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What is Absorption Cost and what are its pros and cons?
Absorption cost is the total cost of manufacturing a product. It includes all types of costs associated right from the beginning and till the end of manufacturing a product. Labor, insurance, and costs of raw materials are included while calculating absorption costs. Companies also include overhead costs to calculate the final absorption cost.
There are differences between absorption and variable costs. Absorption cost considers all costs, such as overhead costs and costs of raw materials even if all the products are not sold at the end of the accounting period. Absorption costing being applied to accounting, inventory in the balance sheet goes up while the value of expenses goes down in the income statement.
Absorption Cost Vs Variable Cost
The main difference between absorption cost and variable costs lie in the treatment of fixed overhead costs. In absorption costing all overhead costs are calculated as per unit value even if products are not sold at the end of the accounting period.
In variable costing, fixed overhead costs are not calculated as per unit value. It is taken as a lump sum and kept in a separate line specifically on the income statement. The fixed overhead costs are divided into two parts in the case of absorption costing- the cost of goods and the cost of inventory.
Advantages of Absorption Costing
As the "cost of goods not sold" is included in absorption costing, the expenses in the income statement remain intact. Absorption costing shows more of fixed inventory rather than goods sold. This helps companies avoid excess costs in managing inventory.
Absorption costing accounting is a more accurate accounting system as it considers the total amount of inventory rather than only the values of goods sold. It reduces the value of expenses in the current accounting period in the income statement. So, in the case of absorption costing the bet income goes up in comparison to variable costing.
Disadvantages of Absorption Costing
Absorption costing results in unfavorable results while the prices of products are increased as fixed overhead costs are considered. Variable costing in such cases is more applicable as it does not consider the per-unit value of a good.
In the case of the application of absorption costing, net income goes up. As the unit fixed price of products goes down with increasing products, the net income goes down for the unsold products.
Absorption costing can lead to inflation in the pricing of products of a company as all fixed costs are not removed from the revenues earned till all the products of companies are sold.
Finally, absorption costing does not reflect the financial and operational efficiency of a company.
Example
Suppose a company selling pens produce 10,000 units in January. 5,000 of its products are sold by the end of January while the labor costs were $5. There are fixed overhead costs of $ 20,000 in the month. According to the absorption costing method, the company will assign $2 {20,000 / 10,000) in each product as a fixed overhead cost.
The absorption cost per unit is $5 + $2 = $7. As, 5,000 goods were sold, total value of goods sold is ($7 × 5,000) = $ 35,000. The ending inventory will be ($7 × 5,000) = $ 35,000 (i.e., $7 total cost per unit × 5,000 pens still in ending inventory).
Points to Note
Absorption cost is the total cost of production of a good.
Absorption cost considers fixed overhead costs on a per-unit basis.
The net income in absorption costing goes down due to unsold products.
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