Advantages & Disadvantages of Absorption Costing
Choosing the correct costing system for your business can prevent headaches down the road when you expand, but it also helps you make data-driven decisions about the performance of your business right now. Absorption costing systems, some of the most widely used systems in business, assign all manufacturing costs to products. These systems are used by many businesses, but they're not perfect.
One of the main advantages of using absorption costing in a small business is that it complies with generally accepted accounting principles, or GAAP. Conversion from a non-GAAP costing system to a GAAP costing system can be expensive and time consuming, but if your business begins operations using a GAAP-compliant system, little additional work is involved once the system is set up. This is most important for small businesses that want to expand in the future or plan to seek external financing. Many banks or other lenders expect to be able to assess creditworthiness using financial statements prepared in accordance with GAAP. If your costing system does not comply with GAAP, you may be forced to reconcile the figures at a point in the business when you do not have the resources or time to do so.
Absorption costing systems tend to be less complicated to initially set up than other costing systems. For example, many small businesses use a type of absorption system known as job-order costing, which requires traceable material and labor to be traced directly to the products that are being produced and overhead to be allocated to products based upon a rate. Once the overhead rate estimates are calculated, the process of allocation becomes trivial using job-order costing. However, activity-based costing, a non-absorption costing alternative, requires the identification of every activity that goes into producing a product and a determination of how these activities affect the overhead incurred. This can be a difficult and time-consuming process.
The biggest drawback of absorption costing systems is the way they handle fixed overhead costs. In an absorption costing system, all costs of manufacturing are assigned to products. When companies do not sell all of the products they produce in a period, these costs get hung up on the balance sheet. This causes income to be artificially inflated during periods when the number of units produced exceed the number sold. In addition, income is artificially deflated when the number of units produced is less than the number of units sold. This can be a huge problem for small businesses, because sales are often more variable in small businesses, and many small-business owners are unaware of this phenomenon. Managers unfamiliar with this problem could incorrectly attribute increases and decreases in income to company performance, which could reduce the quality of managerial decisions.
Absorption costing systems do a poor job of accounting for costs that are considered nonmanufacturing costs but really are unavoidable for manufacturers. For example, your small business may produce two different products. One product is a mass-produced product with little customization, and the other product is customized to customer specifications. Under absorption costing systems, the cost of the personnel who process customer orders for custom goods could not be included as part of the cost of manufacturing the custom product. This often leads to the undercosting of custom goods and the overcosting of mass-produced goods under absorption systems.