Meaning and definition of Absorption Costing
Absorption costing, also known as full absorption costing, can be defined as a managerial accounting cost method of expensing all costs related to manufacturing of a specific product. The absorption costing method involves the use of total direct costs and overhead costs related to the manufacturing of a product as the cost base. Besides, absorption costing is also required by the Generally Accepted Accounting Principles (GAAP).
As presented by Investopedia, some of the direct costs related to manufacturing a product consist of wages for workers involved physically in manufacturing a product, the raw materials involved in production, as well as the overhead costs, like utility costs. Moreover, absorption costing counts anything that is a direct cost in production of goods. Besides, absorption costing is promoted by the advocates for the future benefits provided.
Absorption costing is, therefore, different from the other costing methods as it takes into account fixed manufacturing overhead (counting expenses like factory rent, utilities, amortization). It is, moreover, difficult to factor in the fixed manufacturing overhead expenses into computing the per unit price of goods, which are not accounted for by oother methods like Variable costing.
Advantages and disadvantages of Absorption Costing
The key advantages of absorption costing include:
- It identifies the importance of fixed costs involved in production.
- The absorption costing method is accepted by Inland Revenue as stock is not undervalued.
- The absorption costing method is always used for preparing financial accounts.
- The absorption costing method shows less fluctuation in net profits in case of constant production but fluctuating sales.
- Contrasting marginal costing which involves fixed cost changing into variable cost, it is cost into the stock value thus distorting the stock valuation.
The main drawbacks of Absorption Costing include:
- Since absorption costing emphasized on total cost that is to say both variable as well as fixed, it is not useful for management to use to make decision, control, and planning.
- Besides, since the manager emphasizes on the total cost, the cost volume profit relationship is ignored. The manager, therefore, needs to use his intuition for decision making.