Cost Accounting

What Are the Limitations of Absorption Costing?

The term “absorption costing” refers to a method of inventory costing that treats all direct and indirect manufacturing costs 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.

Further, it can lead to inaccurate unit costs. This is because fixed costs are allocated to products based on production volume, but not all fixed costs are actually related to production.

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 is 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 sales and distribution overheads are period costs and do not produce future benefits and, therefore, should not be included in the cost of the product.
With absorption costing, fixed costs are allocated to products based on production volume. This can lead to distorted product costs since fixed costs don’t vary with production volume. For example, if fixed costs are $1,000 and there are two products that each require 50 units of production, each product would have $500 of fixed costs allocated to it. However, if one of the products requires 100 units of production and the other only requires 50, the product that requires more products will have a higher cost per unit even though the fixed costs are the same.

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.

Product mix changes

Another limitation of absorption costing is that it can be difficult to allocate costs accurately when the product mix changes. This is because fixed costs are allocated to products based on production volume, but not all fixed costs are actually related to production.

For example, if a company has $100 of fixed costs and produces 100 units of product, each unit of product would have $1 of fixed costs allocated to it. However, if $50 of the fixed costs are actually related to production and $50 are not, each unit of the product would actually only have 50 cents of production-related fixed costs allocated to it.

Conclusion

absorption costing is a method used to allocate all manufacturing costs, fixed and variable, to products produced during a period. All manufacturing costs are assigned to products, regardless of whether the costs are variable or fixed. The total cost of each product manufactured includes all of the manufacturing costs incurred during the production process, and absorption costing, therefore, provides a more accurate representation of the true cost of each product.

However, there are some limitations to absorption costing. First, absorption costing does not reflect the true cost of each unit of production since it includes both fixed and variable costs. Second, absorption costing does not consider the time value of money; therefore, it is not a true representation of the cost of production. Third, absorption costing does not consider the impact of future demand on the cost of production. Fourth, absorption costing assigns all manufacturing costs, whether variable or fixed, to products produced during a period. This can lead to over- or under-absorption of manufacturing costs, which can distort the true cost of each product.

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