Question

 

• Discuss what absorption, variables, and throughput costing are.
• Determine when each would be used.
• Provide an explanation and example of all three.

Answer 1

Absorption Costing

CIMA has defined Absorption Costing as "a method of costing that, in addition to direct costs, assigns all, or a proportion of, production overheads costs to cost units by means of one or more number of absorption rates."

According to this:

• It is a costing technique which accumulates all costs associated with production of goods or services.
• It is also known as full costing as it creates a complete picture of the financial situation.
• It ensures that all costs incurred for the manufacture of a product are well recovered from the selling price assuming the customers are willing to pay for it.
• The theoretical justification for absorption costing is to honor the matching principle for all manufacturing costs.
• This method shows a higher net income when production exceeds sales.

Variables Costing

Variable costs are directly related to production. These are also called formula cost since one can calculate before hand toal variable costs of a planned production. A tailor knows how much cloth and stitching time is required for one shirt. Similarly, a manufacturing concerns can work out variable cost per unit by adding up raw-materials, labor plus a part of variable manufacturing overheads (power usage and auxiliary raw materials). Main features of the variable costing method are given as under:

• It is used for internal purpose only.
• It is not acceptable for external reporting or income tax purposes.
• Its use includes: (i) Break-Even Point, (ii) relevant cost analysis, and (iii) short term decision-making.
• Firms with high variable costs are less prone to business risk compared to high fixed cost firms such as hotel or airlines.
• The difference between hi-variable and hi-fixed costs, affects financial structure and break-even points. The latter resort to more debt financing and their Break-Even Points are usually high.
• There would a higher net income when sales exceed production

Throughput Costing

Throughput costing treats all costs as period expenses except for direct materials. It is also called super-variable costing. It is very suitable for those companies where labor and overheads are fixed costs. Assembly-line and continuous processes that are highly automated are most likely to meet this criterion. In such company, workers are usually well-educated engineers or technicians employeed on permanent basis.

Main features are:

• It helps incremental analysis for meeting special orders when there is an excess capacity. An airline can take passengers much below the normal fare when it observes that some seats are empty for want of booking or cancellation or no-show passengers.
• It is a dynamic, integrated, principle-based approach.
• It provide managers with decision support information for optimization of resources.

When They Would Be Used

1. Absorption Costing: Absorption costing can be used as an accounting trick to temporarily increase a company’s profitability by moving fixed manufacturing overhead costs from the income statement to the balance sheet.
2. Variables Costing: This method is used to:

• Conduct break-even analysis to determine the number of units needed to be sold to begin earning a profit
• Determine the contribution margin on a product, which helps to understand the relationship between cost, volume, and profit
• Facilitate decision-making by excluding fixed manufacturing overhead costs, which can create problems due to how fixed costs are allocated to each product

  3. Throughput Costing

• Throughput costing is not used for external reporting because it gives significant different net income figures than those revealed by absorption costing. It provides less incentive to produce for inventory than variable or absorption costing since inventory value figures are very low. Throughput costing has relevance only for internal uses of management.

Examples

Absorption Costing: For example, Wintax Company creates 5,000 products with Variable Cost per unit being $60 direct materials, $110 direct labor, and $40 variable overhead. In addition to the per-unit costs, the fixed overhead is $100,000. In order to obtain the product cost under absorption costing, first the per-unit costs are added together (direct labor, direct materials, variable overhead). After that, per-unit costs need to be obtained from the fixed overhead so that the per-unit overhead can be applied to the per-unit cost. Adding the overhead to the per-unit costs completes what is absorption costing per unit.

​​​​​​Solution- Per-Unit Costs Fixed-overhead per-unit
(direct labor + direct materials +variable overhead) + (fixed overhead / number of units)
($210) + ($20)
Absorption cost per unit: $230

Variable Costing:

Let us assume ABC Limited is a manufacturer of mobile phone covers. The company currently has received an order for 1,000,000 mobile covers at a total contract price of $350,000. However, the company is not sure whether the order is a profitable proposition. The following are the excerpts from the entity’s income statement for the calendar year ending in December 2017:

• Raw material = $300,000
• Labour cost = $150,000
• Machinery = $100,000
• Insurance = $50,000
• Equipment = $100,000
• Utilities (fixed overhead) = $40,000
• Utilities (variable overhead) = $150,000
• Number of mobile covers produced = 2,000,000

Now, based on the above information calculation of variable costing will be,

• Variable costing formula= (Raw material + Labour cost + Utilities (variable overhead)) ÷ Number of mobile covers produced
• = ($300,000 + $150,000 + $150,000) ÷ 2,000,000
• = $0.30 per mobile case
• As per the contract pricing, the per unit price = $350,000 / 1,000,000 = $0.35 per mobile case

Therefore, the variable costing is lower than the pricing offered in the contract which means that the order should be accepted.

Throughput Costing:

Direct materials $3/unit

Direct labor $9/unitO

$7/unitFixed costs $3500 for 10,000 units

Total cost per unit (throughput costing) $3

The total cost per unit is $3 because throughput costing only considers direct materials as part of product costs all other costs are considered period costs.