Question

Kindly provide an explanation as to what are the main concepts pertaining to arriving at relevant costing and discuss how these principles might apply to a manufacturing company. illustrate with examples

Answer 1

Costing Methods in Manufacturing

Variable Costing Defined

Variable costing, a method where all fluctuating expenses from manufacturing are considered to be part of inventory expenses, is useful for various types of analysis and decision-making but does not take into account any fixed manufacturing overhead costs.

Each organization must keep track of what it is spending on the goods and services it creates and sells. Accountants and managers usually look at each unit of a product and service that a company produces. Each unit that is manufactured comes with its own costs. Manufacturing costs are the sum of all the expenses a company has when it turns raw materials into its finished products.

Manufacturing costs are either fixed or variable. A fixed cost is an expense that is related to operating a company for a specific period of time and that stays the same despite any change in the company's activity level. Examples of fixed costs include rent and/or mortgage, property taxes, insurance, interest expenses, utilities, and depreciation. In contrast, a variable cost is an expense that increases or decreases with the level of production. Variable costs can require more precise planning. Examples of variable costs include direct materials, direct labor, production supplies, and freight.

A company's variable costs in the manufacturing process include direct materials, direct labor, and variable overhead. Direct materials are items that workers put together to create a finished product and are easily identifiable as part of the product. Direct labor is the hours spent producing a product or providing a service that can easily be traced to the product or service. Variable overhead refers to the indirect costs incurred by manufacturing a product—costs that fluctuate based on volume. An example of variable overhead is an electric utility bill, because the amount of electricity used will vary based on how many shifts a factory is running.

The distinction between variable and fixed costs is important for proper planning and budgeting.

Variable costing, also known as direct costing, is a method in which the company considers all fluctuating expenses from manufacturing to be part of inventory costs. Companies often use variable costing to analyze performance and make decisions. The use of variable costs as the sole costs tells a company how much it pays for its fixed costs. However, variable costing may not be the best method for a company to use when determining pricing, because it does not consider all costs associated with the manufacturing of the product. The variable costing method is useful for planning but is not sufficient to meet external reporting requirements mandated by generally accepted accounting principles (GAAP), a set of rules and standards that companies must follow when they report financial information. Nonetheless, variable costing is helpful for a company when it is comparing products of the same product line.

An inventory cost is an expense that a company incurs for carrying a stock of goods, such as warehousing and depreciation. Depreciation is the gradual loss of an asset's value, such as a machine that wears out. With variable costing, fixed manufacturing costs are not included with inventory costs. Instead, the company considers them as period costs because they happen for a given period. Other variable costs that are unrelated to manufacturing are still considered as period costs and are recorded as expenses when they are incurred.

Besides variable costing, there are two other methods used in manufacturing to assign costs: absorption costing and throughput costing. These methods differ in how they are used for reporting and in how they treat inventory and period costs.

Absorption costing, also called full costing, is an inventory costing method in which the accountant considers both variable manufacturing costs and fixed manufacturing costs as inventory costs. In this method, the inventory is in effect "absorbing" all costs associated with the manufacturing process. This also means that companies keep their fixed costs as part of operating expenses and not as production costs.

Consider a company called Doll Toys, Inc. that makes high-end dolls. When Doll Toys, Inc. produces 1,000 units, its variable cost per unit is $10 in direct materials, $20 in direct labor, and $5 in variable overhead. The company has fixed costs of $10,000. Under the absorption costing method, the company determines its product cost with the following formula:

\begin{aligned}\text{Absorption Cost per Unit}&=(\text {Direct Materials per Unit}+\text{Direct Labor per Unit}+\text{Variable Overhead per Unit)}+\left(\frac{\text{Fixed Costs}}{\text{Number of Units}}\right)\\&={(\$10}+\$20+{\$5)}+\left(\frac{\$10{,}000}{1{,}000}\right)\\&=\$35+\$10\\&=\$45\end{aligned}Absorption Cost per Unit​=(Direct Materials per Unit+Direct Labor per Unit+Variable Overhead per Unit)+(Number of UnitsFixed Costs​)=($10+$20+$5)+(1,000$10,000​)=$35+$10=$45​

Absorption costing helps companies determine where they can save costs and increase profits. Additionally, absorption costing is the method companies must use when they calculate their taxes and publish financial statements. GAAP requires companies to use absorption costing in published financial statements. Because almost all companies use GAAP, investors, government officials, and members of the public can compare the financial performance of different companies and therefore make wiser decisions. Therefore, even if managers believe that a different method of inventory costing is more helpful as they make decisions, the accountants who work with them have to use absorption costing when it comes to financial reporting.

The least popular inventory costing method is throughput costing. Throughput costing is the least popular method because it is primarily used to approximate capacity. With throughput costing, only direct materials are considered inventory costs, and other manufacturing costs are expensed as period costs when they are incurred. Throughput costing helps companies figure out how much capacity they have to produce goods or services.

Some companies use throughput costing because it encourages managers to keep their inventory stores lean. When companies have fewer items of inventory in stock, they can use the money that they would have spent on that extra inventory for other, more urgent needs. Less inventory means fewer items to store, keep warm or cool, insure, and protect from damage, spoilage, or shrinkage (theft of inventory). Also, inventory items that are stored for long periods may become outdated when technology or trends change. If that happens, then the company has to consider whether to sell the items at a discount, throw them away, or continue to use them even if doing so may affect profitability. If managers are able to reduce excess inventory, they may even be able to reduce the amount of warehouse space the company has, thereby saving on rent. For these reasons, it makes sense for managers to consider throughput costing, especially for businesses that spend significant amounts on inventory. Throughput costing also works well for businesses where most of the production process is completed by robots or other machines.

Costing Methods

	Variable Costing	Absorption Costing	Throughput Costing
Used for external reporting?	No, it does not comply with GAAP.	Yes. The absorption costing method is the only one of the three that is used in preparing financial statements for external reporting purposes in compliance with GAAP.	No, it does not comply with GAAP.
Used for internal reporting?	Yes, it shows where companies can save costs and increase their profitability.	Yes, it shows company performance and provides helpful data when making decisions and planning.	Yes, it can help companies make capacity decisions during the fast-paced production process.
Which costs are considered inventory costs?	Direct materials Direct labor Variable overhead	Direct materials Direct labor Variable overhead Fixed overhead	Direct materials
Which costs are considered period costs?	Fixed overhead All selling, general, and administrative expenses	All selling, general, and administrative expenses	Direct labor Variable overhead Fixed overhead All selling, general, and administrative expenses

There are three main costing methods that companies use for different objectives: variable costing, absorption costing, and throughput costing. Each of these breaks down expenses in a different way.