Which of the following costs at a manufacturing company would be treated as a product cost under both absorption?

What is absorption costing?

Under generally accepted accounting principles, manufacturers must allocate periodic production costs to all items produced. Inventory valuation systems divide these costs—labor, materials purchases, and factory overhead—between items sold and those still in stock.

Financial accounting principles do not require that assigned overhead costs be causally related to the demands of individual products, so many companies continue to use direct labor to allocate overhead, even though direct labor may account for less than 5% of total manufacturing costs. Moreover, businesses can use a single plantwide burden rate for allocating overhead to products, regardless of the diversity of their production processes.

In absorption costing, all manufacturing costs are included in the product cost. This means direct costs (such as materials and labor) and indirect costs (such as overhead) are included in the final product cost. This costing method is used in manufacturing businesses to determine the total cost of each product produced. By including all manufacturing costs, businesses can better understand the actual cost of producing their goods.

Under the absorption method of costing (aka "full costing"), the following costs go into the product:

·       Direct material (DM)

·       Direct labor (DL)

·       Variable manufacturing overhead (VOH)

·       Fixed manufacturing overhead (FOH)

Under absorption costing, the costs below are considered period costs and do not go into the cost of a product. They are, instead, expensed in the period that occurred:

·       Variable selling and administrative

·       Fixed selling and administrative

While absorption costing meets compliance requirements, it is essential to note that this method does not always give an accurate picture of the profitability of individual products.

Therefore, a company's overhead allocation scheme may not correspond to the underlying production process or the demands of individual products on the enterprise's resources.

Auditors won't question cost-of-sales, or inventory valuation estimates merely because the company has used an aggregated, simplistic method for assigning overhead costs to products. As long as the split of costs between goods sold and goods still in stock is reasonably accurate, the needs of financial reports will have been met.

How is absorption costing different than variable costing?

Absorption costing is a method used in manufacturing to account for all of the costs associated with manufacturing a product. This includes both the direct costs (such as materials and labor) and the indirect costs (such as overhead).

On the other hand, variable costing only includes the direct costs of manufacturing a product. It does not include any of the indirect costs.

The main difference between absorption costing and variable costing is that absorption costing allocates a portion of the fixed manufacturing costs to each unit produced, while variable costing does not. This makes absorption costing more accurate in determining the actual cost of manufacturing a product. However, it also makes absorption costs more complex and time-consuming to calculate.

Does absorption costing provide relevant product cost information to decision-makers?

The absorption costing method is generally accepted as the best way to allocate manufacturing costs to products, which is a falsehood. The popularity of absorption costings stems from the fact that it is easy to calculate and implement and meets GAAP regulatory requirements.

Traditional standard cost systems in manufacturing companies are designed not to measure product costs accurately but to value inventory. The standard costs usually bear no relation to the resources consumed to design, produce, market, and deliver the product.

In absorption costing, the cost of an individual unit produced will include direct materials, labor, and both fixed and variable manufacturing overhead costs. These costs are not recognized as expenses in the month a company pays for them. Instead, they are recorded as assets in the form of inventory until the units produced are sold. Once this happens, they are charged against a company's cost of goods sold. Absorption costing is typically required for financial and income tax reporting purposes.

The traditional allocation system assigns manufacturing overhead based on a single cost driver, such as direct labor hours, direct labor dollars, or machine hours. It is optimal when there is a relationship between the activity base and overhead. This most often occurs when direct labor is a large part of the product cost. The single cost driver's theory is that the selected cost driver increases as overhead increases, and further analysis is more costly than valuable. Each method has its advantages and disadvantages. These are advantages of the traditional method:

While this cost system is compliant with external reporting, it does not give managers relevant performance measurement and product cost information. One criticism is that absorption costing can lead to the over-costing of products. This can happen when there are many indirect costs, and these costs are allocated to products that do not reflect the actual cost of manufacturing the product.

Another criticism of absorption costing is that it can lead to the under-costing of products. This can happen when there are many direct costs, and these costs are allocated to products that do not reflect the actual cost of manufacturing the product.

Seriously distorted product costs can lead managers to choose a losing competitive strategy by de-emphasizing and overpricing highly profitable products and expanding commitments to complex, unprofitable lines. The company persists in the losing strategy because executives have no alternative sources of information to signal when production costs are distorted. After many years of declining market share and reduced profitability, managers learned how erroneous product costs led to poor product mix and pricing decisions.

Consider the following example where a company manufactures 10,000 units of a particular product with a cost per unit of $10 in direct materials, $8 in direct labor, and $2 in variable manufacturing costs. The company also has fixed manufacturing overhead costs totaling $40,000 per year.

Under absorption costing, the cost per unit can be calculated as follows: $10 (direct materials) + $8 (direct labor) + $2 (variable manufacturing costs) + $4 ($40,000 per year in fixed manufacturing overhead costs divided by 10,000 units) = $24 per unit.

What are the challenges of using absorption costing?

