BENEFITS AND LIMITATIONS OF ABSORPTION COSTING

Benefits of using absorption costing

• Conforms with the accrual concept of matching costs with revenues
• Stock valuation complies with financial reporting standard IAS 2

• By analyzing over/(under) absorption of overheads any inefficient utilization of resources may be revealed
• By apportioning and allocating fixed production overheads to cost centers the company can make managers more aware of costs/services provided by each cost centre and this may facilitate cost reduction
• If the company uses absorption costing it will base its pricing policy on full product cost and this ensures all costs are covered (provided that budgeted activity is achieved to avoid under absorption)
• fixed costs are becoming more significant in business operations. Absorption costing emphasizes the importance of such costs by including them in the cost of production

limitations of using absorption costing

• Absorption costing is more complex in its application and the company will have to recognize this in preparing its management accounts
• Absorption costing is not as useful as variable costing or marginal costing for short-term decision-making purposes due to the inclusion of fixed costs
• As the absorption rate of fixed production overhead is based on anticipated production and the overheads are estimated there is a greater likelihood of under or over absorption

• By using absorption costing the company may have difficulty dividing fixed overhead expenses between production and service departments. Sometimes this may result in arbitrary and inaccurate allocations

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