When Accounting Deceives: How Absorption Costing Distorts Profit

Posted by Dmytro Dodenko

Reporting requirements

External financial reporting requirements in most countries stipulate that when valuing inventory (calculating its cost), only production costs should be included. Therefore, accountants classify incurred costs into Product Costs and Period Costs.

Product Costs are costs identified with goods purchased or produced for resale. In a manufacturing organization, these are the costs that the accountant attributes to specific types of products. Consequently, they are included in the cost of Inventory (Finished Goods) or Work in Process (WIP) until those goods are sold.

At the time of sale, they are recognized as expenses and matched against sales revenue to calculate profit (the Matching Principle).

Period Costs are expenses that are not included in inventory valuation; therefore, they are treated as expenses falling within the period in which they were incurred.

The Nature of Production Costs

Production costs can be variable or fixed (semi-fixed).

• Short-term variable costs change in direct proportion to the volume of production or level of activity (i.e., doubling activity leads to a doubling of variable costs).
• Fixed costs are costs incurred over a certain period that remain unchanged in magnitude over a wide range of production volumes. Examples include depreciation charges for factory buildings, administrative salaries, equipment rent, heating costs, etc.

The Source of Distortion

Financial reporting for external users (according to GAAP/IFRS standards) requires that all acquisition, processing, and delivery costs be included in the product cost. There is no separation of fixed and variable costs in this valuation. Accounting is conducted in accordance with these requirements. As a result, the inventory cost includes fixed costs which do not depend on production volume and, under Variable Costing, would be reflected as period costs.

If production and sales volumes match and do not change from month to month, the profit will be the same regardless of the chosen costing method.

However, under the classic method (Absorption Costing), product cost changes depending on production volume even if the cost of materials and resources has not changed. This can lead to a distortion in the evaluation of performance results for the period.

Let’s consider a hypothetical example:

Enterprise “N” produces only one product.

• Variable production costs: 20 UAH/unit.
• Selling price: 25 UAH/unit.
• Fixed manufacturing costs: 200 UAH/month.
• Other fixed costs: 200 UAH/month.

For simplicity, assume there is no Work in Process (WIP). Data on production and sales quantities are presented in Table 1.

Table 1: Production and Sales Volumes

Let’s analyze how the performance of Company “N” will be reflected in reports using Absorption Costing (Table 2) and Variable Costing (Table 3).

Report Using Absorption Costing (Full Cost Allocation)

Table 2

Report Using Variable Costing

Table 3

Analysis

Compare these reports. How would you evaluate the company’s performance? And if you were the business owner, how would you rate the manager’s work?

• In Month 1: Production and sales volumes are at the same level. Finished goods inventory (FG) does not change. Net profit is the same using both methods.
• In Months 2 and 4: Production volume exceeds sales volume, and inventory at the end of the period increases. The profit calculated under Absorption Costing is higher than the profit under Variable Costing. This is because a portion of the fixed costs under Absorption Costing was deferred to the next period (capitalized in inventory).

• In Months 3 and 5: Sales volume exceeds production volume, and unsold inventory decreases. The profit calculated under Absorption Costing is significantly lower than the profit under Variable Costing.
• In Month 2: Under Absorption Costing, profit is much higher than under Variable Costing, even though sales volumes and prices remained unchanged. This means the enterprise did not earn more cash, yet reported profit increased. Moreover, the enterprise increased its inventory of unsold finished goods, meaning a significant amount of funds was withdrawn from circulation and frozen in inventory. The enterprise will likely experience a shortage of free cash flow to settle with suppliers.
• In Month 5: Compared to the previous Month 4, sales volume increased, all products were sold, and there is no ending inventory. However, the Absorption Costing report shows that key indicators (net profit and profit margin) deteriorated compared to Month 4.

Conclusion

As we can see, using a report based on full cost allocation (Absorption Costing) does not provide adequate information for evaluating enterprise performance and making managerial decisions. Moreover, using this method provokes managers to manipulate indicators, increasing net profit by building up inventory of unsold products.

Conversely, a manager’s actions that improve the financial position of the enterprise (increasing sales and reducing inventory) may be evaluated as negative when calculating cost using the full allocation method (see Month 5 in the example).

Thus, financial accounting does not always provide correct data for analyzing enterprise activity. Relying solely on regulated financial accounting data can lead to erroneous conclusions.

Advantages of Variable Costing

• Decision Relevance: Variable Costing provides information that is more useful for decision-making.
• Inventory Neutrality: It eliminates the impact of inventory changes on profit.
• Avoids Capitalization: Variable Costing avoids capitalizing fixed overhead costs in illiquid inventory.

Arguments in Favor of Absorption Costing

• Consistency for External Users: Different enterprises may have different levels of fixed costs. Accounting cost, which includes fixed manufacturing costs, helps compare the activities of different enterprises (the Comparability Principle). Furthermore, this practice has been established for a long time, and using uniform standards ensures consistency in financial reporting.
• Smooths Seasonality: Absorption Costing avoids reporting fictitious losses in businesses with a seasonal nature (when production is high but sales are low).
• Auditability: The correctness of classifying costs as manufacturing or non-manufacturing is much easier to control. The same costs can be both variable and semi-fixed (e.g., electricity or other energy carriers). Norms for allocating such costs are often determined experimentally. The user of such information is the company’s management. For external users (auditors, tax authorities), it is logical to use cost determined by functional classification – production/non-production costs. Such reporting is easier to verify.