What is Absorption Costing?
The term “absorption costing” refers to a method of inventory costing that treats all direct manufacturing costs and all indirect manufacturing costs (both variable and fixed) as inventory costs.
This method can be defined as “the method that includes all direct manufacturing costs and all indirect manufacturing costs as inventory costs.”
Limitations of Absorption Costing
Despite having several advantages in cost and management accounting, the following are the main limitations of absorption costing:
Difficulty in comparison and control of cost.
Absorption costing depends on the level of output, so different unit costs are attained for different output levels. An increase in the volume of output normally results in reduced unit cost and a reduction in output results in an increased cost per unit due to fixed expenses. This makes comparison and control of cost difficult.
Not helpful in the managerial decision.
Absorption costing is not very helpful in taking managerial decisions such as a selection of suitable product mix, whether to buy or manufacture, whether to accept the export order or not, choice of alternatives, the minimum price to be fixed during the depression, the number of units to be sold to earn the desired profit etc.
Cost vitiated because of fixed cost, including inventory valuation.
In absorption costing, a portion of the fixed cost is carried forward to the next period because the closing stock is valued at the production cost, inclusive of the fixed cost.
Fixed cost inclusion in cost is not justified.
Many accountants argue that fixed manufacturing administration and selling and distribution overheads are period costs and do not produce future benefits and, therefore, should not be included in the cost of the product.
Apportionment of fixed overhead by an arbitrary method.
The validity of product costs under this technique depends on the correct apportionment of overhead costs. But in practice, many overhead costs are apportioned by using arbitrary methods, which ultimately make the product costs inaccurate and unreliable.
Not helpful for the preparation of a flexible budget.
In absorption costing, no distinction is made between fixed and variable costs. It is not possible to prepare flexible without making this distinction.