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Companies must use and choose between absorption costing and variable costing in their
accounting systems. Either choice has its fair share of advantages and disadvantages.
Primary advantages of the absorption costing are (i) recognizes all of the costs involved in production (including fixed costs). (ii) Does a better job of accurately tracking profit during an accounting period. (iii) It is in compliance with the generally accepted accounting principles (GAAP). The major drawbacks of using absorption costing include: (i) Fact
that it's not particularly helpful for analysis designed to improve operational
or financial efficiency. (ii)Not useful for comparing product lines. (iii) Can skew the picture of a company's profitability.
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.
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.
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
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.
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 costing are not deducted from revenues unless all of the company's manufactured
products are sold. In addition to skewing a loss and profit statement, this can potentially mislead both company management
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.
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.
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