Absorption costing is the full costing method that considers variable and fixed overheads. It comes with several advantages as compared to the marginal costing method.
Absorption costing is a simple and less costly method as compared to the modern activity-based costing approach. However, it comes with limitations against other costing methods a well.
Let us discuss some key advantages and disadvantages of absorption costing as compared to other methods.
What is Absorption Costing and How Does it Work?
Absorption costing is a cost accounting approach that absorbs all direct costs. It accounts for all direct fixed and variable costs of producing products or services.
Absorption costing considers fixed overheads that marginal costing excludes from the total cost calculation. For that notion, it is also called total absorption cost or full cost method.
Some variable direct costs include:
- Cost of Raw Material
- Direct Labor costs
- Direct machine hours
- Other direct variable costs such as energy costs of running manufacturing machines
Some direct fixed overheads include:
- Depreciation of manufacturing machinery
- Insurance costs of machinery and plant
- Rent, insurance, and maintenance costs of the production facility building
Absorption costing will also include any other direct cost variable or fixed that can be directly attributed to the cost of goods sold (COGS).
Absorption costing is the conventional and standard costing method that is accepted under the US GAAP rules. Thus, all companies need to adopt this full costing method for reporting and compliance purposes.
Accounting for Overheads
Absorption costing includes both variable and fixed overheads into the total cost calculations. That distinguishes it from the marginal costing method.
Overheads can be calculated with the following approach.
Apportionment of Overheads
The first step is to allocate and apportion overheads to different products and services.
- Overheads should be allocated to specific departments, products, and services.
- Common and shared sources should be apportioned between different departments.
- Common overheads should be distributed fairly to different production departments.
Reapportionment and Adjustments
Some fixed overheads can be shared by several departments. Many departments offer services on a reciprocal basis to each other. Thus, in this step fixed overhead costs can be reapportioned or adjusted for sharing fairly between these service departments or cost centers.
Absorption of Overheads
After allocation, apportionment, and reapportionment, the costs should be absorbed using a suitable overhead absorption rate.
Overhead absorption can be done by using any one of the following measures:
- Units produced
- Machine hours
- Labor hours
- Percentage of direct wages
- Percentage of prime costs
Under or Over-Absorption of Overheads
A key differentiation of absorption costing against the marginal costing method is the adjustment for under or over-absorption of overheads.
If absorbed overheads are higher than the actual overheads, then there is an over-absorption. It is added back to the gross profit before reaching net profit per unit.
If absorbed overheads are lower than the actual overheads, then there is an under-absorption. It is deducted from the gross profit per unit.
Challenges with Total Absorption Costing
Absorption costing allocates fixed and variable overheads to the inventory for the calculation of total costs. It means the closing inventory costs that remain unsold will be much higher in absorption costing than other methods.
It also means that accounting manipulation can change the closing inventory levels and costs to adjust profits artificially. Absorption costing cannot detect that.
Another challenge for absorption costing is to calculate the net profits accurately. It spreads fixed overheads across all units produced regardless of the fact that units unsold do not generate sales.
It means higher closing inventory costs will generate higher net profits under absorption costing. That may not be the actual representation of the company’s profits and can lead to misinformed decisions.
Advantages of the Total Absorption Costing Vs Marginal Costing – TAC Vs MC
Despite a few challenges, the full costing method has some advantages as compared to the conventional marginal costing method.
The most obvious is the allocation of fixed overhead costs that marginal costing excludes. It offers a better product costing and pricing analysis to the management.
As compared to variable or marginal costing, the full costing method values closing inventory accurately. It accounts for all costs (fixed and variable overheads) to calculate the total product costs.
However, managers must be careful when interpreting the total costs as closing inventory may be overvalued in some cases.
Absorption costing also allows for the adjustments of over or under-absorption of overheads. It allows management more control over overhead cost allocations.
Compliance with the reporting standards is also an added advantage of absorption costing against the marginal costing method.
