The main advantages of using absorption costing system are as follows:
- Absorption costing takes account of the fixed overheads that are involved in the manufacturing process and includes them into the cost of the product, which presents a more realistic cost of a product.
- Absorption Costing is the most suitable method for the purposes of preparation of accounts. This is the method which is acceptable under the Generally Accepted Accounting Principles(GAAP ). The main reason for this is that under absorption costing stock is not under-valued as it not only accounts for the directly attributable expenses (mostly variable) but also the fixed manufacturing overheads.
- Absorption costing shows a decreased cost of sales and increased revenues of the company than the marginal or variable costing especially when inventory levels are rising. As the formula to calculate the cost of sales is “Opening Stock + Purchases – Closing Stock”, the remaining stock at the end of the year under absorption costing has a higher value than reported under marginal costing.
- The absorption costing is the best way of costing 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 on a more realistic ‘selling price’ as well as profits.
- Absorption costing is a suitable method for businesses which have a constant demand for products. This not only makes the costing task simpler, easier and systematic for such businesses but also takes into account the effects of fluctuating turnover as the costs attached to the products are already absorbed into the products.
The main disadvantages of absorption costing are given below:
- Absorption Costing unlike Marginal Costing cannot be used as an effective monitoring tool to evaluate profitability of a company. This is because the absorption costing includes fixed costs in the cost of the product, which will be fixed irrespective of the output or production, while marginal costing is based on the contributions earned per unit which includes only the variable costs of the product.
- As the cost of the product is based on both the fixed costs as well as the variable costs, this method cannot be used for the purposes of management decision-making and/or planning further actions like forecasting, budgeting etc.
- Absorption costing can make the company’s performance look more desirable and good. This is because the fixed costs are included into the product cost directly and is not deducted from the revenues until the sale is realized and products are actually sold. So, this procedure can be used to manipulate company’s profitability status and increase chances of ‘creative accounting’ which could ultimately mislead the economic decisions of stakeholders, especially potential investors.
- Absorption costing makes it difficult to do cost volume profit (CVP) analysis, because with the addition of fixed costs the variations in the variable cost of the product becomes difficult to determine. It makes it difficult for the management of the company to assess the efficiency and effectiveness of operations of the business.
- The profits for a period are needed to be adjusted for under/over absorption of the fixed cost. This situation arises because the fixed overheads that are being absorbed into the cost of products are estimated, as original overheads are realized when actual fixed costs are incurred. This can make the calculation of profits complicated and difficult, especially when a company has too many products.