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Criticism of Absorption Cost System
Finance & Accounting
Pages 5 (1255 words)
Student’s Response: “The answer certainly depends on the market. Baring an abnormal demand serge for a particular product at the end of a fiscal year, overproduction results on excess inventory. Since on traditional costs allocation systems overhead is distributed to the entire production, overproduction hides the higher costs of production in the excess inventories.
As common sense would have it, fixed cost remains fixed no matter what the level of production is. Hence, in such a case managers often tend to over produce thinking it’s better to allocate the fix overhead over a wider range of output and reducing the cost per unit (since spreading fixed cost over greater units tends to drive down fixed cost per unit and when fixed costs per unit go down then so does the overall costa per unit), thus seeking an increase in profit per unit of output. The lower fixed cost per unit does of course increase the level of profitability. But a couple of factors need to be considered while making the overproduction decision. While over producing tends to allocate fixed cost over a greater units of output, we need to see whether we really need to over produce. Many factors would need to be considered including the demand for the excess produce, storage and handling costs, cash flow situation etc. ...
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