The absorption costing method of production, or absorption costing, is one of the most widely used methods for determining the cost of producing a product or delivering a service. In absorption costing, all costs associated with producing a product or delivering a service, including direct materials, labor, overhead, and selling, are included in the cost of a product or service.
Absorption costing is based on the idea of allocating the total cost of producing a product or service to the various components of production. For example, overhead includes overhead such as rent, utilities, insurance, and other costs that are related to running the business but are not directly associated with the production or delivery of a specific product or service. Also, the labor cost to produce or provide the product or service is included in the cost of the product or service.
Absorption costing is used to determine the total cost of a product or service. This total cost includes both direct and indirect costs. Direct costs are those costs that are directly related to producing the product or delivering the service, such as the cost of materials and labor. Indirect costs are those costs that are associated with running the business but are not directly related to the production or delivery of the product or service, such as rent, insurance, and general overhead.
The process of absorption costing is relatively simple. First, the total cost of producing a product or delivering a service is determined. This total cost includes both the direct and indirect costs mentioned above. Then, the total cost is allocated to each of the components of production, such as materials, labor, overhead, and selling expenses. The total cost is divided by the total number of units produced or services delivered, and the resulting per-unit cost is the absorption cost of the product or service.
The advantage of absorption costing is that it provides a complete picture of the total cost of production or delivery of a product or service. This allows managers to make informed decisions about how to increase efficiency or reduce costs. The disadvantage of absorption costing is that it does not take into account the opportunity costs associated with production. Opportunity costs are those costs that would have been incurred had the resources been used for a different purpose. Since absorption costing does not measure opportunity costs, managers may make decisions to produce at a lower cost than is appropriate for the amount of benefit produced.
In conclusion, absorption costing is a commonly used method for determining the cost of producing a product or delivering a service. While absorption costing provides a complete picture of total production cost, it does not account for opportunity costs and may lead to inefficient decision making. Therefore, when considering the use of absorption costing, managers should be aware of the potential limitations of this method.
