Absorption costing

While a common and widely used method in financial and management accounting, it has some notable disadvantages when it comes to allocating indirect costs (overheads). These disadvantages can significantly impact decision-making, particularly in modern business environments where overheads constitute a larger proportion of total costs. We will discuss these drawbacks, supported by real-life context and a reference to the NHS case study.

1. Inaccuracy in Cost Allocation

Absorption costing distributes overheads using arbitrary bases such as labour hours or machine hours. This approach can lead to distorted product costs because it assumes a direct relationship between the allocation base and the incurred overheads. In many modern businesses, overheads arise from diverse activities (e.g., IT support, logistics, administration) that are not directly proportional to labour or machine hours.

For instance, in a high-tech manufacturing environment like ArcelorMittal or Boeing, using labour hours to allocate overheads may understate the true cost of complex products and overstate the cost of simpler ones. This misrepresentation can lead to poor pricing and product mix decisions.

2. Encouragement of Inefficiency

Absorption costing can create perverse incentives. Since fixed overheads are absorbed into product costs, increasing production volume lowers the cost per unit (by spreading the fixed costs over more units). Managers may be incentivised to overproduce even if there is no demand, leading to excess inventory and potential waste.

This was evident in traditional NHS costing systems, where departments received funding based on average costs. There was little incentive to streamline operations or account for cost drivers accurately. As highlighted in the NHS case study (CIMA, 2010), the Service Line Reporting (SLR) and Patient-Level Information and Costing Systems (PLICS) were introduced to address these shortcomings by tracing overheads more directly to clinical activities.

3. Lack of Decision-Usefulness

Absorption costing is primarily designed for financial reporting and inventory valuation, not for internal decision-making. It provides limited insight into how resources are consumed by different activities or services. Managers require more detailed information about cost behaviours and drivers to make strategic decisions, especially in service industries or complex manufacturing setups.

In the NHS, understanding how overheads such as building maintenance, IT support, or HR services relate to specific clinical procedures is critical. Traditional absorption costing obscures these relationships, making it difficult to assess the efficiency or profitability of service lines.

4. Difficulty in Identifying Cost Drivers

Indirect costs often support multiple products or services, making it challenging to trace them accurately. Absorption costing lacks the flexibility to assign costs based on actual resource consumption, especially for support activities. This can lead to over- or under-costing of products, impairing pricing, budgeting, and investment decisions.

As Table 3 in the NHS case study shows, activity-based costing (ABC) was introduced to link overheads to specific cost drivers (e.g., patient admissions, diagnostic tests), improving transparency and accountability.

NHS

In the UK’s National Health Service (NHS), traditional costing systems based on averages were ineffective in linking costs to actual patient care. Indirect costs such as facilities management or administrative overheads were spread across services without considering how much each department actually used them. This made it hard for clinical teams to understand how their actions affected costs and performance.

The introduction of ABC and SLR allowed for more accurate allocation of overheads, linking them to clinical activities and helping trusts to manage resources better. It also supported tariff-setting under Payment by Results (PbR) by ensuring that prices reflected true resource consumption (CIMA, 2010).

Opinionated facts and Reflections

Absorption costing, while widely used, has notable disadvantages, particularly when it comes to allocating indirect costs or overheads. One major issue is the arbitrary allocation of overheads. Since overhead costs cannot be directly traced to specific products, they are distributed using bases such as labor or machine hours, which may not reflect actual resource consumption. This can lead to cost distortion, where some products appear more expensive while others seem cheaper than they truly are (Atrill & McLaney, 2018).

In industries with complex operations, like healthcare or manufacturing, this distortion becomes even more problematic. For instance, in the National Health Service (NHS), traditional top-down costing models made it difficult to understand the link between clinical activities and overhead spending. According to the NHS case study from the Chartered Institute of Management Accountants (CIMA, 2010), activity-based costing (ABC) was proposed as an alternative. ABC allowed costs to be traced more accurately using cost drivers, leading to more informed decisions and improved financial outcomes.

Furthermore, the inability of absorption costing to support effective cost control is another drawback. Since overheads are seen as fixed or inevitable, they can be overlooked in performance analysis. This can cause overheads to increase unnecessarily, without proper scrutiny or justification. Blythe (2024) emphasizes that unless managers understand what drives overhead costs, it becomes difficult to control them effectively, especially when operating in resource-constrained environments.

Real-life examples like ArcelorMittal, a global steel manufacturing company, further demonstrate this challenge. With a wide range of products and extensive machinery use, relying on a single overhead absorption rate based on labor hours would be misleading. Instead, more granular costing methods like ABC help them allocate indirect costs with higher precision, leading to better pricing and production decisions (Himme, 2024).

Conclusion and Recommendation

While absorption costing is useful for external financial reporting, it has several limitations when applied to internal management purposes, especially in the allocation of indirect costs. For organisations with high overheads or complex operations, transitioning to activity-based costing can improve the accuracy and usefulness of cost information. This shift enhances transparency, supports better decision-making, and promotes accountability at all levels of the organisation.

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