Absorption costing is in essence a managerial accounting method for calculating the costs pertaining the manufacturing of products. Absorption costing makes use of overhead costs and total direct costs required in manufacturing products. Absorption counting is often compared with director variable costing, in which the fixed overhead costs of manufacturing are not assigned or allocated to, or not absorbed by in other words, by the manufactured products. Hence, variable costing is often touted to be a useful method for decision making by the management. Nevertheless, absorption costing is considered to be necessary for income tax reporting as well as for external financial reporting.
Firms often juggle between variable costing and absorption costing for managing their accounting systems. There are certain benefits and demerits involved in this method. Merits include absorption costing method taking in consideration all necessary costs involved in products such as fixed costs. It precisely tracks the profit margins over the long-term and it is acceptable with GAAP regulations. Demerits include absorption costing being an unviable method for improving operational costs and efficiency. Moreover, it is an inefficient method for product comparison as it is an ineffective tool for measuring the profitability of a company. Absorption cost essentially means that all costs of the company are absorbed by its manufactured products.
It also takes into consideration production costs, direct costs and variable costs. It calculates salaries, utility bills and facility rental amounts. It can assist a company in mitigating costs and ensure the profitability curve. The primary benefit of selecting absorption costing is that it is well complaint with GAAP regulations. Absorption costing is mostly required for taxation purposes as well as filing official reports, regardless of its inefficiency in various departments. Additionally, absorption costing generates an accurate profitability curve of a company in question. This is fundamentally important for a firm working tightly side by side with seasonal production and ramping up sales correspondingly.
As observed, absorption costing results in a hypothetical flow of company profits with prospective signs in the future, which is falsified. Reason being, fixed costs are not subtracted from revenues until all the inventory is sold from shelves. More so, it assists in portraying a skewed profit-loss statement, which can represent and misinform investors and managers alike.
For comparison of profits, variable costing method is advised which generates conclusive results. By observing the profit differences associated with production costs side by side, net revenue can be determined, facilitated by variable costs. Moreover, absorption costing is an inefficient tool for calculating volume and cost as variable costing facilitates. It is tough to estimate costs averaging at various production levels. As a result, it renders long-term decision making quite cumbersome for managers.