Limitations of Absorption Costing Vs Activity-Based Costing
Activity-Based Costing (ABC) is a modern costing method that allocates costs based on activities rather than costs per unit.
The ABC method considers production activities, cost drivers, and cost pools that lead to a more comprehensive costing analysis.
A basic limitation of absorption costing is that it excludes indirect product costs from the total cost calculation.
Customization and automation of production mean fewer labor hours and more machine hours. That also leads to more indirect overhead costs of production. Thus, excluding these costs from the total production costs can be risky.
Activity-based costing addresses this limitation of absorption costing by identifying activity drivers and cost pools. It means the ABC method offers precise costing and pricing information to the management than absorption costing.
As compared to the ABC method, absorption costing is a simpler method to implement though. Also, it is less expensive and does not require any sophisticated cost accounting skills as compared to the ABC method.
Pros and Cons of Absorption Costing
The absorption costing method comes with several advantages and disadvantages when compared to other costing approaches. As we discussed above, it offers more information than the traditional marginal costing but comes with some limitations against the ABC method.
Pros Explained
Full Production Costs
Absorption costing includes full costs of production; variable and fixed overheads. Hence, it is termed the full costing method. It means it offers better product costing information as compared to the marginal costing method.
Tracking Profits
As the full costing method accounts for all costs, it calculated the ending inventory costs higher than the marginal costing method. It becomes an advantage and disadvantage in certain situations.
If the company produces more units in anticipation of higher future demands, it can show higher profits on its income statement.
Less Complicated and Expensive
Another key advantage of the absorption costing method is its simplicity as compared to the modern costing methods such as the ABC method.
Also, the full costing method does not require sophisticated software or special skills. Thus, it is less costly and less complicated as compares to the ABC method.
Suitable for Businesses with Uniform Production Demand
Many businesses produce similar products in batches that do not require customization. Although these trends are diminishing, however, absorption costing is a suitable method for such production facilities.
Total cost absorption for these manufacturing facilities will be uniform. Hence, these facilities will absorb full production costs and generate higher profits due to economies of scale.
GAAP Compliance
Another key advantage of the absorption costing approach is that is compliant with the US GAAP rules. Any companies following marginal costing methods will have to report using absorption costing.
Cons Explained
Inaccurate Inventory and Profit Figures
Accounting for fixed overheads means ending inventory will be charged higher costs. If a large proportion of current inventory goes unsold, it may show unrealistic profits.
It also means accounting manipulations can distort periodic profits artificially. True profits should be realized when products are sold and not held at warehousing facilities.
Exclusion of Indirect Costs
As compared to the ABC approach that includes indirect production costs as well, the absorption costing method falls short here.
Indirect costs have become an increasingly important factor in the total production cost of products or services. Thus, absorption costing may not live up to the expectations of modern manufacturing facilities.
No Help in Operational Efficiency Decisions
Customized production and seasonal demand mean that production levels change all the time. Absorption costing does not provide control over operational efficiency in these situations.
Absorption costing fails to provide substantial information on changing costs and volumes in these circumstances as compared to other costing methods.
Not Suitable for Customized Production Facilities
As compared to the ABC method, it does not support the manufacturing facilities that have customized products. The ABC method allocates costs based on activities and cost drivers. Hence, absorption costing is not suitable for customized product manufacturing facilities.
No Help in Performance Evaluations
In terms of decision-making information and analysis, the absorption costing method offers little assistance.
Marginal costing can help identify product costing and pricing based on contribution per unit. The ABC method offers comprehensive information regarding product pricing, costing, customer profitability, and performance management.
Concluding Remarks
Absorption costing includes fixed overhead costs for calculations of the total product cost. It means its product costing is better than the traditional marginal costing method.
The absorption costing offers several benefits of simplicity, fewer costs, and fewer skills requirements for implementation. However, it comes with several disadvantages as compared to other costing methods such as a lack of support for decision-making, exclusion of indirect costs, etc.