Many businesses use absorption costing to determine the value of their ending inventory and cost of goods sold. Absorption costing, also called fully-absorbed costing, adds the cost of the direct materials, direct labour and factory overhead to determine the total-cost per unit. The company multiplies this total-cost per unit by the number of units in ending inventory to determine the ending value of the inventory. The company multiplies this total-cost per unit by the number of units sold during the year to determine the cost of goods sold. Absorption costing comes with both advantages and disadvantages.
Considers All Costs When Pricing
One advantage of absorption costing is that it considers all of the costs that contribute to the final product in some way. This includes both direct costs and indirect costs. Direct costs refer to costs that can be traced directly to the product itself, such as direct materials or direct labour. Indirect costs refer to costs that cannot be traced directly to the product and are allocated to the product, such as property taxes or plant manager's salary.
Required for GAAP
Generally accepted accounting principles (GAAP) represent the standards that most companies follow for financial reporting. Generally accepted accounting principles require companies to use absorption costing for all external reporting. Companies who use a different form of product costing for internal analysis still need to maintain an absorption costing system for GAAP. Companies who use absorption costing for all product costing have an advantage in that the same costs can be used for all purposes.
Discourages Profitable Business
A disadvantage of absorption costing involves pricing decisions. When a company has excess capacity and it considers various business opportunities, it may deny business that would generate profits for the company. The company evaluates each business opportunity using absorption costing as its base cost. The company accepts business opportunities that provide revenue above the absorption cost and rejects business opportunities that provide revenue below the absorption cost. Some of the business that the company rejects may contribute additional profits to the company when it has excess capacity.
Skews Discontinuing Business Decisions
Another disadvantage of absorption costing involves skewing the results of decisions made to discontinue business segments. When the company uses absorption costing in the decision, the analysis includes fixed costs that will remain whether the company eliminates the segment or not.