Question

Do you AGREE or DISAGREE with each statement below? Provide ONE brief explanation, citing relevant information provided above. Treat each statement independently. No computations necessary. Insert Excel rows as needed.

a. Switching to variable costing to report operating income in order to raise external capital

b. Using full absorption costing in order to evaluate performance of individual product line managers

c. Comparing contribution margin by product line in order to decide with product lines to expand

d. Using gross margin by product line in order to decide how to price various product lines

Answer 1

A) Disagree :

Swithcing to variable costing to report operating income to raise xternal capital is, first of all, an unethical approach towards attracting investors, venture capitalistsor bank/institutions by showing favourable results achieved through manipulative reporting or manipulative cost accounting.

In variable cost reporting, fixed costs are taken as sunk costs i.e a cost which would not have impact in decision making and since it has to be incurred irrespective of any scenario, it is not taken into reporting.

The same is the case for other costs which are not fixed but are irrelevant.

Even though the logic of not reporting these costs is correct, the intention in this case is not fair.

For investing in a company, the investors shall be well aware of the fixed costs of the company as well since as the saying goes "Fixed costs is a dangerous enemy of bad times", since it has to be incurred irrespective of the sace at which company is operating which leads to unnecessary losses which cannot be avoided.

B) Disagree :

Absorption Costing

Absorption costing, also called full costing, includes anything that is a direct cost in producing a good in its cost base. Absorption costing also includes fixed overhead charges as part of the product costs. Some of the costs associated with manufacturing a product include wages for workers physically working on the product; the raw materials used in producing the product; and all of the overhead costs, such as all utility costs, used in production. In contrast to the variable costing method, every expense is allocated to manufactured products, whether or not they are sold by the end of the period.

As noted above, since this method takes into consideration even the the fixed over heads that are not incurred in manufacturing a product but simply allcoated to the production of a specific product. This enhances the cost of the product leading to abrupt mark up pricing. Due to apportion of fixed overhead to the product the price of the product also increases sharply making it less competitive in the market which ultimately effects the sale and market capitalisation.

Instead, the product shall be priced taking into consideration only variable costs, and the fixed costs shall be left to be recovered from the profits i.e the mark up over the variable costs. This ensures long term sustainability of the product. The prices can be increased once the market share is achieved.

A great alternative to this is absorption costing method, which appropriately allocated fixed overheads on the basis of cost drivers.

C) Disagreed :

Since fixed costs are allocated over the product line, it is only logical to ascertain the profitability of the product on the basis of contribution it is deriving per unit of sales.

But also at the same time, a profound analysis is required into the fixed cost drivers used by each product line.

It might be possible that a product that generates more contribution per unit of sales be absorbing a large proportion of overhead costs in the manufacturing making its true profitability lower than the product in comparison.

One product might need less marketing and the other might need huge marketing making it's overall profitability less than the former product.

Since fixed overheads are a true cost, and every business at the end of the days aspires to achieve NET PROFIT not just GROSS PROFIT or contribution, it is important to take decisions on the basis of net profitability of product after allocating the overheads to each product.

D) Disagreed :

This tehnique of pricing is only useful and appropriate in case market is really competitve and the company is willing to operate at losses. This technique only recovers the direct costs of the company leading to gross profit but net losses due to pricing or mark up over direct costs.

This technique is appropriate for remaining competitive in an already competitive market to capitalise the market share and increase prices later, but in the long run, this will test companies ability to operate at losses and company might either close it operations or cut down on its cost to remain profitable.