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.”
Despite having several advantages in cost and management accounting, the following are the main limitations of absorption costing:
Distorts profitability during periods of fluctuating production
Absorption costing allocates fixed costs to products based on a predetermined production volume, regardless of actual production levels. This can lead to distorted profitability figures, particularly during periods of fluctuating production. For instance, if production volume decreases, fixed costs are allocated to a smaller number of units, artificially inflating unit costs and reducing reported profits.
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 making managerial decisions such as the selection of a 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.
Absorption costing is primarily focused on matching costs with revenues for external reporting purposes. It may not provide the most relevant information for short-term decision-making, such as pricing or special order considerations, which often require a closer examination of variable costs and incremental cost behaviour.
Cost is vitiated because of fixed costs, 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.
Absorption costing can lead to inflated inventory values during periods of low production, as fixed costs are still included in the COGS. This can impact financial ratios and balance sheet presentations.
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.
Limited applicability for service industries
Absorption costing is primarily designed for manufacturing companies, and it may not be as applicable for service industries where there are fewer direct costs and more indirect costs. Service industries may benefit more from cost allocation methods like time-driven activity-based costing (TDABC).
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 the 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.
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.