What is Absorption Costing?
Absorption Costing is a costing technique in which all manufacturing costs (variable and fixed) are considered as costs of production. Fixed overhead is treated as a product cost, not a period cost. All variable manufacturing costs and fixed production overheads to manufacturing are charged to the product.
Other costs, such as administrative and selling and distribution overheads, are written-off against the profit of the period in which they arise. Therefore, full cost of a product or stocks comprises the variable (direct) and fixed (indirect) costs of production. Hence, absorption costing is also known as full costing.
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Advantages of Absorption Costing
- It is a recognized and accepted accounting practice for external reporting.
- It uses the accrual accounting concept of matching costs with revenue for a particular time period.
- Fixed cost is absorbed in the production cost and the inventory valuation complies accounting standards.
- There is a proper adjustment of under or over absorption of fixed costs.
- The fixed production overheads are also allocated to different units/divisions.
- It is better for the firms which follow cost plus pricing method.
Limitations of Absorption Costing
- The advocates of marginal costing are of the view that carrying over the fixed cost component of the existing year, which has been debited to profit and loss account to the next year, is not appropriate.
- The profit and loss account will be affected to the extent of value of closing inventory.
- It is not helpful in taking managerial decisions where management wants to know the incremental cost on account of increased output.