Posts tagged "variable-costing"

Variable Costing Realities

What are the differences between variable and absorption costing methods? One of the biggest differences between variable costing and absorption costing is the manner in which the fixed manufacturing cost is charged off. Both variable and absorption costing use direct cost, variable cost and variable manufacturing cost are considered to be the product expense.

Variable costing charges off fixed manufacturing cost as period cost, in full at the end of every period. In doing this, the product cost won’t reflect any fixed cost. Managers can use such information to get the bare minimum cost of manufacture of a product. Many say that by not showing fixed manufacturing cost, it will be more difficult to keep accurate and competitive prices. They are essentially opening themselves up to failure if they charge to much, they’ll lose market shares. Yet if they under budget fixed manufacturing, the price could be far too less and they may lose money in the long run.

But Wait, There’s More About Variable Costing

Absorption costing charges off fixed manufacturing cost as a product cost, so the product will reflect this overhead expense. This would be a full look at all cost contributing to the making of a good and can help managers decide on proper pricing. The only con to this kind of costing is the number of time needed to follow through with matching fixed manufacturing to each product. This method is far easier to use with manufacturers that make only a very small limited amount of products, thus easier to cost match and more cost effective to use.

To change direction..

Total cost of production, in terms of economics, refers to the sum of all economic costs involved in manufacturing a product. This includes all fixed costs (costs such as rent, electricity bills, utility bills, etc. that have no bearings on and cannot be directly allocated to the manufacturing process) that must be incurred regardless of the volume and quantity of production, variable costs (expenses such as cost of raw materials, spare parts, labor cost, etc. which are incurred for the exclusive purpose of production and can be directly allocated to the production process) and opportunity cost (cost of the next best alternative that was given up in favour of the chosen alternative).

More About Variable Costing

Overhead costs. The profit or loss figure is reached by calculating the gap between total costs and total sales revenue. A cost sheet is ready to record such costs and to reach the profit or loss figure (as the case might be).

The TVC is the sum of all those costs that change in direct proportion to the variation in the quantity or volume of production. Such costs include cost of raw materials, labor cost, cost of operations, variable overheads, packaging, etc. An increase in the size of production results in an increase in variable costs and vice versa.

Either way, which ever form of costing use, it is only perfect after the fact. In both ways, managers will have to adopt the information into consideration for the coming period and make a budget. The application of each type of costing are GAAP approved, so whichever is chosen will have to be stuck to each period. If the costing method is changed because one is more appropriate for your company, it must be noted in the Summary of Accounts and mentioned to the IRS when filing your next year’s taxes.

Variable Costing – Profiled

Absorption cost systems are widely used to develop financial accounts. These systems are intended to absorb all production costs (variable or fixed) into costs of units produced. Absorption costs techniques allow manufacturing costs to be traced and allocated into product costs. There are various types of absorption costing systems: job order costing, ABC costing, and process costing. In job order costing, costs are allocated to products in batches or piles, and the expenses of each specific batch are traced separately using job order cost’ sheets. In process costing, products are produced in a continuous process and costs are systematically allocated to the product. In ABC costing, costs are assigned from cost centers to products. Because a unit’s cost in the absorption cost systems are made of variable and fixed costs, they can be quite misleading.

Absorption cost systems can incentive overproduction when the overhead rate is calculated on the basis of units produced. Units produced is higher than units sold. In order to calculate this overhead cost, one should divide the total fixed cost by units produced and multiply the result by units sold. This overhead rate will be lower when more units are produced and when variable and fixed costs remain constant. In this process, fixed costs are being spread over more units, thus lowering unit’s cost. This technique allows profit to increase when production increases. Quantity of units produced is greater than quantity of units sold. In this case part of the fixed costs are divided by units and part of the total production (including its costs) is inventoried. The costs inventoried aren’t taken to the income statement, thus increasing profits for that period, and misleading managers to overproduce.

Variable Costing, Is It Really That Simple

In some cases, managers don’t understand how this costing process works. In the most of the cases, they’re only worried about increasing production and lowering units’ cost. Other managers that have their compensation tied to the period’s profit also feel motivated to overproduce, once profit increases as quantity produced increases.

There are many ways to reduce the incentive of overproduction. The first one charges inventory holding costs against profits. In this process, inventory values are increased by the expenses of capital plus storage costs. Managers that are evaluated based on residual income, tend to dislike this system; first, because it increases data processing complexity, and second, because it decreases residual income when there is an overproduction as well as an increase in inventory. This system doesn’t eliminate completely the incentive to overproduce. However, it makes overproduction less profitable to managers.

