 |
| Image: Moneybestpal.com |
Absorption costing is a method of accounting for the costs of production. Allocating fixed and variable costs to the goods or services that are sold is a part of it. To put it another way, whether they are direct or indirect, all costs are treated as product costs in absorption costing.
Also known as full costing or full absorption costing, absorption costing is a costing method. It is predicated on the notion that each good or service ought to cover a reasonable portion of the expenses associated with running the company. For the purpose of preparing financial statements or tax returns, absorption costing is frequently employed.
Absorption costing has the benefit of revealing the true profitability of each good or service. Absorption costing represents the entire resources used by any good or service by incorporating all costs in the product cost. Managers may be better able to decide on price, product mix, and profitability as a result of this.
Absorption costing also complies with internationally recognized financial reporting standards (IFRS) and generally accepted accounting principles (GAAP) (IFRS). These guidelines call for absorption costing in order to ensure that all costs are matched with the revenues they produce for external reporting purposes.
Absorption costing, however, also has significant drawbacks. One of them is that it may impair managers' and business units' performance. Absorption costing might encourage managers to produce more or less than necessary since it includes fixed costs in the price of the product. In the short run, overproduction may increase earnings, but it can also increase inventory levels and reduce cash flow. The short-term effects of underproduction may include decreased profitability, but they may also include lower inventory levels and higher cash flows.
The ability to hide cost behavior is another drawback of absorption costing. Absorption costing does not differentiate between fixed and variable costs since it treats all costs as product costs. Due to this, it may be challenging to determine how costs alter as activity or sales volume changes. Absorption costing can also mask manufacturing inefficiencies or underutilized capacity.
Although absorption costing is a valuable technique for tracking manufacturing costs, it also has certain drawbacks. For internal decision-making and performance evaluation, managers should be aware of these limits and use other techniques such as variable costing or activity-based costing.
