Absorption costing‘s main drawback is that it can artificially inflate a company’s profitability over the course of an accounting period because all fixed costs are not subtracted from revenues until all of the company’s manufactured goods are sold. Additionally, it is useless for line-by-line comparisons of products or studies intended to increase operational and financial efficiency.
The accounting technique known as absorption costing, often referred to as full costing, allots an identical amount of the overhead cost to each finished unit of inventory in order to incorporate fixed overhead costs in the cost of goods sold. Publicly traded corporations are required to apply the generally accepted accounting principles, or GAAP, method of Absorption costing for their income statements. This system offers a few benefits, especially for outside analysts, but it also has a lot of drawbacks.
It appears as though more units are created add overhead expenses while in fact they represent revenue potential because Absorption costing allocates fixed overhead costs to the unit level. Absorption costing allocates $1 to each baseball for a total cost of $5 per baseball if a company produces 100 baseballs per month at a variable cost of $4 and fixed overhead expenditures of $100 per month. Absorption costing makes it appear as though the company is sustaining a loss of $.50 per baseball but, in reality, the company is profiting $.50 per ball because creating 10 extra units merely adds variable cost rather than fixed cost.
Costs Hide in Inventory
- Inventory shows as an asset on a company’s balance sheet. Since the company allocates fixed overhead to the finished unit level in Absorption costing, until the company sells a unit, the cost does not show up as an expense, or Cost of Goods Sold. This means that if a company builds 10,000 units of a finished good in a period, with $1 fixed overhead allocated to each unit, and sells only 1,000 of those units, $9,000 of the fixed overhead incurred in that period will show on the balance sheet as an asset, rolled into the cost of inventory, instead of as a cost.
Unsuitable for Irregular Volume
Theoretically, Absorption costing will correctly reflect the real cost of items sold if a corporation uses it and produces and sells an equal number of units each quarter. This approach of costing will, however, give the impression that variable costs and fixed overhead move with sales if production or sales are inconsistent. In reality, only the amount of output has an impact on variable costs; sales or production levels have no bearing on fixed overhead expenses. Variable costing provides a much clearer picture of the expenses associated with operating the firm for unpredictable production and sales patterns.
Absorption costing has its benefits, particularly for external reporting. The fact that Absorption costing combines variable and fixed costs allows a company to report its profits to shareholders without disclosing too much detail to competitors. In addition, since the business includes costs as an inventory asset on the balance sheet until it sells the inventory, this method sometimes benefits a slow quarter’s metrics. The alternative to absorption costing, known as variable costing, presents costs in a way that internal decision makers find useful. A well-informed manager will look at costs using both methods.