One of the critical challenges of absorption costing is that it can lead to sub-optimal decision-making in a manufacturing setting. This is because absorption costing assigns all manufacturing costs (direct materials, direct labor, and overhead) to products, regardless of whether the product actually incurs those costs. This can lead to situations where a company continues to produce a product even though it is not profitable, simply because the absorption costing method does not accurately reflect the actual cost of manufacturing the product.

Another challenge of absorption costing is that it can lead to artificially high or low profits in certain situations. This is due to how absorption costing assigns manufacturing overhead costs to products. In some cases, absorption costing can lead to a product being assigned too much overhead, which artificially decreases the profit of that product. In other cases, absorption costing can lead to a product being assigned too little overhead, which artificially increases the profit of that product.

What are the benefits of using absorption costing?

There only real benefits to using absorption costing are that they are GAAP compliant and easy to calculate. As manufacturing operations can become complex with many moving parts, dividing the total overhead cost pool by a single driver removes much complexity while sacrificing granularity and cause-effect relationships.

Traditional allocation assigns costs as period or product costs, and all product costs are included in the cost of inventory, which makes this method acceptable for generally accepted accounting principles (GAAP).

Are all manufacturing costs considered under Absorption Costing?

All manufacturing costs are classified as material, labor, or overhead and assigned to products regardless of whether they drive or are driven by production.

All manufacturing costs are considered to be part of the product cost. In contrast, nonmanufacturing costs are not considered production costs and are not assigned to products, regardless of whether the costs are based on the products. For example, the machines used to receive and process customer orders are necessary because product orders must be taken, but their costs are not allocated to particular products.

There is only one overhead cost pool and a single measure of activity, such as direct labor hours, making the traditional method simple and less costly. The predetermined overhead rate is based on estimated costs at the budgeted activity level. Therefore, the overhead rate is consistent across products, but overhead may be over-or underapplied.

Disadvantages of the traditional absorption method

The absorption costing method is the traditional approach to manufacturing accounting. While it has its advantages, there are also several significant disadvantages to using this method.

Using the single cost driver may over-allocate overhead to one product and under allocate overhead to another product, resulting in erroneous total costs and potentially setting an incorrect sales price. The use of the single cost driver does not allocate overhead as accurately as using multiple cost drivers.

One of the most significant disadvantages is that absorption costing can lead to distorted product costs. All manufacturing costs, including variable and fixed costs, are assigned to each unit produced. This can lead to artificially high costs for some products and artificially low costs for others.

Another disadvantage of absorption costing is that it can lead to sub-optimal decision-making. This is because absorption costing focuses on the short-term goal of reducing unit costs rather than on the long-term goal of maximizing profitability. This can lead to decisions that may be beneficial in the short term but harmful in the long term.

Despite these disadvantages, absorption costing remains the most commonly used method of manufacturing accounting. This is because it is generally more straightforward than other methods, such as activity-based costing. Absorption costing also has the advantage of being well-established and well-understood by accountants and financial professionals.

Absorption vs. Activity Based Accounting

The difference between the traditional method (using one cost driver) and the ABC method (using multiple cost drivers) is more complex than simply the number of cost drivers. When direct labor is a large portion of the product cost, the overhead costs tend to be consistently driven by one cost driver, typically direct labor or machine hours; the traditional method appropriately allocates those costs.

To some degree or another, the absorption method has become a reality for many manufacturers and may continue to be necessary in the near future.

When technology is a large portion of the product cost, the overhead costs tend to be driven by multiple drivers, so using multiple cost drivers in the ABC method allows for a more precise allocation of overhead.

Another factor to consider in determining which of the two primary overhead allocation methods to use is the cost associated with collecting and analyzing information. When deciding which method to use, the company must consider these costs, both time and money. (Figure) compares overhead in the two systems. The ABC method is more expensive in time and other costs in many cases.

An essential component in determining the total production costs of a product or job is the proper allocation of overhead. For some companies, the often less-complicated traditional method does an excellent job of allocating overhead. However, overhead allocation is a more complex issue for many products, and an activity-based costing (ABC) system is more appropriate.

Absorption costing and activity-based Costing differ in approach. Absorption costing assigns costs to individual units, whereas activity-based Costing focuses on company activities as a central cost and then assigns indirect costs to units.

One significant advantage of activity-based Costing is that it allows companies to understand the cost and profitability of individual units produced or services rendered. This increased accuracy is achieved by essentially converting indirect costs to direct costs. Activity-based Costing can be applied to all business costs, not just production-related overhead.

On the other hand, activity-based Costing can be challenging to implement, requiring expertise and investment in software and training. It may not be as useful to companies whose overhead costs are primarily volume-related or companies whose overhead represents a small proportion of their overall costs.

Absorption costing, meanwhile, is easier to implement yet recognized as perfectly compliant with generally accepted accounting principles and IRS reporting requirements. The downside, however, is that it may offer less insight to those charged with making strategic decisions regarding production practices and costs.

