Absorption Costing: Advantages and Disadvantages

GAAP Compliant and Accurate, but It May Be Misleading

What Is Absorption Costing?

Companies must choose between absorption costing or variable costing in their accounting systems, and there are advantages and disadvantages to either choice. Absorption costing, or full absorption costing, captures all of the manufacturing or production costs, such as direct materials, direct labor, rent, and insurance.

Variable costing, on the other hand, includes all of the variable direct costs in the cost of goods sold (COGS) but excludes direct, fixed overhead costs. Absorption costing is required by generally accepted accounting principles (GAAP) for external reporting.

Key Takeaways:

  • The main advantage of absorption costing is that it complies with GAAP and more accurately tracks profits than variable costing.
  • Absorption costing takes into account all production costs, unlike variable costing, which only considers variable costs.
  • The drawbacks to absorption costing are that it can skew the picture of a company's profitability and does not help improve operations or compare product lines.

Understanding Absorption Costing

A company's management can choose to view costs in different ways. Firms that use absorption costing choose to allocate all costs to production. The term "absorption costing" means that the company's products absorb all the company's costs.

Even if a company chooses to use variable costing for in-house accounting purposes, it still has to calculate absorption costing to file taxes and issue other official reports.

Under variable costing, the other option for costing, only the variable production costs are considered. Overhead costs, such as rent and wages, are treated separately.

Advantages of Absorption Costing

Some of the primary advantages of absorption costing are that it complies with generally accepted accounting principles (GAAP), recognizes all costs involved in production (including fixed costs), and more accurately tracks profit during an accounting period.

GAAP Compliance

One of the main advantages of choosing to use absorption costing is that it is GAAP compliant and required for reporting to the Internal Revenue Service (IRS).

Accounting for All Production Costs

Absorption costing takes into account all of the costs of production, not just the direct costs as is the case with variable costing. Absorption costing includes a company's fixed costs of operation, such as salaries, facility rental, and utility bills. Having a more complete picture of cost per unit for a product line can help company management evaluate profitability and determine prices for products.

Tracking Profits

Absorption costing also provides a company with a more accurate picture of profitability than variable costing, particularly if all of its products are not sold during the same accounting period as their manufacture. This is significant if a company ramps up production in advance of an anticipated seasonal increase in sales.

Disadvantages of Absorption Costing

The disadvantages of absorption costing are that it can skew the picture of a company's profitability. In addition, it is not helpful for analysis designed to improve operational and financial efficiency, or for comparing product lines.

Skewed Profit and Loss

Absorption costing can cause a company's profit level to appear better than it actually is during a given accounting period. This is because all fixed costs are not deducted from revenues unless all of the company's manufactured products are sold. In addition to skewing a profit and loss statement, this can potentially mislead both company management and investors.

No Influence on Operational Efficiency

Absorption costing fails to provide as good an analysis of cost and volume as variable costing. If fixed costs are a substantial part of total production costs, it is difficult to determine variations in costs that occur at different production levels. This makes it more difficult for management to make the best decisions for operational efficiency.

Not Suited to Product Line Comparison

Variable costing is more useful than absorption costing if a company wishes to compare different product lines' potential profitability. It is easier to discern the differences in profits from producing one item over another by looking solely at the variable costs directly related to production.

Article Sources
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  1. Internal Revenue Service. "Part 4. Examining Process—Chapter 43. Retail Industry —Section 1. Retail Industry."

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