Absorption costing, also known as full costing, is a costing method where all costs of production are assigned to the product. This includes both variable costs (like raw materials and direct labour) and fixed manufacturing overheads (like rent, depreciation, and salaries of production supervisors).
It is the standard costing method used for external financial reporting as per accounting principles like GAAP and IFRS.
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Basic Characteristics of Absorption Costing
1. All Production Costs Included: It includes both fixed and variable manufacturing costs in product cost.
2. Cost Allocation: Overheads are allocated based on a predetermined absorption rate (e.g., per machine hour or labour hour).
3. Inventory Valuation: Closing stock includes a share of fixed manufacturing costs, making inventory valuation higher than marginal costing.
4. Profit Measurement: Profit varies with changes in inventory levels, since fixed costs are allocated to unsold stock.
5. Focus on Production: Only costs related to production are absorbed, not selling or administrative expenses.
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Advantages of Absorption Costing
1. Complies with Financial Reporting Standards: Required under GAAP/IFRS for reporting financial statements.
2. Accurate Inventory Valuation: Provides a more comprehensive view by including fixed production costs.
3. Profit Realization: Spreads fixed costs over units, reducing per-unit cost at higher production levels.
4. Better Cost Control: Helps in analysing total production cost.
5. Useful in Long-Term Pricing: Incorporates all costs, making it better for setting long-term price policies.
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Limitations of Absorption Costing
1. Inventory-Level Profit Variation: Higher inventory inflates profits since fixed costs are carried forward in closing stock.
2. Complex Overhead Allocation: Requires allocation bases which may not always be precise.
3. Less Useful for Decision-Making: Doesn’t highlight variable vs fixed costs, which are essential in decisions like make-or-buy.
4. May Encourage Overproduction: To show higher profits by increasing inventory and deferring fixed costs.
5. Not Ideal for Short-Term Decisions: Doesn’t clearly show contribution margin for evaluating short-run profitability.
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Applications of Absorption Costing
1. External Financial Reporting: Used in preparing profit and loss statements, balance sheets under accounting norms.
2. Inventory Valuation: Helps in valuing closing stock for financial reporting.
3. Budgeting and Planning: Total cost data assists in preparing realistic budgets.
4. Pricing of Products: Used in industries where long-term pricing strategies must cover all incurred costs.
5. Performance Evaluation: Offers insights into departmental efficiency based on full cost usage.
6. Tax Reporting: Required for cost determination in taxation in many jurisdictions.
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Conclusion
Absorption costing is a foundational method in financial accounting and reporting, offering a complete view of product cost by including fixed overheads. While it's excellent for long-term planning and compliance, it is less suited for short-term internal decision-making compared to marginal costing.
