Absorption Costing

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  What is absorption costing? A managerial accounting cost method of expensing all costs associated with manufacturing a particular product. Absorption costing uses the total direct costs and overhead costs associated with manufacturing a product as the cost base. Generally accepted accounting principles (GAAP) require absorption costing for external reporting. Absorption costing is also known as full absorption costing .  As presented by Investopedia, some of the direct costs related to manufacturing a product consist of wages for workers involved physically in manufacturing a product, the raw materials involved in production, as well as the overhead costs, like utility costs. Moreover, absorption costing counts anything that is a direct cost in production of goods. Besides, absorption costing is promoted by the advocates for the future benefits provided. WHY ABSORPTION COSTING absorption costing  –  is used to calculate inventory valuations and profit calculations in financial statements This method is always used to prepare financial accounts; GAAP Compliant One of the main advantages of using absorption costing in a small business is that it complies with generally accepted accounting principles, or GAAP. Conversion from a non-GAAP costing system to a GAAP costing system can be expensive and time consuming, but if your business begins operations using a GAAP-compliant system, little additional work is involved once the system is set up. This is most important for small businesses that want to expand in the future or plan to seek external financing. Many banks or other lenders expect to be able to assess creditworthiness using financial statements prepared in accordance with GAAP. If your costing system does not comply with GAAP, you may be forced to reconcile the figures at a point in the business when you do not have the resources or time to do so. Ease of Setup  Absorption costing systems tend to be less complicated to initially set up than other costing systems. For example, many small businesses use a type of absorption system known as job-order costing, which requires traceable material and labor to be traced directly to the products that are being produced and overhead to be allocated to products based upon a rate. Once the overhead rate estimates are calculated, the process of allocation becomes trivial using job-order costing. However, activity-based costing, a non-absorption costing alternative, requires the identification of every activity that goes into producing a product and a determination of how these activities affect the overhead incurred. This can be a difficult and time-consuming process.  References    Managerial Accounting: Ray H. Garrison, et al.
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