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18/10/2018 02:56:08 PM

Absorption Costing

Absorption costing is required under generally accepted accounting principles for financial statements distributed to external users. Under absorption costing, the cost of goods manufactured includes direct materials, direct labor, and factory overhead costs.

Both fixed and variable factory costs are included as part of factory overhead. In the financial statements, these costs are included in cost of goods sold (income statement) and inventory (balance sheet).

The reporting of income from operations under absorption costing is as follows:

Sales                                               $XXX

Cost of goods sold                           XXX

Gross profit                                      $XXX

Selling and administrative expenses XXX

Income from operations                    $XXX

The income statements illustrated in the preceding chapters of this text have used absorption costing.

Advantages

There are several advantages to using full costing. Its main advantage is that it is GAAP-compliant. It is required in preparing reports for financial statements and stock valuation purposes.

In addition, absorption costing takes into account all costs of production such as fixed costs of operation, factory rent, and cost of utilities in the factory. It includes direct costs such as direct materials or direct labor and indirect costs such as plant manager’s salary or property taxes. It can be useful in determining the selling price for products.

 

Disadvantages

Since absorption costing includes allocating fixed manufacturing overhead to the product cost, it is not useful for decision-making. Absorption costing provides a poor analysis of the costs for a product. Therefore, variable costing is used instead to help management make product decisions.

Absorption costing can skew a company’s profit level due to the fact that all fixed costs are not subtracted from revenue unless the products are sold. By allocating fixed costs into the cost of producing a product, the costs can be hidden from a company’s income statement. Hence, absorption costing can be used as an accounting trick to temporarily increase a company’s profitability by moving fixed manufacturing overhead costs from the income statement to the balance sheet.

 


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