How can absorption costing help companies improve their profits?

2 Reducing tax liability

Absorption costing can also help companies reduce their tax liability, by increasing their inventory value and decreasing their taxable income. This is because absorption costing allocates fixed costs to the inventory, which are not expensed until the inventory is sold. Therefore, when sales are lower than production, the inventory value increases and the cost of goods sold decreases, resulting in lower taxable income. Conversely, when sales are higher than production, the inventory value decreases and the cost of goods sold increases, resulting in higher taxable income. This can help companies smooth out their income fluctuations and lower their average tax rate.

3 Complying with external reporting standards

Absorption costing can also help companies comply with external reporting standards, such as the generally accepted accounting principles (GAAP) or the international financial reporting standards (IFRS). These standards require companies to use absorption costing for preparing their financial statements, such as the income statement, the balance sheet, and the statement of cash flows. This can help companies present a consistent and accurate picture of their financial performance and position to their stakeholders, such as investors, creditors, regulators, and customers.

4 Avoiding underestimating costs

Absorption costing can also help companies avoid underestimating their costs, by including all the relevant costs that affect their production and sales. This can help companies avoid making unrealistic assumptions or projections about their profitability and cash flow. For example, a company that uses absorption costing may be more aware of the impact of changes in production volume, sales volume, fixed costs, and variable costs on their profits. This can help the company plan ahead and manage its resources more efficiently and effectively.

5 Enhancing internal control

Absorption costing can also help companies enhance their internal control, by providing a clear and comprehensive record of their costs and revenues. This can help companies monitor and evaluate their performance and identify any deviations or discrepancies that may indicate errors, fraud, or inefficiencies. For example, a company that uses absorption costing may be able to detect and correct any overproduction, underproduction, overpricing, underpricing, overstocking, understocking, or wastage that may affect their profits. This can help the company improve its quality, customer satisfaction, and profitability.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?