Criticisms of Absorption Costing

1. Criticisms of Absorption Costing • Absorption costing is a powerful and widely used tool because it tries to approximate “full” or “normal “ cost. However, absorption costing has a number of weaknesses. • Recall that units costs can be highly misleading because unit costs include both fixed and variable costs and fixed costs per unit depend on • Number of units used to compute the overhead rate • Number of units produced vs. number sold

2. Criticisms of Absorption Costing • Formula on p.495 is key: FC absorbed to COGS = FC/Units Produced * Units Sold • Absorption costing can distort production incentives when the overhead rate is based on units actually produced and units produced > units sold. Why • Part of this period’s overheads is “inventoried”

3. Criticisms of Absorption Costing • In effect, because the fixed costs are being spread over more units, the per-unit cost falls. However the working capital tied up in inventory due to the overproduction is costly and overproduction increases the risk of obsolescence. Generally, these costs are not visible to manufacturing managers, so they overproduce even when the firm would not want them to do so.

4. Criticisms of Absorption Costing • To stop this one may: • Implement JIT policies … costly to the firm • Have corporate policies on how much inventory can be carried … hard to monitor • Impose a cost of capital charge on inventories so manufacturing managers “see” the overproduction cost … “right” cost of capital is hard to ascertain. • Give managers stock options … used to appear more intelligent a solution that it does now with the market down and out … even in good times, incentive effect is small.

5. Variable Costing & Criticisms • An alternative to absorption costing is variable costing where fixed overhead is treated as period cost and written off to COGS (Table 10-5). • Using variable costing doesn’t always fix the problem: unexpected costs are a fact of life and if managers classify some of them as variable, then part of these unexpected costs can be inventoried, leading to incentives to overproduce (Table 10-6, p. 501).

6. Variable Costing & Criticisms • Let’s understand Table 10-6. • Panel A is traditional absorption costing • In Panel B, the extra expense is treated as a period cost and expensed. Note in particular that since VC is based on units sold and the number of units sold are the same both years, VC is also the same. • In Panel C, the extra expense is treated as variable cost and inventoried.

7. Variable Costing & Criticisms • Other issues with variable costing: • Cost classification may induce managerial gaming – managers know more about cost behavior than do their bosses. Fixed costs may be classified as variable – this restores overproduction incentives. • Variable costs ignore the cost of fixed factors required to operate the business. In practice, absorption costing based full costs are more widely used. Also GAAP may require full costing of inventories.

8. Criticisms of Unit Costs • Units costs can be highly misleading!! • Unit costs are just an average of the costs measured by the accounting system. • Even though they are stated per unit of output, unit costs are neither marginal costs nor incremental costs because the normal accounting system ignored opportunity costs. • Unit total costs are neither fixed nor variable, but rather a mishmash of many dissimilar costs with dissimilar behavior (in units produced).

9. Practice tips • Data permitting, always try and compute: • Actual overhead expense, overhead applied and OH over/under-absorbed. • Is the over/under-absorbed OH written off to COGS or inventoried? • How much FOH is inventoried every year/period? • If there are multiple years, you how much did inventoried FOH increase or decrease each period? Often these numbers are a useful check on your final answer to the problem. So on to the problems …

10. Key definitions to keep in mind • Let’s recall some key formulae from Chapter 10: • Recall that overhead application rate is always computed based on budgeted or estimated numbers for both overhead and the usage of the allocation base. • Overhead applied = Actual Units times Overhead Application Rate (OAR) • Actual Overhead – Overhead applied = Overhead underabsorbed if > 0 • Actual Overhead – Overhead applied = Overhead overabsorbed if < 0