Running head: ABSORPTION COST SYSTEMS 1

Absorption Cost Systems

Absorption Cost Systems 2

Global Issue: Allocation Theory and Absorption Cost Systems

Review of Subject

Absorption cost is a commonly used costing system utilized in different organization as a

mean of cost allocations. The absorption cost system is designed to enable products or services

cost tracking and allocation to allow for decision making, monitoring and control for financial

reporting, tax reporting and book balance of inventory and cost of products and services.

Absorption cost is used in various manufacturing and nonmanufacturing settings to serve the

same objectives. In absorption costing, all variable manufacturing costs and fixed costs are

captured to reflect inventories costs of products. The two main systems for absorption costing

are job order cost systems and process cost systems. This paper outlines the importance of cost

allocation theory and how proper allocation of cost support organization to succeed and how

managers use them to make decisions based on financial the associated gains and risks. More

specifically the paper will cover the absorption cost different methods, pros and cons and the

how managers hold accountability in reporting accurate and appropriate financial reports.

(Zimmerman, 2017).

Discussion

Cost Allocation Theory

Cost allocation is associated a set of costs to a cost object. Organizations aim to achieve

several goals by cost allocation. First, it provides managers the ability to make informative

decisions and secondly, it allows management to have the appropriate control over the finance

side. Different methods of cost allocation are used by managers depending on the purpose and

the need. Cost allocation system reveals cost saving opportunities and allow organizations to cut
Absorption Cost Systems 3

any duplication of effort or reduce non-profitable steps along their operation (Zimmerman,

2017).

In one of my project working on pipelines repairs, a general contractor was hire on a time

and material base contract to perform certain activates. Initially, the project control team started

reporting an overrun in spending compared with estimated budget. Further review of the times

and material invoices indicated that the contractor was not requested to report detailed work

break down structure (WBS) with the invoices and it was difficult to determine the reason behind

the cost overrun. As project manager, the first step we took was to enforce a WBS to the

contractor and allocate the initial estimate to that work structure. In addition to that, specific

budget was allocated to changes as contingencies for all unanticipated work. The contractor was

requested to report their cost against specific buckets within the budget with a defined scope.

Upon receiving the first invoice, it was evident to the project team that the contractor had

excessive labor and equipments on site which were not utilized, however were billed to the

project. Cost saving took place immediately and unnecessarily equipments and labor were

rejected and pushed to the contractor to ensure only utilized employee and equipment are billed

to the project. The saving was significant and the cost allocation enabled us to monitor and

control the cost more closely. In addition to that, the cost breakdown enabled the project team

to code invoices appropriately to the different business units according to accounting

requirement.

Absorption Cost System

In cost absorption system all the different costs including direct or indirect which impact

the costs of production is accounted for. This could entails labor costs, material costs, variable

costs and fixed costs related to manufacturing the product. The unit cost of manufacturing
Absorption Cost Systems 4

specific product is then determined using this system (Zimmerman, 2017). The system is also

referred to as “Cost-Plus” approach focuses on distributing manufacturing cost only to products

which help management in evaluating the company’s market position and how to remain

competitive and determine selling prices (Wilkinson, 2013).

Job order cost system and process cost system are the two different systems in absorption

cost. The systems are both backward looking in which they report incurred cost of inventories

to determine cost saving opportunities and find ways to be more efficient in production. The

volume of the inventory manufactured determines is an important factor in driving the overhead

costs being allocated to the product. The rate of overhead is typically calculated based on

budgeted overhead expenses in manufacturer over the expected volume planned to be produced.

This estimate is not accurate as changes in planned volume can occur. Only at the end of the

year the actual overhead rate can accurately be calculated. In addition to that, the plantwide

overhead rate is also an estimate until the end of the business cycle is reached. Overall, the

estimate provides some indication about the product cost during the year to assist in overall

profit related decisions (Zimmerman, 2017).

Even though the absorption cost system is a simple method and it provides an overall

picture of products’ cost, it has some disadvantages. The most obvious disadvantage is that this

system does not accurately account for the additional overhead or indirect across the

organization which is not directly related to the manufacturing line. Accountants overcome this

issue by assigning this additional overhead cost when they balance their financial reporting

(Wilkinson. (2017).
Absorption Cost Systems 5

Conclusions

Cost allocation is essential for all organizations and businesses. In manufacturing

setting, cost systems are used either absorption or variable depending on the structure to ensure

profit is estimated and calculated. In absorption cost systems, the overhead expense only shows

in the financial reporting when the products are sold which help in improving the profit with

revenue generated after selling products. While the disadvantage on the other side that it can

provide inaccurate profit at some period by not including actual incurred expenses with overhead

associated with other department within an organization. Accountant will need to consider this

misleading in the profit and ensure they are somehow indicating a correction to the hidden

expenses (Johnston, 2017). Accountants should be conducting their work under rules and

regulations per the profession standards of the accounting industry. They are accountable to

ensure financial reports are accurate. They carry ethical responsibility toward internal

management, employees, external shareholders and public. Accountants should ensure they

disclose information to the appropriate stakeholders in a timely manner in accordance with the

code of conduct and the profession standards. This is how management and shareholders can

work to maximize profit and sustain a successful business.

Absorption Cost Systems 6

References

Freedman . (2017). Ethical Responsibility in Accounting. Retrieved October 10, 2017, from

http://smallbusiness.chron.com/ethical-responsibility-accounting-58071.html

Johnston . (2017). Advantages & Disadvantages of Using Absorption Vs. Variable Costing.

Retrieved October 10, 2017, from http://smallbusiness.chron.com/advantages-

disadvantages-using-absorption-vs-variable-costing-34282.html

Wilkinson, J. (2013). Absorption Cost Accounting • The Strategic CFO. Retrieved October 10,

2017, from https://strategiccfo.com/absorption-cost-accounting/

Wilkinson. (2017). Absorption vs variable costing Advantages and Disadvantages • The

Strategic CFO. Retrieved October 10, 2017, from https://strategiccfo.com/absorption-vs-

variable-costing-advantages-and-disadvantages/

Zimmerman, Jerold (2017). Accounting for Decision Making and Control. (9th Edition).

McGraw-Hil.