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In: Accounting

the bottom line is, absorption costing can create an illusion of efficiency by spreading the fixed...

the bottom line is, absorption costing can create an illusion of efficiency by spreading the fixed manufacturing overhead cost over a large volume of output.

The question then is: If absorption costing method may produce such "misleading" results on the income statement, why do companies even use this method...why are they allowed? Why doesn't anybody stop them? And, can anybody present an argument in favor of variable costing that would eliminate the issue caused by the misuse of absorption costing?

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Expert Solution

It is true that under absorption costing fixed manufacturing overheads are distributed among the units produced and therefore are charged to income statement only for those units which have been sold in the current year. Due to such distribution of cost, it might leads to the higher profits than variable costing as manufacturing overheads of closing inventory are not charged in the year of production. However, it is not appropriate to say that it creates an illusion of efficiency since as per the matching concept of accounting, all the items of expenses and revenues should be matched and should be charged in the same year.

If the units have been sold in some other year than the year of production, then it is appropriate to charge the related expenses of such units in the year in which these have been sold rather than expensing out in the year in which they have been produced. Because of this reason, companies are allowed to use absorption costing method. Absorption costing is specifically required for external financial reporting and for income tax reporting purposes. Absorption costing also helps in calculating the total manufacturing cost of the products.

In case of variable costing, all the fixed manufacturing overheads are charged to the income statement in the year in which they have been incurred regardless of when the units are sold. As such, the matching concept of accounting is totally defeated in case of variable costing as related costs are not matched & booked with the related revennues generated. Moreover variable costing, is used only for managerial decision making and is not used by external authorities. As such management opting for variable costing will have to prepare two sets of financial statements one under variable and one under absorption which leads to double load of work.

ekkarill92 answered 10 months ago
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