The Evolution of Absorption Costing: A Dynamic Journey From Past to Present

Learn about absorption costing, a method used to allocate both variable and fixed manufacturing costs to units of production. Explore the advantages and disadvantages of absorption costing and how it differs from other costing methods. Gain insight into how absorption costing impacts pricing decisions and helps understand a company's true production costs.

What is Absorption Costing?

Absorption costing is an accounting method used by companies to allocate both variable and fixed manufacturing costs to products. It is also known as full costing or full absorption costing. This method makes sure that all costs, both direct and indirect, are included in the cost of producing a product.

The Principle Behind Absorption Costing

The principle behind absorption costing is to allocate costs to inventory manufactured during the accounting period. It involves classifying all production costs, such as direct labor, direct materials, and overhead costs, as product costs and including them in the inventory valuation.

How Absorption Costing Works

Under absorption costing, direct costs, like direct labor and direct material costs, and indirect costs, like manufacturing overhead, are treated as the cost of production. These costs are absorbed or included in the units produced during the accounting period.

The following are the steps involved:

1. Identify all direct and indirect production costs.
2. Allocate the direct costs directly to the produced units.
3. Apportion the indirect costs using a suitable allocation basis.
4. Calculate the cost per unit by dividing the total cost by the number of units produced.

Advantages of Absorption Costing

Absorption costing offers several advantages:

• All costs are accounted for in the product cost, providing a comprehensive picture.
• Helps in determining the correct selling price by reflecting the full cost incurred in the production process.
• Aids in measuring profitability accurately.

Disadvantages of Absorption Costing

Despite its advantages, there are a few disadvantages to consider:

• Overheads cannot be easily allocated and might allocate certain fixed costs to products unnecessarily.
• Not suitable for decision-making as the cost is affected by sales volume and production levels.
• This method assumes that inventory levels have a correlation with sales, which may not always be true.

Conclusion

Absorption costing is a widely used accounting method that ensures all production costs are allocated to products. It provides a comprehensive view of the costs involved and assists in determining accurate selling prices.

However, businesses must also consider its limitations and suitability before adopting absorption costing as their preferred costing method.

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