As the name suggests, absorption costing is the method of costing in which the entire cost of manufacturing a product or providing a service is absorbed in it. In contrast to the variable costing (Activity based costing) method, it includes both fixed and variable costs for absorption in addition to the direct costs. As all the costs incurred are absorbed, this method is also sometimes referred to as Full absorption costing or Total absorption costing (TAC).
Variable costing is generally used for the managerial decision making whereas as per the Generally Accepted Accounting Principles (GAAP), an organization is bound to use the absorption costing method for financial reporting purposes.
Advantages and Disadvantages of Absorption Costing System
Advantages of Absorption Costing System
1. Absorption costing recognizes fixed costs in product cost. As it is suitable for determining price of the product. The pricing based on absorption costing ensures that all costs are covered.
2. Absorption costing will show correct profit calculation than variable costing in a situation where production is done to have sales in future (e.g. seasonal production and seasonal sales).
3. Absorption costing conforms with accrual and matching accounting concepts which requires matching costs with revenue for a particular accounting period.
4. Absorption costing has been recognized for the purpose of preparing external reports and for stock valuation purposes.
5. Absorption costing avoids the separating of costs into fixed and variable elements.
6. The allocation and apportionment of fixed factory overheads to cost centers makes manager more aware and responsible for the cost and services provided to others.
Disadvantages of Absorption Costing System
1. Absorption costing is not useful for decision making. It considers fixed manufacturing overhead as product cost which increase the cost of output. As a result, it does not help in accepting specially offered price for the product. Various types of managerial problems relating to decision making can be solved only with the help of variable costing system.
2. Absorption costing is not helpful in control of cost and planning and control functions. It is not useful in fixing the responsibility for incurrence of costs. It is not practical to hold a manager accountable for costs over which he/she has not control.
3. Some current product costs can be removed from the income statement by producing for inventory. As such, managers who are evaluated on the basis of operating income can temporarily improve profitability by increasing production.