Absorption costing is a method for accumulating the costs associated with a production process and apportioning them to individual products. This type of costing is required by the accounting standards to create an inventory valuation that is stated in an organization’s balance sheet. A product may absorb a broad range of fixed and variable costs. These costs are not recognized as expenses in the month when an entity pays for them. Instead, they remain in inventory as an asset until such time as the inventory is sold; at that point, they are charged to the cost of goods sold.
Absorption Costing Components
The key costs assigned to products under an absorption costing system are:
- Direct materials: Those materials that are included in a finished product.
- Direct labor: The factory labor costs required to construct a product.
- Variable manufacturing overhead: The costs to operate a manufacturing facility, which vary with production volume: Examples are supplies and electricity for production equipment.
- Fixed manufacturing overhead. The costs to operate a manufacturing facility, which do not vary with production volume. Examples are rent and insurance.
It is possible to use activity-based costing (ABC) to allocate overhead costs for inventory valuation purposes under the absorption costing methodology. However, ABC is a time-consuming and expensive system to implement and maintain, and so is not very cost-effective when all you want to do is allocate costs to be in accordance with GAAP or IFRS.
You should charge sales and administrative costs to expense in the period incurred; do not assign them to inventory, since these items are not related to goods produced, but rather to the period in which they were incurred.
Absorption Costing Steps
The steps required to complete a periodic assignment of costs to produced goods is:
- Assign costs to cost pools: This is comprised of a standard set of accounts that are always included in cost pools, and which should rarely be changed.
- Calculate usage: Determine the amount of usage of whatever activity measure is used to assign overhead costs, such as machine hours or direct labor hours used.
- Assign costs: Divide the usage measure into the total costs in the cost pools to arrive at the allocation rate per unit of activity, and assign overhead costs to produced goods based on this usage rate.
Absorbed overhead is manufacturing overhead that has been applied to products or other cost objects. Overhead is usually applied based on a predetermined overhead allocation rate. Overhead is over absorbed when the amount allocated to a product or other cost object is higher than the actual amount of overhead, while the amount is under absorbed when the amount allocated is lower than the actual amount of overhead.
For example, Theintactone Corporation budgets for a monthly manufacturing overhead cost of $100,000, which it plans to apply to its planned monthly production volume of 50,000 widgets at the rate of $2 per widget. In January, Theintactone only produced 45,000 widgets, so it allocated just $90,000. The actual amount of manufacturing overhead that the company incurred in that month was $98,000. Therefore, Theintactone experienced $8,000 of underabsorbed overhead.
In February, Theintactone produced 60,000 widgets, so it allocated $120,000 of overhead. The actual amount of manufacturing overhead that the company incurred in that month was $109,000. Therefore, Theintactone experienced $11,000 of overabsorbed overhead.
Absorption Costing Problems
Since absorption costing requires the allocation of what may be a considerable amount of overhead costs to products, a large proportion of a product’s costs may not be directly traceable to the product. Direct costing or constraint analysis do not require the allocation of overhead to a product, and so may be more useful than absorption costing for incremental pricing decisions where you are more concerned with only the costs required to build the next incremental unit of product.
It is also possible that an entity could generate extra profits simply by manufacturing more products that it does not sell. This situation arises because absorption costing requires fixed manufacturing overhead to be allocated to the total number of units produced – if some of those units are not subsequently sold, then the fixed overhead costs assigned to the excess units are never charged to expense, thereby resulting in increased profits. A manager could falsely authorize excess production to create these extra profits, but it burdens the entity with potentially obsolete inventory, and also requires the investment of working capital in the extra inventory.
Advantages of Absorption Costing:
- It suitably recognises the importance of including fixed manufacturing costs in product cost determination and framing a suitable pricing policy. In fact all costs (fixed and variable) related to production should be charged to units manufactured. Price based on absorption costing ensures that all costs are covered. Prices are well regulated where full cost is the basis.
- It will show correct profit calculation in case where production is done to have sales in future (e.g., seasonal sales) as compared to variable costing.
- It helps to conform with accrual and matching concepts which require matching cost with revenue for a particular period.
- It has been recognised by various bodies as FASB (USA), ASG (UK), ASB (India) for the purpose of preparing external reports and for valuation of inventory.
- It avoids the separation of costs into fixed and variable elements which cannot be done easily and accurately.
- It discloses inefficient or efficient utilisation of production resources by indicating under-absorption or over-absorption of factory overheads.
- It helps to make the managers more responsible for the costs and services provided to their centres/departments due to correct allocation and apportionment of fixed factory overheads.
- It helps to calculate gross profit and net profit separately in income statement.
Disadvantages of Absorption Costing:
- Difficulty in Comparison and Control of Cost:
Absorption costing is dependent on level of output; so different unit costs are obtained for different levels of output. An increase in the volume of output normally results in reduced unit cost and a reduction in output results in an increased cost per unit due to the existence of fixed expenses. This makes comparison and control of cost difficult.
- Not Helpful in Managerial Decisions:
Absorption costing is not very helpful in taking managerial decisions such as selection of suitable product mix, whether to buy or manufacture, whether to accept the export order or not, choice of alternatives, the minimum price to be fixed during the depression, number of units to be sold to earn a desired profit etc.
- Cost Vitiated because of Fixed Cost included in Inventory Valuation:
In absorption costing, a portion of fixed cost is carried forward to the next period because closing stock is valued at cost of production which is inclusive of fixed cost.
- Fixed Cost Inclusion in Cost not Justified:
Many accountants argue that fixed manufacturing, administration and selling and distribution overheads are period costs and do not produce future benefits and, therefore, should not be included in the cost of product.
- Apportionment of Fixed Overheads by Arbitrary Methods:
The validity of product costs under this technique depends on correct apportionment of overhead costs. But in practice many overhead costs are apportioned by using arbitrary methods which ultimately make the product costs inaccurate and unreliable.
- Not Helpful for Preparation of Flexible Budget:
In absorption costing no distinction is made between fixed and variable costs. It is not possible to prepare a flexible budget without making this distinction.