Absorption Costing - Explained
What is Absorption Costing?
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Table of ContentsWhat is Absorption Costing?Absorption Costing vs. Variable CostingAdvantages of Absorption CostingDisadvantages of Absorption CostingAcademics Research on Absorption Costing
What is Absorption Costing?
Absorption costing is a costing method in which all costs attributed to the production of a product are estimated. This costing method entails a full estimation of total expenses incurred in manufacturing a product. Direct costs such as costs of procuring raw materials, labor wages and indirect costs such as costs of acquiring a facility, utility costs and others are calculated in absorption costing. The absorption costing method accumulates all costs of a finished product including overhead costs and direct costs. Expenses estimated under the absorption costing method are necessary for external accounting or reporting purposes. They are also required for GAAP.
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Absorption Costing vs. Variable Costing
Absorption costing and variable costing are two distinct methods of assigning costs to the production of goods and services. In the case of variable costing, all the fixed overhead costs are excluded when calculating the product cost of a manufactured good. Absorption costing on the other hand, allocates fixed overhead costs across units of production manufactured at a given time. Included in the calculation of cost when using the absorption costing method are fixed costs but variable costing only include variable costs. Also, per-unit cost of products is not determined by variable costing, it is determined by absorption costing.
Advantages of Absorption Costing
The use of the absorption costing method comes with a lot of benefits. The major benefits of this costing method include;
- Absorption costing method reflects fixed costs that are attributable to the production of goods and services. It identifies the necessity of fixed costs when estimating costs involved in production.
- It is a more accurate costing method when compared to other traditional costing methods and even its counterpart; variable costing.
- Absorption costing also account for the expenses of unsold products, this is important for external reporting as required by GAAP.
- This method achieves a better and higher net income estimation. This is because it helps to achieve less fluctuation in net profits.
Disadvantages of Absorption Costing
Despite the good benefits that companies can derive from using the absorption costing method, it has some disadvantages. The major dark sides of this costing method include the fact that it results in the increase of net income. Because this method accounts for fixed costs, the higher the goods produced at a time, the lesser the fixed costs that will be attributable to the production of the goods, which in turn causes the net income to increase. Hence, the fixed costs accounted for in this method is less favorable compared to variable costing. Another disadvantage of absorption costing is that cost volume profit (CVP) is difficult to analyze when it is being used.
Academics Research on Absorption Costing
- Strategic transfer pricing, absorption costing, and observability, Gx, R. F. (2000). Management Accounting Research, 11(3), 327-348. This article investigates the use of transfer pricing as a strategic device in divisionalized firms that face duopolistic price competition. It finds out that when transfer prices are observable, firms' headquarters charge a transfer price above the marginal cost of the intermediate product to induce their marketing managers to behave as the softer competitors in the final product market.
- Breakeven Analysis under Absorption Costing, Solomons, D. (1968). The Accounting Review, 43(3), 447-452. This paper attempts to clarify the assumptions that underlie the classical breakeven chart and specifically to adapt the breakeven chart to a situation in which absorption costing is being used. It suggests that it is essential to recognize that in its usual form, breakeven analysis is based on a direct costing approach to cost behavior that is not universally accepted.
- Direct, Relevant or Absorption Costing?, Staubus, G. J. (1963). The Accounting Review, 38(1), 64. This article presents direct costing as a product costing and inventory valuation technique that is unsatisfactory on three grounds. These grounds include the weakness of historical cost as a basis of asset valuation, the lack of foundation for the fixed cost assumption and lastly the failure of direct costing to differentiate between wastage and utilization of productive capacity during a reporting period.
- The conceptual foundations of absorption costing, Fekrat, M. A. (1972). The Accounting Review, 47(2), 351-355. This paper explains that the critical point to the controversy over absorption and direct costing is the relationship of a fixed burden to the definition of an asset. It also shows that even though this conclusion is sound and irrefutable, it has been advanced for reasons that are not systematically related to micro theory. [PDF]
- An improved methodology for absorption costing: efficiency based absorption costing (EBAC), Benjamin, S. J., Muthaiyah, S., & Marathamuthu, M. S. (2009). Journal of Applied Business Research, 25(6), 87. This article discusses an improved, efficiency-based absorption costing (EBAC) method. EBAC represents an algorithm that absorbs costs based on efficiency as the main driver and its results are compared with other methods such as ABC to prove its efficiency. EBAC results in significant cost changes compared to ABC and the traditional costing system.