Advantages of absorption costing approach:
The main advantages of using an absorption costing system are as follows:
- Absorption costing takes account of the fixed overhead involved in the manufacturing process and includes them in the cost of the product, which presents a more realistic cost of production.
- Absorption costing is the most suitable method of preparing accounts and is acceptable under generally accepted accounting principles (GAAP). The reason is that, under absorption costing approach, the stock is not undervalued as it not only accounts for directly attributable expenses but also the fixed manufacturing overhead.
- Absorption costing shows a decreased cost of sales and increased revenues for the company compared to the marginal or variable costing approach, especially when inventory levels are rising. The remaining stock at the end of the period under this costing method has a higher value than reported under marginal costing.
- Absorption costing is the best way of valuing inventories and computing the cost of goods sold for smaller companies. Adoption of absorption costing makes calculations easier for small businesses, as it is unlikely that these entities have a lot of products. Additionally, it makes these businesses able to absorb fixed costs in advance and sell their products at a more realistic selling price and increase profits.
- Absorption costing is suitable for businesses that have a constant demand for their products. As all production costs are already absorbed by the output, absorption costing not only makes the costing task simpler, easy and more systematic but also takes into account the effect of fluctuation in turnover.
Disadvantages of absorption costing approach:
The main disadvantages of absorption costing are given below:
- Absorption costing includes fixed manufacturing overhead in the unit product cost, which remains fixed irrespective of the quantum of output achieved during the period. Variable costing, on the other hand, considers only variable manufacturing costs to determine the unit product cost and focuses on the contribution made per unit of output. Therefore, unlike variable costing, absorption costing cannot be directly used as a monitoring tool to evaluate output and profitability performance.
- As the cost of a product is based on both fixed and variable manufacturing costs, absorption costing cannot be used for management decisions and/or planning further actions like forecasting, budgeting, etc.
- Absorption costing can make a company’s performance look more desirable and good. This is because the fixed manufacturing overhead cost is included in the product cost directly and is not deducted from the revenue until the products are actually sold and sales are realized. So, this procedure can be used to manipulate a company’s profitability status and increase the chances of creative accounting, which could ultimately mislead the economic decisions of attached parties and stakeholders, especially potential investors.
- Absorption costing is not best suited for cost volume profit (CVP) analysis because, with the addition of fixed manufacturing overhead, the variations in cost at different levels of output become difficult to determine. Hence, it becomes difficult for the management to truly assess the efficiency and effectiveness of business operations.
- Under absorption costing, the manufacturing overhead cost is charged to work in process using a predetermined overhead rate. This rate is often based on estimated data because the actual overheads can’t be known and recorded until they are actually incurred by the company. Therefore, the profit for a period needs to be adjusted for under or over absorption of manufacturing overhead. This can make the calculation of profits complicated, especially when a company has too many products.
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