Question

In financial statements and tax filings the absorption cost approach makes more sense as it does not give management any choice in shifting costs. This affects NPV analysis, though, management is responsible for all costs and this can also lead to analytical problems. For example, factory depreciation costs are not part of production, and many believe, including me, that when looking at product costs, these should not be considered. While they are a part of the business, including these costs will often lead to bad decision making. If a product costs 75 and sells for 90, then all else being equal it should be sold. If we, however, include fixed manufacturing overhead in the cost, the item may seem to have a cost of 100 which is above cost, and so it should not be sold. This would be an error as the administrative overhead would remain as a cost, and we would lose the 15 per unit we could earn to offset this cost.

Thoughts/Questions?

Answer 1

Absorbtion cost is an approach /method to capture all associated costs related to manfacturing a product,including fixed over heads

generally depreciation which is fixed overhead  will treated as indirect cost such that it will be not included in product cost ,more particularly while taking a decisions on basis of incremental costing.

But depreciation is incurred while manfacturing of products : eg use of machinery, etc such that it is associated to manfacturing of product

In absorbtion costing any fixed over head costs will be alloated to the products manfcatured such that it will increase the cost of a product, where as in variable cost approach it will be not associated to product such that it will be treated as expense as sepertae line item .

generally any factory depreciation which is related to specifc manfacturing a product will be treated as productt cost for the particular product then it will be added to cost which is very influential in decison making, these costs will be considered while decison making

if we include fixed manfacturing over head as part of cost it will increase the cost of product which makes incompetent in the market ., so by analyisng the situation fixed costs is considered only to recover the cost once fixed manfacturing costs recovers then our manfacturing costs will be considered for decision making