Question

In the case, Jamie put together a total cost for the first order of specialty candles by adding up all of the direct material, direct labor, and allocated MOH; in other words, he used absorption costing. This is the method commonly discussed in textbooks because it is also the method required by GAAP for financial reporting purposes. However, there are several other methods for allocating costs to a product or order:

Variable Manufacturing Cost. This method of tracking costs includes only DM, DL, and the variable portion of MOH. No fixed manufacturing costs or selling and administrative (S&A) costs are included

Total Variable Cost. This method of tracking costs includes DM, DL, variable MOH, and variable S&A. However, fixed costs are still omitted

Full cost. This method of tracking costs includes all of the costs of the business, including all S&A costs

Discuss the pros and cons of each of the four costing methods. Which method do you think Wedge should use for its new line of specialty candles? Defend your answer.

Answer 1

PROS AND CONS OF ABSORPTION COSTING

PROS :

• GAAP COMPLIANCE : The main advantage of absorption costing is that it is in compliance with GAAP and required for reporting to the Internal Revenue Service
• ACCOUNTS FOR ALL PRODUCTION COSTS : Absorption costing takes into account all of the costs of production. Absorption costing includes a company's fixed costs of operation which is helpful to company management in evaluating profitability and determining prices for products.
• TRACKS MORE PROFIT ACCURATELY : Absorption costing also provides a company with a more accurate picture of profitability. This can be especially important for a company that ramps up production well in advance of an anticipated seasonal increase in sales.

CONS :

• CAN CHANGE PROFIT AND LOSS : Absorption costing can cause a company's profit level to appear better than it actually is during a given accounting period. This is because all fixed costs are not deducted from revenues unless all of the company's manufactured products are sold.
• DOESN'T HELP IMPROVE OPERATIONAL EFFICIENCY : If fixed costs are an especially large part of total production costs, it is difficult to determine variations in costs that occur at different production levels.This makes difficult to managers to take decision regarding operational efficiency.
• NOT USEFUL FOR COMPARISON OF PRODUCT LINES : Companies cannot easily compare the potential profitability of different product lines.

PROS AND CONS OF VARIABLE MANUFACTURING COST :

PROS :

• It provides a better understanding of the effect of fixed costs on the net profits because total fixed manufacturing cost for the period is shown separately on the income statement.
• It applies to accounting methods to track business expenses and profits.

CONS :

• Financial statements prepared under this do not conform to generally accepted accounting principles.
• Variable costing does not assign fixed cost of manufacturing to units of products. So the production costs cannot be truly matched with revenues.
• It is usually not the base for evaluating top executive’s efficiency.

PROS AND CONS OF TOTAL VARIABLE COST

PROS :

• It is a key component in the analysis of corporate profitability.
• Total variable cost is used as a line item in an income statement that is organized in a contribution margin format, where only variable costs are included in the calculation of the contribution margin and which can help in CVP analysis.

CONS :

• It does not assign fixed cost of manufacturing to units of products. So the production costs cannot be truly matched with revenues.
• Total variable cost is not compiled at the individual unit level.

PROS AND CONS OF FULL COST METHOD :

PROS :

• The full cost method is a cost accounting method used in the oil and gas industry.
• It determines the complete end-to-end cost of producing products or services.
• Advantages of full costing include compliance with reporting rules and greater transparency.

CONS :

• It leads to difficulties in determining variations in costs at different production levels.
• The full cost method makes a company more susceptible to large non-cash charges whenever the preceding factors result in an expected cash flow decline.
• The need for periodic impairment reviews also increases the accounting cost associated with this method.

CONCLUSION :

Since ,Cost of first order is considered in new line of specialty candles , it is advisable to used absorption costing as it will help to reduce the burden of both fixed and variable cost. In absorption costing, since a considerable amount of overhead costs are allocated to the product, a significant proportion of the product’s cost may not be directly traceable to the product. The management can also push forward costs to the subsequent period when the products are sold. Under absorption costing, managers can improve their profit performance by building up inventory. If we use Variable manufacturing cost then fixed manufacturing costs or selling and administrative (S&A) costs are not considered and in case of Total variable cost , fixed cost is not at all considered.