total cost is comprised of direct labor and material costs as well as variable and fixed manufacturing overheads. Then, the total cost is divided by the total number of units produced.
Absorption costing can also temporarily increase a company’s profitability. It does this by moving fixed manufacturing overhead costs to the balance sheet. For example, in the same period, a company might incur $300,000 in fixed manufacturing overhead costs. However, with variable costing, the overhead costs are charged to expenses when they are incurred. Thus, a skewed profit and loss statement can mislead investors and management.
If you want to use absorption costing to determine the overall cost of your inventory, you’ll need to know the total cost of goods sold (COGS). Simply multiply the total cost by the number of items sold. For example, if 8,000 units were sold at $7 each, your cost per unit would be $56,000. However, if only 2,000 units were sold at $7 each, you’d still have $14,000 worth of inventory. This method does have limitations. The cost per unit calculation is often inaccurate if you don’t track production expenses. Additionally, the cost per unit is inaccurate if you change the variable costs that are used in production.
For example, if you have a fixed product cost (such as a factory rental), the absorption costing calculation formula will not recognize it as an expense until the product has been sold. Meanwhile, the fixed production salaries are capitalized as an expense in January and as an inventory in March. Period costs, on the other hand, are expenses that are not related to the manufacturing process. This prevents the calculation of profits based on a company’s inventory, and also ensures that products are priced appropriately.
Disadvantages of absorption costing
There are two major disadvantages of absorption costing. First, the method can cause inflation in pricing, since it adds fixed costs to variable ones, and consequently, net income is increased. Second, absorption costing cannot be used to evaluate the efficiency of an operation, because profits must be adjusted for under or over-absorption of fixed costs. In addition, this type of accounting is difficult to apply to companies with multiple product lines.
Compared to other costing methods, absorption costing has fewer disadvantages. It involves fewer skills and requires less effort to implement. However, it is not as helpful as other costing methods and lacks decision-making support. Moreover, it fails to consider indirect costs, which may skew the picture of profitability. This is why absorption costing is often disregarded by companies. And if the method is used, the company may not be fully transparent about its costs.
In conclusion, absorption costing is a valuable tool for companies to use when determining the cost of their products. By taking into account all of the associated costs, businesses can more accurately price their goods and make sure they are turning a profit. While there are some drawbacks to this type of accounting, it remains the most common method used by businesses today.