Absorption costing is a popular method of calculating costs to determine the prices of a product or service to pave the way for necessary or desired profits. There are companies that oppose the idea of absorption costing and practice variable costing. Many companies combine absorption costing and variable costing for a holistic approach. You can check out the absorption costing pros and cons to deem it suitable or unsuitable for your company.
List of Pros of Absorption Costing
1. Factoring in Fixed Costs
Every operation, be it production or marketing, selling or servicing, will have fixed costs. The fixed costs are relevant over a period of time. These fixed costs allow a rather simple approach to determine the price of a product or service. Since all fixed costs are factored in, the eventual price determined by the decision makers would be inclusive of all costs.
2. Accurate Profit Assessment
By accounting for all fixed costs, absorption costing allows accurate assessments of profit. This is particularly true in case of seasonal production in which case the produce is not necessarily sold immediately but over a period of time in the near future. Also, absorption costing allows calculating the exact costs and revenues within a specified period of accounting to ensure required profits.
3. Accountable & Acceptable Method
Absorption costing holds the managers and executives making the decisions responsible. The accountability helps in not only ensuring company profits but also for external reports. Absorption costing is commonly used by enterprises that are eyeing stock valuation. Since fixed and variable costs are not factored in, thus bringing in discrepancies, the method is preferred by many.
List of Cons of Absorption Costing
1. Poor Decisions
Absorption costing can lead to poor decisions. In manufacturing, the overhead costs are usually fixed but there are many variable costs that must be factored in. There are many types of services that must also factor in specific issues in given circumstances to determine the right price. Factoring in fixed prices alone has several inherent problems and that would be sufficient to influence managers and executives to make decisions which wouldn’t be the smartest.
2. Unrealistic Accountability
Managers and executives don’t always have control over all prices or costs. The variable costs are beyond their control. It is also difficult to pre-empt all kinds of variable costs. In such scenarios, it is unfair to hold managers and executives accountable for something that they cannot control.