Question

Absorption costing (also called the full cost method) treats all costs of production as product costs, regardless of whether they are variable or fixed. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for CVP computations. Under absorption costing, the cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred.

Is the above statement true or false?

Answer 1

Solution

Yes, the above statement is true.

Explanation:

Absorption costing is a traditional method, followed under Generally Accepted Accounting Principles. The method does not discriminate between variable manufacturing costs and fixed manufacturing costs. All manufacturing costs, including overheads are considered product costs.

Note: Variable cost is that cost item, which changes with the changes in level of activity. Hence, variable cost per unit is constant for a given activity range.

Fixed cost does not change with changes in the level of activity. Fixed cost per unit varies with the level of activity.

The product cost under absorption costing would include,

Variable manufacturing costs:

Direct materials

Direct labor

Variable manufacturing overhead and

Fixed manufacturing overhead

The cost per unit is computed as follows,

Total product cost/number of units produced

As regards selling and administration costs, these costs including the variable portion as well as the fixed portion of selling costs and are treated as period costs. These costs are reported as incurred and deducted from gross margin to compute operating income.

Selling and general administrative expenses are considered period costs and do not form part of product cost under traditional system.

The presence of sunk costs such as fixed overhead make the traditional system unsuitable for CVP (cost-volume-profit) analysis for short-term decision making.