Question

When output volume increases, do variable costs per unit increase, decrease, or stay the same within the relevant range of activity?

How can absorption costing lead to incorrect short-run pricing decisions?

Answer 1

When output volume increases, variable cost per unit stay the same within the relevant range of activity.

Variable cost vary with volume of production or output, whereas fixed cost remains unchanged irrespective of changes in the volume of output. It is to be understood that unit variable cost stay same at different levels of output and total variable cost changes in direct proportion with the number of units.

On the other hand, total fixed cost stay same disregard of changes in units, while there is inverse relationship between the fixed cost per unit and the number of units.i.e. if volume of output increases fixed cost per unit will be reduced and when volume of output decreases fixed cost per unit is increased.

Yes, Absorption costing lead to short term pricing decision.when we take decisions with regards to :

(1) Make or buy decision

(2) Accept an order or not

(3) Determination of selling price in different conditions

(4) Evaluation of alternative choices

(5) subcontract some of the Production processes or not

Absorption costing lead to incorrect pricing decision. Let's understand it better with the help of hypothetical example.

Assume a company makes 100 toys per month for a variable cost of $4 and fixed overhead costs are $100 per month. Absorption costing allocates $1 to each toy as fixed cost and $4 for each toy as variable cost in this way total cost of toy per unit will be $5.00

If company has an special order of more 10 toys at $4.50 each.

Absorption costing makes it look as the company taking a loss of $0.50 per toy.

But infact it is making a profit of $0.50 per toy because it is not adding fixed cost by producing 10 more units.

Fixed cost is irrelevant for decision making for short term period because it is already incurred it will not increase or decrease whether we accept the order or not. Fixed cost is a sunk cost that were incurred in past.

But absorption costing considered both fixed and variable cost even at the time of taking short term decision, thus absorption costing lead to incorrect short term pricing decision.

Thank you:)