Absorption Costing vs. Variable (Direct) Costing
Absorption cost systems are widely used to prepare financial accounts. These systems are designed to absorb all production costs (variable or fixed) into costs of units produced. Absorption costs techniques allow manufacturing costs to be traced and allocated into product costs. There are different types of absorption costing systems: job order costing, process costing, and ABC costing. In job order costing, costs are assigned to products in batches or lots, and the costs of each specific batch are traced separately using job order cost’ sheets. In process costing, products are produced in a continuous process and costs are systematically assigned to the product. In ABC costing, costs are assigned from cost centers to products. Because a unit’s cost in the absorption cost systems are made of variable and fixed costs, they can be very misleading. Absorption cost systems can incentive overproduction when the overhead rate is calculated based on units produced, and units produced is higher than units sold. In order to calculate this overhead cost, one should divide the total fixed cost by units produced and multiply the result by units sold. This overhead rate will be lower when more units are produced and when variable and fixed costs remain constant. In this process, fixed costs are being spread over more units, thus lowering unit’s cost. This technique allows profit to increase when production increases, and quantity of units produced is higher than quantity of units sold. In this case some of the fixed costs are divided by units and part of the total production (including its costs) is inventoried. The costs inventoried are not transferred to the income statement, thus increasing profits for that period, and misleading managers to overproduce. In some cases, managers do not understand how this costing process works. In the majority of the cases, they are only worried about increasing production and lowering...
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