DEFINITION OF ABSORPTION COSTING AND ITS ADVANTAGES & DISADVANTAGES

Absorption costing is a costing method that includes all manufacturing costs — direct materials, direct labor and both variable and fixed manufacturing overhead in the cost of a unit of product. Absorption costing is also referred to as the full cost method. Because absorption costing includes all cost of production as product costs.

Absorption costing is a tool that helps to determine the end-to-end cost of producing a service or a product. It offers an accurate view of the costs that occur to produce an inventory. It includes variable and fixed costs that are needed for manufacturing a product.

It is a conventional costing which is required for both external financial reporting and tax reporting. In the case of absorption costing, the cost of production will be as follows:-

Cost of production = Direct material + Direct labor + Direct expense + variable factory overhead + Fixed factory overhead

Absorption costing treats all manufacturing costs as product costs, regardless of whether they are variable or fixed.

Advantages of Absorption Costing

• The absorption costing method complies with GAAP and is recognized by ASB in India, ASG in the United Kingdom and FASB in the United States of America for preparing external reports.
• It is in tandem with matching accounting concepts that makes it necessary to match costs with revenues for a specific accounting period.
• It is now easy to calculate net and gross profits separately in the income statement
• The technique recognizes fixed costs, and thus the pricing ensures all the costs are covered
• Absorption costing helps a firm to calculate and showcase the actual profit calculation even during seasonal sales and production
• The allocation of fixed factory overheads to cost centers makes management aware of the cost
• It is a recognized and accepted accounting tool for stock valuation and preparing external reports
• You do not need to separate the costs into variable and fixed if you have adopted the absorption costing method
• The absorption method shows efficient as well as inefficient utilization of resources by indicating over-absorption or under-absorption of factory overheads.
• The stock is not undervalued if you use the absorption costing process
• This accounting tool is used in preparing the valuation of inventory
• The managers are more aware and responsible because of this process

Disadvantages of Absorption Costing

1. In absorption costing fixed factory overhead is allowed on production based on a pre-determined rate, But it is not easy to determine the accurate denominator volume to determine the rate, So, cost allocution becomes difficult,
2. Absorption costing does not produce information on contribution margin, As a result, it cannot assist in various
3. Cost control and cost comparison become difficult.
4. The cost volume profit relationship is not taken into account as the manager has put his onus on the total cost
5. It is a matter of debate between accountants that fixed costs are period costs. They do not have any future advantages and hence should not be added to the cost of inventory and product
6. The mangers can show inflated profit and not the real one as he can easily increase the operating income of a particular period by boosting the production even if there is no actual demand for that product.