Criticisms of Absorption Costing

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					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
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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”
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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.
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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.
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    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).
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    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.

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    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

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           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).
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                   Practice tips
• Data permitting, always try and compute:
• Actual overhead expense, overhead applied and OH
• Is the over/under-absorbed OH written off to COGS or
• 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 …
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    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
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