In: Accounting
locate a journal article about absorption and/or variable costing. In the subject line of your post, include the name of the article that you read. Post a link to that article with your initial post, and provide a summary and a reaction to the article. The summary should be approximately 250 words, and the reaction should be approximately 150 words. The summary should describe the major points of the article, and the reaction should demonstrate your interpretation of the article and how you can apply that knowledge.
Absorption and variable costing (Understanding of methods of costing,Comparison and contrast)
Absorption Costing -
(i) Production is 100 units. Then cost per unit would be = (1000/100)+5 = 15/-
(ii) Production is 50 units. Then cost per unit would be = (1000/50)+5 = 25/-
(iii) Production is 200 units. Then cost per unit would be = (1000/200)+5 = 10/-
So, as the production level is increased, fixed cost is absorbed with higher quantities that results in reduction in per unit cost of the product.
Variable Costing
(i) Direct Materails,
(ii) Direct Labour,
(iii) Variable Manufacturing Overheads.
Table :- Costs considered in allocation to products in Absorption and Variable Costing
Costs | Absorption Costing | Variable Costing |
Direct Material | Considered | Considered |
Direct Labour | Considered | Considered |
Variable manufacturing overhead | Considered | Considered |
Fixed Manufacturing Overhead | Considered | Not Considered |
Reconciliation of Income under both the methods can be done in following way -
Income under Variable Costing | XXX |
+Fixed Manufacturing Overhead (beginning & end of inventory) | XXX |
Income under Absorption Costing | XXX |
So we can conclude that -
Both the methods of costing are equal important and have respective purpose, use,advantages and disadvantages. The management should use these methods according to their use and reports they want to prepare
The Managers should used variable costing as these reports are easier to understand because overhead changes with cost drivers.
Managers can use variable costing for the purpose of CVP analysis.
The impact of Fixed cost can be analysed and its impact can be easily seen. The Management can analyse the impact of direct and variable cost on the value of inventory and calculate Marginal contribution Reports.
However, variable costing is not acceptable for Financial Reporting. Absorption costing are considered as more useful and consistent with Financial Reporting, GAAPs. In Financial Reports all the costs related to the product are charged to the product. This requires reconciliation of Profits.
For tax reporting purpose also, absorption costing is used instead of variable costing approach.
Absorption Costing is not useful for making managerial decisions as cost of product per unit changes with change in production level. According to this method, cost would be less where production quanting increases. However, this may not be profitable for the company all the time.
Absorption costing is not very used for cost reduction strategies and implementing cost control.
For startups, absorption costing may not prove to the best method for computing the costs in long run as level of product is very low and per unit cost as per absorption costing will be high (as it includes fixed expenses also). For startup fixed costs would be recovered in long run, what actually matters is the variable cost to find the profitablity of the unit.
Absorption costing is useful for the the manufacturing units having single products.
The profits calculated in Absorption costing provides insight into the recovery of all the expenses (Fixed +variable) over the selling price. That is if a company is in profit, that means the entity is able to recover all the costs from its selling price. And it calculates the correct profit because both costs variable and fixed are actually incurred.
Absorption costing helps the managers to recognise fixed expense department wise/unit wise as the fixed costs are absorbed on the basis of product/department/unit. Hence, the managers can analyse the scope of reduction in fixed cost in a particular area/department/unit.
So, both the methods are being used in real world. Both the methods are useful to the management with their advantages and limitations. It depends on the management what kind of report it need and according the methods of costing should be deployed. Ex - If management wants to analyis its direct cost, it should go for variable costing and if it wants to compute the overall profit absorption costing should be used.