Question

Critics of absorption costing have increasingly emphasized its potential for leading to undesirable incentives for managers. Give an example.

Answer 1

Absorption costing, also known as full costing, is an accounting method that includes fixed overhead costs in the cost of goods sold by allocating an equal portion of the overhead cost to each finished unit of inventory. Absorption costing is the Generally Accepted Accounting Practices, or GAAP, method and publicly held companies must use this method on their income statements. While this system has some advantages, particularly for outside analysts, it also has a number of disadvantages.

Inadequate for Managerial Decision Making

Because absorption costing allocates fixed overhead costs to the unit level, it makes it appear as though additional units produced add overhead cost, when in fact they are revenue opportunities. If a company makes 100 baseballs per month for a variable cost of $4 and fixed overhead costs are $100 per month, absorption costing allocates $1 to each baseball for a total cost of $5 per baseball. If the company has an opportunity to sell another 10 baseballs at $4.50 each, absorption costing makes it look as if the company is taking a loss of $.50 each, when in fact it is making $.50 each because it is not adding fixed cost by producing 10 more units, only variable cost.

Costs Hide in Inventory

Inventory shows as an asset on a company's balance sheet. Since the company allocates fixed overhead to the finished unit level in absorption costing, until the company sells a unit, the cost does not show up as an expense, or Cost of Goods Sold. This means that if a company builds 10,000 units of a finished good in a period, with $1 fixed overhead allocated to each unit, and sells only 1,000 of those units, $9,000 of the fixed overhead incurred in that period will show on the balance sheet as an asset, rolled into the cost of inventory, instead of as a cost.