What is Absorption Costing?
Many are wondering to find out the real meaning of it. Absorption costing technique is also termed as Traditional or Full cost Method. According to this method, the cost of a product is determined after considering both fixed and variable costs. The variable costs, such as those of direct materials, direct labour, etc. are directly charged to the products while the fixed costs are apportioned on a suitable basis over different products manufactured during a period. Thus, in case of Absorption costing all costs are identified with the manufactured products.
What are the advantages of Absorption Costing ?
Under Absorption Costing each unit of product has to bear its total share of cost. It may be true that some products may not be able to bear their full share of cost but may be able to contribute to the overall profitability of the firm. For example, a product can be sold at a price which is sufficient to recover more than its variable cost required to produce it, but may not be sufficient to recover its full share of fixed cost. On the other hand, there may be products which contribute much more than their share of variable and fixed costs. Under absorption costing, the management is interested in knowing whether or not a product can produce an adequate return on investment after absorbing its share of the overall cost whether fixed or variable or direct or indirect. This is because in the long run, all costs must be more than recovered to assure a satisfactory return to the investors on their investment.
However, charging of fixed costs creates problems and this can be considered as one of the disadvantages of absorption costing . These costs are apportioned to different products on some suitable basis, e.g. as a percentage of direct material, as a percentage of direct labour or as a rate per article, etc. But, there is always some doubt about the suitability of the method adopted for appointment of these fixed costs. It cannot be said with definiteness that the fixed costs so charged are really the costs which should have been charged to each of the different products. It, therefore, brigs more inexactness in costing. Moreover, fixed costs have to e incurred whether there is production or no production. It means cost of a product not only depends upon the costs which are directly incurred but also on the volume of output.