Question

Because the absorption-cost approach includes allocated fixed costs, it does not clarify how the company’s costs will change as the sales volume changes. Identify three specific reasons why some managers prefer the variable-cost approach.

Answer 1

Three specific reasons why managers prefer variable cost approach -

1. Effective Cost Control: Under Variable cost approach, behavior of cost items is identified and classified into Fixed and Variable costs. By classifying the costs into fixed and variable costs the management is better able to control costs. Since Fixed costs do not change with change in level of output, the management, hence the production department focuses on controlling only the variable costs. Fixed costs, like insurance, administrative expenses etc are not controllable by the production department. The responsibility to control the fixed overheads and expenses is assigned to administrative teams or other teams at whose level these may be controlled. Hence, There is better cost control by identifying and allocating responsibility for cost control of different cost items to teams to whom these directly relate. Under absorption costing, since all costs are allocated to product cost, whether fixed or variable, assigning responsibility for their control becomes difficult.

2. Better Product Pricing decisions: It is contended that to decide if the company should manufacture and sell additional quantity of products than it is currently manufacturing, it should see the impact of additional quantity on its profits. If by producing one additional unit of product, its profit increases than before, it should go ahead and manufacture that product else, it should not. Fixed costs are sunk costs and are not going to change with level of output. Hence fixed costs should not be considered while taking decisions on additional product manufacturing and its pricing. This type of decision making is possible in variable costing approach where costs are divided into fixed and variable and only variable costs are taken into consideration while taking decision on sales volume changes and its pricing.

3. Management planning and control: At the planning or budgeting stage, the management wants to see the impact of sales volume changes on its profits. It would analyse what would be total revenue, costs and profits at different levels of production. For this, variable cost approach is helpful. Here management would first divide the costs into fixed and variable. Now the management will see the sensitivity analysis as to how the total costs will change at different level of production. By This management can determine the optimum quantity that it should plan to sell and also determine the best price at which its total profits will be maximum. This helps management in better production planning and management control.