Question

A significant criticism of absorption costing is that it leads to inaccurate product costs. Is this true? Why would a traditional costing system lead to inaccurate product costs? And what could be done about it? In your response, discuss whether your company applies absorption costing in the decision-making process.

write at least 150 words

Answer 1

Absorption cost systems ensure that all manufacturing costs are assigned to products.

Absorption Costing acts as Incentives to overproduce:

Increasing production reduces average costs (per unit costs decrease as you spread fixed costs over larger volume).

Increasing production may artificially raise profits (more fixed manufacturing overhead costs are deferred in inventory)

Problem occurs with numerous product lines As some products absorb too much overhead and others too little overhead, even then also all products get equal share of cost and it leads to inaccurate product costs.

Absorption costing can cause a company's profit level to appear better than it actually is during a given accounting period. This is because all fixed costs are not deducted from revenues unless all of the company's manufactured products are sold.

To overcome the disadvantages of Absorption costing , we can use Activity-based costing (ABC):

Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

Activity-based costing identifies all of the specific overhead operations related to the manufacture of each product. Not all products require the support of all overhead costs, so it is not reasonable to apply the same overhead costs to all products.

Accountants created the ABC method to solve the problems of inaccuracy that result from the traditional costing approach. Managers needed more accurate costing methods to determine which profits were actually profitable and which were not.

A fundamental difference between traditional costing and ABC costing is that ABC methods expand the number of indirect cost pools that can be allocated to specific products. The traditional method takes one pool of a company's total overhead costs to allocate universally to all products.

But even if a company chooses to use variable costing for in-house accounting purposes, it still has to calculate absorption costing to file taxes and issue other official reports, because absorption costing is in compliance with generally accepted accounting principles (GAAP),

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