Both methods have pros and cons, but ultimately, it's up to each manufacturing company to decide which method is best. Some companies may find direct costing more accurate, while others prefer absorption costing because it provides a holistic view of manufacturing overhead.

Management Decisions Impact on Organizational Cost

Manufacturing overhead allocation can be a very controversial topic. Some people argue that it's necessary to accurately track production costs, while others believe it leads to unfair cost allocations and ultimately hurts the manufacturing process.

The most important principle of effective cost management is leadership's understanding and acceptance of the reality that the majority of all organizational cost is structural. Costs are built into an organization by management systems and management decisions.

Therefore, the second part of this reality lies in management's ability to accept change, challenge their own past decisions, and aggressively embrace the power and potential of their employees. It lies in the ability to accept that most organizational cost has been created and supported by past leadership decision-making.

The deeper the executive knowledge of their organization's cost drivers, the greater the opportunity for effective cost management versus cost-cutting. In the end, effective, process-driven cost management is founded on the company's culture. It is a way of life. In many cases, it is also the only path to organizational survival.

The Absorption Death Spiral

Manufacturers that allocate reactively risk sub-optimizing their profits and doing unnecessary damage to their businesses. In his book, "Activity-Based Costing" by costing expert Douglas Hicks, the author described a scenario he has witnessed play out several times in his career, which he calls the Death Spiral.

The Death Spiral occurs when the current year's calculation of product costing rates are based solely on last year's costs and volume of business or on the upcoming year's budgeted costs and volume of business.

In his example, Hicks shares a case study of a $10 million contract manufacturer that performs contract manufacturing for unique products to customer specifications. As all products are unique, there is no benchmark market price to reference when bidding on these contracts. Instead, this organization must estimate the market price by estimating the cost of manufacturing the products under each contract and then adding a target margin to generate an acceptable profit. In developing their cost estimates, the firm calculates annual costing rates based on the prior year's actual activity.

However, during one troublesome year, a strike occurs at its primary customer, decreasing sales to $9 million. The organization anticipates the sales drop will only be temporary, so they maintain their routine management and support structure throughout the period.

When calculating their costing rates for the following year, the accountant takes the previous year's actual costs and bases and calculates new rates. Intuitively, the rates are now higher than in previous years. As a result, the company will now enter higher bid prices to secure new manufacturing contracts.

Not surprisingly, the higher prices make the manufacturer less competitive, causing sales to drop to $8 million. The same thing happened the following year. The exact high overhead costs over a small base increase the starting bid price again, resulting in even less competitive estimates.

Inevitably, the contract manufacturer falls into the downward "death spiral."

Declining sales stemmed from a misunderstanding of the term actual. Actual costing rates exist at the volume and mix of business necessities the company has structured itself, also known as practical capacity.

There is also an upward death spiral. If the same company experiences a significant but temporary increase in business, receiving a one-time order for $8 million to be shipped over two years.

As a result, sales would increase to $14 million for two years before returning to the $10 million level supported by the company's core business. Unfortunately, accounting personnel calculates costing rates in the same manner as always, using actual costs and bases. As a result, costing rates declined during the year when the one-time order was being manufactured.

Once the one-time order is completed, the profitability of the company's $10 million core business dropped significantly due to the company's passing "phantom" cost reductions, caused only by the extra volume generated by the one-time order, through to their customers. As a result, the year after completing the one-time order, the company consistently underbids contracts and winds up with a portfolio of unprofitable or marginally profitable contracts.

As was the case when the volume began to decline, the company should have never looked at itself as anything other than a $10 million manufacturer when costing core business. The one-time order was a layer of business laid on top of the core business from a costing standpoint.

Conclusion: What is absorption costing?

When absorption costing is used to allocate costs to production with a single driver, the costing product will inevitably be incorrect. Although absorption costing is perfectly GAAP compliant, it produces skewed results when assessing true product costing for decision-making purposes.

Absorption costing has remained popular because of its simplicity in calculating and implementing. However, cost accounting professionals must not be comfortable with easy. To understand what a product costs to produce, an investment must be made in people, processes, and systems to establish cause and effect relationships that represent what a product incurs from direct and indirect costs.

It doesn't matter what FASB says, the SEC says, or the IRS says- Laws of nature dictate costs. Ignoring this fundamental principle is akin to running an organization blindly.

In this series:

1. The Evils of Cost Allocation in Manufacturing Production

2. How Distorted Cost Data Leads to Manufacturing Cost Allocations

3. What is absorption costing and how does it impact manufacturing profitability?

4. What is Activity-Based Costing and How Will it Benefit My Organization?

5. Fixing the Manufacturing Overhead Misallocation Problem

Which of the following costs at a manufacturing company would be treated as product cost under variable costing?

Which of the following costs at a manufacturing company would be treated as a product cost under the absorption costing method quizlet?

Which of the following costs may be treated as product cost under absorption costing?

What costs are treated as product costs for a manufacturing company?