Absorption Costing: Meaning, Advantages and Disadvantages

In this article we will discuss about Absorption Costing:- 1. Meaning of Absorption Costing 2. Ascertainment of Profit under Absorption Costing 3. Advantages 4. Disadvantages.

Meaning of Absorption Costing:

Absorption costing also known as ‘full costing’ is a conventional technique of ascertaining cost. It is the practice of charging all costs both variable and fixed to operations, processes and products. It is the oldest and widely used technique of ascertaining cost. Under this technique of costing, cost is made up of direct costs plus overhead costs absorbed on some suitable basis.

Under this technique, cost per unit remains same only when the level of output remains same. But when the level of output changes the cost per unit also changes because of the presence of fixed cost which remains constant.

The change in cost per unit with a change in the level of output in absorption costing technique poses a problem to the management in taking managerial decisions. Absorption costing is useful if there is only one product, there is no inventory and overhead recovery rate is based on normal capacity instead of actual level of activity.

Two distinguishing features of absorption costing are that fixed factory expenses are included in:

(i) Unit cost and

(ii) Inventory value.

Ascertainment of Profit under Absorption Costing:

Under this technique of costing the following proforma is used for the ascertainment of profit:

Income Statement

Income Statement

Illustration 1:

Following data relate to XYZ Company:

Normal capacity 40,000 units per month

Variable cost per unit Rs.6

Actual production 44, 000 units.

Sales 40,000 units @ Rs.15 per unit.

Fixed manufacturing overheads Rs.1,00,000 per month or Rs.2.50 per unit at normal capacity.

Other fixed expenses Rs.2,40,000 per month. Prepare Income Statement under absorption costing.

Solution:

Solution

Advantages of Absorption Costing:

Following are the main advantages of absorption costing:

1. It suitably recognises the importance of including fixed manufacturing costs in product cost determination and framing a suitable pricing policy. In fact all costs (fixed and variable) related to production should be charged to units manufactured. Price based on absorption costing ensures that all costs are covered. Prices are well regulated where full cost is the basis.

2. It will show correct profit calculation in case where production is done to have sales in future (e.g., seasonal sales) as compared to variable costing.

3. It helps to conform with accrual and matching concepts which require matching cost with revenue for a particular period.

4. It has been recognised by various bodies as FASB (USA), ASG (UK), ASB (India) for the purpose of preparing external reports and for valuation of inventory.

5. It avoids the separation of costs into fixed and variable elements which cannot be done easily and accurately.

6. It discloses inefficient or efficient utilisation of production resources by indicating under-absorption or over-absorption of factory overheads.

7. It helps to make the managers more responsible for the costs and services provided to their centres/departments due to correct allocation and apportionment of fixed factory overheads.

8. It helps to calculate gross profit and net profit separately in income statement.

Disadvantages of Absorption Costing:

Following are the main limitations of absorption costing:

1. Difficulty in Comparison and Control of Cost:

Absorption costing is dependent on level of output; so different unit costs are obtained for different levels of output. An increase in the volume of output normally results in reduced unit cost and a reduction in output results in an increased cost per unit due to the existence of fixed expenses. This makes comparison and control of cost difficult.

2. Not Helpful in Managerial Decisions:

Absorption costing is not very helpful in taking managerial decisions such as selection of suitable product mix, whether to buy or manufacture, whether to accept the export order or not, choice of alternatives, the minimum price to be fixed during the depression, number of units to be sold to earn a desired profit etc.

3. Cost Vitiated because of Fixed Cost included in Inventory Valuation:

In absorption costing, a portion of fixed cost is carried forward to the next period because closing stock is valued at cost of production which is inclusive of fixed cost.

4. Fixed Cost Inclusion in Cost not Justified:

Many accountants argue that fixed manufacturing, administration and selling and distribution overheads are period costs and do not produce future benefits and, therefore, should not be included in the cost of product.

5. Apportionment of Fixed Overheads by Arbitrary Methods:

The validity of product costs under this technique depends on correct apportionment of overhead costs. But in practice many overhead costs are apportioned by using arbitrary methods which ultimately make the product costs inaccurate and unreliable.

6. Not Helpful for Preparation of Flexible Budget:

In absorption costing no distinction is made between fixed and variable costs. It is not possible to prepare a flexible budget without making this distinction.

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