What Is Absorption Costing?
It is one of the management accounting methods used to capture the costs associated with manufacturing a product. It captures various costs like cost of materials, labor, rent, and insurance cost—Accepted Accounting Principles (GAAP) mandate absorption costing external account reporting. Absorption costing allocates all the fixed heads of a particular unit produced in that period, unlike variable costing. They do not consider the sale of the product in the market. The expenses on the income statement are much lower due to the addition of the inventory cost.
Significance of Absorption Costing
It is a conventional method of costing. Absorption costing will charge both the fixed and variable costs of the project and is one of the widely used techniques for costing. It includes the overheads for all the processes and operations in an organization. In this absorption costing, the cost per unit of the goods manufactured will change with an increase or decrease in quantity due to consideration of overheads for the manufacturing process even though the fixed cost remains constant. In absorption costing, the cost of each cost center may be direct or indirect. However, direct expenses are obtained along with individual cost centers, and then there its values cannot be readily available to the cost Centre. This distribution of overheads along the Department is known as apportionment.
Advantages of Absorption Costing
One of the key benefits of this kind of costing is that the assets like inventory stay on the balance sheet at the end of the financial year. Since this absorption costing technique allocates overheads of both costs of goods sold along with the stock, the expenses amounting to items still in inventory will not be captured in the current period’s income statement, which is the most accurate accounting method for showing inventory as the expenses related to inventory management is reported as a total cost recovery. This results in the higher net income in this type of cost compared to that of variable costing calculations. If management is looking for internal increment pricing decisions, this costing may not be helpful as it considers the overheads.
Disadvantages of Absorption Costing
One of the disadvantages of absorption costing is that the output level depends on the number of units. Cost per unit also changes with the change in the number of units, which poses a problem to the management in making management decisions. It’s one of the traditional and widely used ways of cost. There is difficulty in comparing cost as costing is dependent on the level of output rather than the contract rate of the unit. There is always cost violation as inventory includes fixed cost, and hence, the value of the fixed price is not justified. Absorption costing may not be helpful preparation of annual budgets. There is no distinction between the fixed and variable costs, and it becomes difficult to prepare a flexible budget in a financial year.
In a nutshell, absorption costing covers all the costs of manufacturing the product, like the cost of materials, cost of labor, rent, and insurance cost. In this costing, all the overhead expenses of inventory are shown as expenses. It is one of the most accurate costing methods.