What is Absorption Costing?
Absorption costing is an accounting cost approach that includes the cost of producing a product or providing a service.
Absorption costing comprises material and labour costs and all production overhead expenses. Each cost centre’s expenses may be direct or indirect.
Advantages of absorption costing
- It appropriately recognises the need to consider fixed manufacturing costs in product cost estimation and defines an appropriate price structure. In reality, all costs (fixed and variable) associated with production should be charged to the unit of product produced.
Prices established based on absorption costing guarantee that all costs are covered completely. The market is well-regulated when the full cost is used as a foundation for pricing.
- It will show the correct profit calculation when production is done to have sales in future ( e.g., seasonal sales) compared to variable costing.
- It helps to confirm accrual and matching concepts which require matching cost with revenue for a particular
- It has been recognised by various bodies as FASB (USA.) ASC (UK) and ASB ( INDIA) to prepare external reports and inventory valuations.
- It avoids separating costs into fixed and variable elements, which cannot be done easily and accurately.
- It discloses inefficient efficient utilisation of production resources by indicating under absorption or over absorption of factory overheads.
- It helps calculate the gross and net profit separately in the income statement.
- It assists in making managers more accountable for the costs and services supplied to their centres/departments due to the proper allocation and apportionment of fixed manufacturing resources.