Understanding the advantages and disadvantages of absorption costing will help you in preparing the income statement as well as valuing your inventory. Marginal costing and absorption costing methods are two major methods to present the income statement of your organization to determine the operating result. The operating result of a particular period using both methods may be different due to inventory valuation.
So, this article explains the meaning, advantages, and disadvantages absorption costing method.
Advantages and Disadvantages of Absorption Costing
What is Absorption Costing?
Absorption Costing is also known as the total costing method is a costing technique in which total costs, both fixed and variable costs are charged to the cost unit and total production overheads are charged based on the budgeted level of activity to determine the cost per unit. However, non-production overheads such as administrative expenses, selling and distribution expenses, and others are treated as period costs, therefore they are charged in the period in which they are incurred.
Absorption Costing Example
Let’s use the scenario below as an example of absorption costing. ABC ltd gives the standard cost of producing each unit of its product as follow:
|Variable manufacturing overheads||5|
|Fixed manufacturing overheads||10|
The company has a normal production capacity of 200,000 units, variable administrative costs of $1 per sales unit, and variable selling and distribution overheads of $1.5 per sales unit. The fixed administrative overhead and selling and distribution overheads of $600,000 and $400,000 respectively. The actual production and sales for 2021 are 190,000 units and 150,000 units respectively. The selling price is $50 and the income tax rate is 30%.
Using the full costing method, the income statement of ABC ltd will be prepared as thus:
Advantages of Absorption Costing
The advantages of absorption costing technique over marginal costing include:
Most Acceptable method of valuing inventory
Absorption costing is the most acceptable method of valuing inventory in the presentation of the income statement. GAAP and IFRS recommend using absorption costing for the inventory valuation. This is because it conforms with the matching and accruing concept of financial accounting which states that costs must match with revenue for an accounting period.
Most realistic Product cost
It provides the most realistic total cost of a product by including fixed manufacturing overheads in the cost of the product. The absorption costing includes all overheads incurred in the process of manufacturing products in the determination cost of the products. It makes the total costs of the product to be more realistic.
It avoids underpricing
It enhances quoting the appropriate price for the product by considering the total cost of production. Using marginal costing may lead to underpricing of a product if the product is valued at a cost lower than the total cost of production.
Suitable for External Reporting
Absorption costing is recognized by international financial reporting standards (IFRS) and Generally accepted accounting principles (GAAP) and others for the preparation and presentation of financial statements for external use.
It enhances accountability
The absorption costing enhances accountability of the managers of the various department to hold responsible for the costs of their departments. This is because the costing technique allocates fixed overheads to their respective departments or cost centers.
Disadvantages of Absorption costing
The limitations of the absorption costing technique include the following:
Inaccurate apportionment of Fixed overheads
The apportionment of fixed overheads to unit cost is very difficult to accurately determine, if not impossible. However, the total costing method involves arbitrary apportionment of fixed overheads which makes it to be inaccurate.
It is not suitable for management decisions
This method is not suitable when making management decisions such as optimal product mix, make or buy decisions, adding or deleting a segment, and others. It is not helpful to decision-making because of the inclusion of fixed costs.
It is not suitable for measuring profitability
Absorption costing is not an effective tool for measuring the profitability of a product because of the inclusion of fixed production overheads in the valuation of inventory. Since inventory is valued at the total cost, managers can use inventory to inflate the profit for the period.
It is not suitable for cost control
It is not an effective tool for cost control. Since the total costs include fixed costs incurred by the departments, it is not practically effective for holding managers accountable for the costs of their departments over which they don’t have total control.
The advantages of absorption costing such as general acceptability, realistic product costs, accountability, and others cannot be overlooked. However, Limitations of the absorption costing technique must also be considered. The major difference between absorption costing and marginal costing techniques is the valuation of inventory. If you need our assistance on management-related tasks or assignments, CONTACT US.
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Afeez is one of the founding partners of Marasas Consulting limited. He consults for both individuals and entities in the area of accounting, management, audit, tax, and investment. He has a wide range of experience both online and offline which allows him to provide relevant and timely professional advice and assistance to business owners with their accounting, tax, management, audit, and investment plans.
Afeez is a member of the Institute of Chartered Accountants of Nigeria (ICAN) and a member of the Nigerian Institute of Management (Chartered). He is a certified Google analyst and strategist. He earned his Bachelor degree in Management and Accounting from Obafemi Awolowo University, Ile-Ife, Nigeria, and earned an ordinary national diploma in Accountancy from The Polytechnic of Ibadan, Oyo State, Nigeria. He earned certification in “Excel Crash Course” and “Reading of Financial Statement” from Corporate Finance Institute, Canada.
Afeez is dedicated to helping clients achieve business success by helping them to establish solid and sound accounting, tax, and financial processes.