The second technique that is to reduce the incentive of overproduction is according to a strict policy against building inventories. This can be done through contracts stating that bonuses tied to net income won’t be paid if inventories exceed a certain amount.

Absorption cost systems can have the unintended consequence of creating an incentive to overproduce because they allocate overhead expenses to inventory. Operational performance as measured by accounting systems uses historical data, and can be manipulated so current production levels exceed demand. By spreading overhead costs over a larger inventory base average costs are lower in the present period because the overhead costs are transferred from the current period to a future period when the inventory is consumed. If managers are evaluated on current period net income, and if absorption accounting system is used, then managers have an incentive to increase production to lower average costs in the present period. But doing this would result in a buildup in inventory. This can be addressed directly by modifying managers’ performance evaluation.

A variable costing system would minimize the effect of overproduction lowering production costs because variable costing treats fixed costs as period costs and are deducted from net income in the period incurred. Criticisms of variable costing systems include; managers have the discretion to identify which costs are fixed and which costs are variable. Variable costing systems do not fully remove the incentive to overproduce because variable costing can still defer current period overhead expenses into future periods in the manner of ending inventory. Managers’ performance evaluations can be amended to directly address this problem by having senior management set inventory levels, or by adopting Just-In-Time production that ties inventory to customer orders. This would take the decision control on inventory levels away from managers. Variable costing systems aren’t required for external reporting so there’s an extra cost to reconcile back to absorption costing. This usually leads business to conclude that the expenses of adopting a variable costing system outweigh the benefits.

Another criticism of absorption costing systems is that they do not accurately reflect product costs. They do not represent opportunity costs, and they do not always reflect cost driver behavior, especially when there are fewer input factors, and when production runs include small special orders. Activity based costing (ABC) systems address these concerns because they better indentify cause and effect cost drivers. These cost drivers can be different on the basis of business activity being monitored. They can be custom tailored to each business unit. This can improve decision making by providing more accurate estimations of opportunity costs, and can focus managements’ attention on activities that drive costs. ABC systems do require self reporting by managers which takes time away from other management activities. ABC systems give managers the decision rights to identify cost driver activities. It has the same problem as absorption and variable costing systems in terms of manager’s incentive to adopt cost drivers that maximize their own reward over the total reward for the house.

These criticisms of absorption costing systems haven’t lead to full scale adoption of alternative costing systems such as variable costing or activities based costing. This does not say that the criticism is unwarranted. The criticism has lead to other less costly methods of control, such as modifications to managers’ performance evaluation, or removal of manager’s decisions rights over inventory levels. Absorption costing is required for external reporting. This means there could be additional reconciliation costs when using alternative costing systems. This leads to a lower cost/benefit ratio. The combination of additional costs and reduced benefits means alternative costing systems that provide more accurate data for decision making aren’t passing internal cost benefit analysis at many firms. These same firms recognize the limits of absorption costing systems and mitigate those with less costly alternatives to full adoption of an alternative costing system.

A third method would be to base managers’ compensation on stock prices instead of accounting earnings. This method will inhibit managers’ actions that could damage the company’s profit maximization plan. However, in cases where the firm has more than one plant, overproduction has a small impact on the value of the firm. This factor decreases the efficiency of stock-based compensation to remove or reduce overproduction incentive.

The forth method consists of the application of just-in-time production systems. Because this process doesn’t begin until a part or a total order is carried out by customers, it reduces inventory levels. In this system, the decision rights are made by demand-driven market orders. Here the production levels are set by demand, not by managers. Just-in-time systems reduce inventories, thus reducing the incentive to overproduce.

Companies can control managers’ incentive to overproduce by adopting variable costing systems. These systems write off all fixed manufacturing costs as a period cost. This won’t allow profit increases with overproduction. In variable costing, product costs are composed only of variable costs. Fixed manufacturing costs are considered period costs and are written off. Variable costing and absorption costing differ from each other in the manner in which they treat fixed costs. Fixed manufacturing costs are written off as a period expense under variable costing. Fixed manufacturing costs are included as part of product costs, as for absorption costing. The advantages of variable costing are that the product’s cost doesn’t change depending on volume change. It reduces the incentive for overproduction. It is important to notice that when production and sales are equal, absorption costing and variable costing will get the same profit amount. Variable costing systems’ benefits mightn’t exceed its total costs, a fact that helps to the systems unpopularity.