Companies must choose between using absorption costing or variable costing in their accounting systems. There are advantages and disadvantages with either choice. Some of the primary advantages of absorption costing are the fact that it recognizes all of the costs involved in production (including fixed costs), it does a better job of accurately tracking profit during an accounting period and it is in compliance with the generally accepted accounting principles (GAAP). Disadvantages of using absorption costing include the fact that it's not particularly helpful for analysis designed to improve operational or financial efficiency, it's not useful for comparing product lines, and it can skew the picture of a company's profitability.
A company's management can choose to view costs in different ways. Firms that use absorption costing choose to allocate all costs to production. The term "absorption costing" refers to the fact that all of the company's costs are absorbed by the company's products. Under variable costing, which is the other option for costing, only variable costs are considered for production. Overhead costs, such as rent and wages, are considered separately.
Advantages of Absorption Costing
One of the main advantages of choosing to use absorption costing is that it is GAAP-compliant and required for reporting to the Internal Revenue Service (IRS). Even if a company chooses to use variable costing for its in-house accounting purposes, it still has to calculate absorption costing to file taxes and issue other official reports.
Absorption costing takes into account all of the costs of production, not just the direct costs, as variable costing does. Absorption costing includes a company's fixed costs of operation, such as salaries, facility rental and utility bills. Having a more complete picture of cost per unit for a product line can be helpful to company management in evaluating profitability and determining prices for products.
Absorption costing also provides a company with a more accurate picture of profitability than variable costing does if all of its products aren't sold during the same accounting period when they are manufactured. This can be especially important for a company that ramps up production well in advance of an anticipated seasonal increase in sales.
Disadvantages of Absorption Costing
Absorption costing can cause a company's profit level to appear better than it actually is during a given accounting period. This is due to the fact that all fixed costs are not deducted from revenues unless all of the company's manufactured products are sold. In addition to skewing a profit and loss statement, this can potentially mislead both company management and investors.
Absorption costing fails to provide as good an analysis of cost and volume as variable costing does. If fixed costs are an especially large part of total production costs, it is difficult to determine variations in costs that occur at different production levels. This, in turn, makes it more difficult for management to make the best decisions for operational efficiency.
Variable costing is more useful than absorption costing if a company wishes to compare potential profitability of different product lines. It is easier to discern the differences in profits from producing one item over another by looking solely at the variable costs directly related to production.