The Advantages of Absorbtion Costing

Absorption costing is defined as a method that includes all manufacturing costs, such as direct labor, indirect labor, variable overheads and fixed overheads. This approach also as called as full costing approach. Nowadays, a lot of companies use absorption costing method for external financial reporting purpose, matching concept is used in absorption costing. Assets like inventory affects the company’s ability to earn more profit, so in accounting field it match the expenses with the revenues that they produce is important. In addition, matching concept request company to record all the expenses that match their revenue to demonstrated company’s profitability in the specific accounting period. Under absorption costing method, fixed manufacturing overhead cost is determined by each unit of output. Moreover, when a unit of fixed manufacturing overhead is sold it will directly include in the Cost of goods sold account as an expense shown on the income statement and the rest of fixed manufacturing overhead that have not been sold would go to inventory account instead of count as expenses. Hence, the matching concept underlies the absorption costing because these expenses should be match the revenue generated from the sale of that inventory.

One of absorption costing method’s advantage is when not all the fixed manufactured overheard is sold during the accounting period, the fixed manufactured overhead cost will go to inventory as an asset instead of expense. Therefore, expense will accrued only if the company actually sells the items in inventory. So, company can improve their profits for the period. According to this, illusory profits means more inventory is produced than is sold under absorption costing method. More production will lead more fixed manufacturing overhead costs go to absorption costing inventory and less expensed during a period therefore there will be more profit. In reality, the company may not able to produce that much and managers want to earn more commission based on the performance of the operating income, so they just buildup the inventory and it ignores to account for expenses related to carrying the additional inventory in order to earn more profit. Therefore, the profit should consider as a phantom profit. According to Managerial Accounting textbook, it indicates break-even point analysis under absorption costing method request both production and sales to analyze it. If company manipulated the inventory such as increase the inventory artificially or seduce dealer to stock more product than the amount that the markets actually demand, the company will have illusory profit.