What are the benefits of absorption costing
Businesses must choose between using the absorption calculation or the variable cost in their accounting systems. There are advantages and disadvantages to each choice. Some of the main advantages of absorption costing are the fact that it takes into account all costs associated with production (including fixed costs), allows more accurate tracking of profit during a accounting period, and is consistent with generally accepted bookkeeping. Principles (GAAP). Disadvantages of using absorption calculations are that they are not particularly useful for analysis to improve operational or financial efficiency, are not useful for comparing product lines, and can skew a company's picture of profitability.
A company's management can see costs in different ways. Companies that use absorption calculation 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. With variable costing, the other possibility of costing, only variable costs for production are taken into account. Overhead costs such as rent and wages are taken into account separately.
Advantages of the absorption calculation
One of the main advantages of choosing to use Absorption Calculation is that it is GAAP compliant and required to report to the Internal Revenue Service (IRS). Even if a company chooses to use variable cost accounting for internal accounting purposes, it still needs to calculate the cost of absorption in order to file taxes and produce other official reports.
The absorption calculation takes into account all production costs, not just the direct costs, as is the case with the variable cost calculation. The cost of absorption includes a company's fixed operating costs such as salaries, equipment rental costs, and utility bills. A more complete picture of the unit cost for a product line can be helpful for management in evaluating profitability and pricing products.
Absorption Costing also gives a company a more accurate picture of profitability than variable costing, when all products are not sold during the same accounting period in which they are manufactured. This can be especially important for a company that is ramping up production well in advance of an expected seasonal increase in sales.
Disadvantages of the absorption calculation
The absorption calculation can make a company's profit level appear better than it actually is during a given accounting period. This is because all fixed costs are not deducted from revenues unless all products made by the company are sold, which, in addition to distorting an income statement, can mislead both management and investors.
Absorption cost accounting does not provide as good a cost and volume analysis as variable cost accounting. When fixed costs are a particularly large part of total production costs, it is difficult to identify variances in costs that occur at different stages of production. This, in turn, makes it difficult for management to make the best decisions for operational efficiency.
Variable costing is more useful than costing when a company is looking to compare the potential profitability of different product lines. It is easier to distinguish the differences in profits in making one item versus another by focusing only on the variable costs directly associated with production.
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