What is Absorption Costing? – Master of Accounting Degrees

Absorption costing, or AC. is a financial system that lives up to its name very well. AC is the system in which the manufacturing costs of the product are piled up and then spread out onto the final products according to the total costs of what went into making them. They are not usually recognized in the monthly expenses as long as a specific entity is paying for them. Instead, they are usually considered to be assets of the inventory until that inventory is sold. At that point, the charge is equivalent only to the goods that were sold. The costs can vary or be fixed depending on how they pile up. AC acts as a major regulator to the former. It covers direct costs such as that of the materials. It also covers indirect costs, such as overhead costs.

An Example of AC

Let’s say that AT&T was using absorption costing in full when cell phones first became domesticized in the early 2000s. The materials included in the inventory would have been the workers’ pay, the materials included to make the phones as well as the fixed and manufacturing overheads. The materials, the workers’ pay and the manufacturing overhead are considered to be the variable costs.

Variable costing has been known to cause some major issues. It brings much less value to the inventory. This often results in problems when trying to determine the true production costs. Variable costs do not cover anything that is fixed, such as utilities or workers’ salaries. If the management goes by the variable costs only, the product’s sale price will be too low. This results in a partial loss of profit.

Advantages and Disadvantages of AC

One advantage of AC is that it takes all costs into account. When management uses the AC in combination with the variable costing, the price is more accurate. This means that the company is much more likely to make the profit that it deserves. Other advantages of AC include that it regulates fluctuating and marginal costing. Fluctuating net profits bring about uncertainty. Marginal costing brings variation into fixed costs, which can distort the product’s stock value. AC works to ensure that most such profit losses are prevented.

AC does come with a couple of disadvantages. Since it emphasizes both fixed and variable costs, it is not considered to be effective for planning, decision-making and control. AC also does not include the exact cost volume. As a result, the management is often left to make their decisions on a hunch rather than on weighing the cost options. Ideally, such a hunch is based on all of the costs listed in the inventory.

Conclusion

Absorption costing is an overall effective way of determining all of the costs that go into the manufacturing process. It helps to prevent profit losses and, in the long run, companies from going out of business. Simply put, very few businesses would be likely to last for very long without AC.