Absorption costing considers all manufacturing costs, both variable and non variable, to be product costs that must be allocated to products. Overhead is often computed as a percentage of direct labor. The determination of a realistic over- head application rate is a serious problem in absorption costing. It is also difficult to focus on the actual variable costs and profit potential associated with a particular product or product line. .
Factory overhead costs that do not vary with changes in volume are included as part of cost of goods produced with absorption costing. Firms often project the expected total overhead for the period based on the past year's costs and expected changes. The total overhead is allocated to individual products using an overhead application rate. The overhead application rate for the cost center is determined by dividing the total factory overhead by the total direct labor costs of the cost center for the period
Two risks are associated with using absorption costing. The first is the dependency of the costing system on accuracy of costing direct labor. The second risk is the determination of the overhead application, which is arbitrary. For these reasons, direct costing is often the recommended method for cost estimating instead of absorption costing. (Direct costing is very useful for decision making, but it is not permitted for financial statements prepared for outside users such as bankers or tax accountants.)
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