Quiz 10: Criticisms of Absorption Cost Systems: Incentives to Overproduce

Business

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Absorption vs. Variable Costing In the field of bookkeeping, variable costing (direct costing) and ingestion costing (full costing) are two distinct strategies for applying creation expenses to items or administrations. The distinction between the two techniques is in the treatment of settled assembling overhead expenses. Under the immediate costing technique, settled assembling overhead expenses are expensed amid the period in which they are acquired. Under the full costing technique, settled assembling overhead expenses are expensed when the item is sold.Variable costing discounts to pay all settled assembling costs acquired amid the year. Ingestion costing customizes the settled overheads between units in stock and units sold in view of machine hours. Ingestion costing net pay is higher than under factor costing of $1.2 million. This implies inventories under ingestion costing are higher by $1.2 million. The closing work-in-process stock includes 20,000 more machine hours than the opening stock img . From the information given, the settled overhead rate connected to items is $60 per machine hour. Compute the fixed overhead rate with the help of formula shown below: img Thus, the overhead rate comes out to be img .

Absorption Costing Absorption costing method is used by the companies to calculate the costs relating to the product by considering all the overheads and the direct costs involved in that product. Absorption Costing involves absorption of all the manufacturing costs by the number of units produced or labor hours to determine the factory wide blanket rate by the company or the enterprise. Cost of Goods Sold It represents the cost attributable to the production of goods which are sold by the enterprise. It includes direct material cost, direct labor cost which incurred for production excluding indirect cost. By acquiring the stock and then using absorption costing, the corporation here would be able to transfer some of the cost burden from COGS to inventories. This will lead to an upsurge in the net proceeds because the COGS value will show a drop by shifting of burden. But it is just a short-term technique to boost up the earnings. The corporation must reverse it because it can mislead the market. Also, when the inventory value is increased, the company must disclose the same in the financial statements. This is the reason the company is purchasing more and increasing the output in the factory.