Cambrige AS and A Level Accounting Notes (9706)/ ZIMSECĀ  Advanced Accounting Level Notes: Absorption Costing: Uses and Limitations of Absorption Costing

  • According to research by CIMA the leading Management Institute
  • Traditional costing methods such as Absorption costing are still in widely used by manufacturing businesses throughout the world
  • There is are reasons for this

Uses/Advantages of Absorption costing

  • Often used to determine inventory values in accordance with International Financial Reporting Standards
  • It is also used to determine a profitable selling price that covers all costs of making each unit
  • Recognises the fact that each unit produced must cover (“absorb”) its share of fixed overheads
  • Adheres to the matching principle by making sure that revenue is matched to expenditure incurred in making that revenue instead of treating Fixed Overhead Costs as period costs
  • Recognises the fact that fixed overheads are essential for production
  • Is more consistent with external reporting rules and regulations such as company laws and IFRSs
  • Produces a profit amounts that fluctuate less when production is constant but sales fluctuate for example in businesses that have seasonal sales

Disadvantages /Limitations of Absorption Costing

  • It is not very useful as for decision making plans as it emphasises fixed overheads examples of decisions that it cannot help make are make or buy, product mix etc
  • Cost absorption is not really a science as a lot of judgement is involved in that regard absorption of costs is somewhat arbitrary
  • Not useful when it comes to cost control as fixed overheads are included since it would be unfair to blame a manager over costs he/she does not control
  • Profit can be inflated by increasing production which reduces cost per unit

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