Absorption Costing

Question 1

Definition of absorption costing

Answer 1

A costing system which treats all costs of production as product costs, regardless of if they are variable or fixed. ​

Question 2

Advantages of absorption costing

Answer 2

Absorption costing includes an element of fixed overheads in inventory values (in accordance with SSAP 9 Accounting standard). ​

Analysing under/over absorption of overheads is a useful exercise in controlling costs of an organisation ​

In small organisations, absorbing overheads into the costs of products is the best way of estimating job costs and profits on jobs ​

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Question 3

Disadvantages of absorption costing

Answer 3

Under this approach, closing inventory is not valued in accordance with accounting standards (IAS 2, Inventories)​

Technique is not used in published accounts. Only used for internal decision making​

Fixed production overheads are not ‘shared’ out between units of production, but written off in full instead

It is more complex to operate than marginal costing (e.g. calculation of absorption rates, over and under absorption etc.)​

It does not provide any useful information for decision making (like marginal costing does). ​

Question 4

Key differences between Marginal and Absorption costing

Answer 4

Marginal costing focuses on variable costs and contribution. It treats fixed costs as period costs​

Absorption costing includes all costs, such as fixed costs. It is widely used in preparing financial statements and for inventory valuation​

Marginal costing is only used internally by managers. It is not used in published financial statements