Question

Explain the how and why variable and absorption costing is used in manufacturing companies.

- List the benefits and weaknesses of each method. In your opinion, when should the variable or absorption costing method be applied?

Answer 1

Variable Costing

Variable costing is one of approach which is used for the purpose of valuation of inventory or calculation of the cost of the product in the company where only the cost linked directly with the production of output are applied to the inventory cost or the cost of the production and other expenses are charged as expense in the income statement.

Examples: Direct Raw Material, Dirrect Labour Costs, Comissions etc

Why is Variable cost used in Manufacturing Companies?

Variable costs change proportionately to the level of output. For manufacturers, a key variable cost is the cost of materials.Manufacturers are vitally interested in unit costs with respect to changes in output levels, since this determines profit per unit of output at any given price level.

Small businesses and new start-ups must keep close watch on their manufacturing costs to make a profit. The term "variable manufacturing cost" applies to accounting methods to track business expenses and profits. Variable costing is appropriate when variable costs were a high proportion of total production costs. Changes in the factory environment have decreased the percentage of variable costs in total manufacturing cost. With automation on the increase in industry, fixed costs become an ever larger element.

How is Variable Cost used in Manufacturing Companies?

Variable Costing focuses attention on the product and its costs. This interest moves in two directions: A.To internal uses of the fixed-variable cost relationship and the contribution margin concept, and B.To external uses involving the costing of inventories, income determination, and financial reporting.

Since variable costing treats fixed manufacturing overhead costs as period costs, all fixed manufacturing overhead costs are expensed on the income statement when incurred. Thus if the quantity of units produced exceeds the quantity of units sold, absorption costing will result in higher profit.

Advantages & Disadvantages of Variable Cost

Advantages:

- Variable costing an be used as a profit planning tool - A profit plan, often called a budget or plan of operations covers all phases of future operations to attain a stated profit goal. Although such a plan includes both long-term and short-term operations, Variable Costing is quite useful in planning for short periods, in pricing special orders, or in making current operation decisions.

- Variable Costing is used as a guide to product pricing

- Similar to financial accounting, managerial accounting accumulates and analyzes data to make logical economical decisions. "Variable costing" is an accounting decision-making tool that managers utilize for internal reporting purposes.

- The Variable Costing procedure is said to be the product of an allegedly incomprehensible income statement prepared for management. By adopting Variable Costing, management and marketing management in particular believe that a more meaningful and understandable income statement can be furnished by the accountant.

Disadvantages:

- The simplicity of Variable Costing allows management to easily understand the resulting figures. However, managers may misapply the principle of variable costing.

- Since Variable Costing income is higher than absorption costing income when sales substantially exceed current production, opponents of variable costing argue that managers who receive only variable cost data are tempted to cut prices to the degree the company profits suffer.

- The opponents of Variable Costing argue that while Variable Costing appears theoretically attractive, it cannot be reliably achieved in practice. For example, there are a number of mixed costs which cannot be readily separated into variable and non variable costs. However, this reasoning is misleading. The variable and non variable components can be reasonably distinguished.

Absorption Costing

Absorption costing is the means by which actual labor and manufacturing overhead costs, which are incurred through payroll and monthly expenses, are translated into hourly rates that are applied to job labor transactions for inclusion in total job cost.

Why is Absorption cost used in Manufacturing Companies?

Absorption costing is useful if there is only one product, there is no inventory and overhead recovery rate is based on normal capacity instead of actual level of activity. Absorption costing is the required inventory method for external financial reporting in most countries. Many companies use absorption costing for internal because it is cost effective and less confusing for managers to use one common method for inventory costing for both internal & external evaluation of reporting and performance.

How is Absorption Cost used in Manufacturing Companies?

It is the oldest and widely used technique of ascertaining cost. Under this technique of costing, cost is made up of direct costs plus overhead costs absorbed on some suitable basis.

Under this technique, cost per unit remains same only when the level of output remains same. But when the level of output changes the cost per unit also changes because of the presence of fixed cost which remains constant.

Advantages & Disadvantages of Absorption Cost
Advantages

- It suitably recognises the importance of including fixed manufacturing costs in product cost determination and framing a suitable pricing policy.

- It will show correct profit calculation in case where production is done to have sales in future (e.g., seasonal sales) as compared to variable costing.

- It helps to conform with accrual and matching concepts which require matching cost with revenue for a particular period.

-  It avoids the separation of costs into fixed and variable elements which cannot be done easily and accurately.

- It helps to calculate gross profit and net profit separately in income statement.

Disadvantages

- Difficulty in Comparison and Control of Cost: Absorption costing is dependent on level of output; so different unit costs are obtained for different levels of output. An increase in the volume of output normally results in reduced unit cost and a reduction in output results in an increased cost per unit due to the existence of fixed expenses. This makes comparison and control of cost difficult.

- Cost Vitiated because of Fixed Cost included in Inventory Valuation: In absorption costing, a portion of fixed cost is carried forward to the next period because closing stock is valued at cost of production which is inclusive of fixed cost.

- Not Helpful for Preparation of Flexible Budget: In absorption costing no distinction is made between fixed and variable costs. It is not possible to prepare a flexible budget without making this distinction.

When Variable Costing or Absorption Costing is used?

In addition to long-range statements to evaluate factors affecting income, companies need short-period income statements that do not consider the entire production and sales cycle. Variable costing meets this need even in small business with limited cost accounting systems. Variable costing is an overhead costing approach that consolidates the desirable features of breakeven analysis and profit planning involving both generally accepted accounting principles and tax regulations require manufacturing companies to use an absorption costing system. The major differences between Variable Costing and absorption costing are briefly discussed as follows:

1. Absorption costing income statement presented in the traditional or functional format makes no distinction between fixed and variable costs. As a result, absorption costing income statements do not show cost-volume-profit relationships as clearly as variable costing income statements.

2. Inventory values are smaller with variable costing because it capitalizes only variable costs as asset. Inventory values using absorption costing have an additional amount for fixed factory overhead.

3. Variable costing income is lower than that for absorption costing when production exceeds sales. Variable costing charges total fixed cost incurred against sales revenue, while absorption costing applies part of it to inventory and defer the cost until sale of the product. If there is an increase in inventories, variable costing income will be less than absorption costing income will be less than absorption costing income.

4. Variable costing income is higher than absorption costing income when units are sold exceeds units produced. Variable costing income always moves in the same direction as sales volume.

5. Conventional absorption costing determines an intermediate income figure called gross margin that reflects the difference between sales and the fixed and variable costs of sales. This figure normally varies significantly from the manufacturing contribution margin determined with variable costing, because we subtract only the variable expenses of the goods sold from sales revenue.

6. The difference between the operating incomes under the absorption Variable Costing is due to the amount of fixed factory overhead in the work-in-process and finished goods inventories.