Absorption Costing: An Overview
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 all the company's costs are absorbed by the company's products.
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 variable costs are considered for production. Overhead costs, such as rent and wages, are considered separately.
Some of the primary advantages of absorption costing are that it is in compliance with generally accepted accounting principles (GAAP), recognizes all costs involved in production (including fixed costs), and does a better job of accurately tracking profit during an accounting period.
- The main advantage of absorption costing is that it is in compliance with GAAP and does a better job of accurately tracking profits than variable costing.
- Absorption costing takes into account all production costs, unlike variable costing, where only variable costs are considered.
- Drawbacks include that it can skew the picture of a company's profitability, and is not helpful for analysis to improve operations or to compare product lines.
The disadvantages of using absorption costing include that it can skew the picture of a company's profitability. In addition, it is not particularly helpful for analysis designed to improve operational and financial efficiency, or for comparing product lines.
Advantages of Absorption Costing
These are some of the primary benefits of absorption costing:
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).
Accounts for All Production Costs
Absorption costing takes into account all of the costs of production, not just the direct costs, as variable costing does. 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 be helpful to company management in evaluating profitability and determining prices for products.
Tracks Profits More Accurately
Absorption costing also provides a company with a more accurate picture of profitability than variable costing if all of its products aren't sold during the same accounting period when they are manufactured. This can be especially important for a company that ramps up production well in advance of an anticipated seasonal increase in sales.
Disadvantages of Absorption Costing
Can Skew 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.
Doesn't Help Improve Operational Efficiency
Absorption costing fails to provide as good an analysis of cost and volume as variable costing does. If fixed costs are an especially large 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 Useful for Comparison of Product Lines
Variable costing is more useful than absorption costing if a company wishes to compare the potential profitability of different product lines. 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.