costing methods - absorbtion and variable costing

Name -Temitope Pedro Student No- 21571 Cost - Accounting Stage 2 Assignment 2

Absorption Costing includes Direct materials, direct labour and Manufacturing overhead (both variable and fixed). Absorption costing treats all production costs as product costs, regardless of whether they are variable or fixed. Under absorption costing, a portion of fixed manufacturing overhead is allocated to each unit of product.

Variable costing includes only variable production costs in product costs. Direct materials, direct labour and variable manufacturing overhead costs. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and is charged against income each period. “Variable costing distinguishes between fixed cost and variable cost” ( IPA 2004, cost accounting)

The distinction between absorption and variable costing is based on the treatment of fixed overhead. Using absorption costing method, fixed overhead assigned to units of inventory is shown in the income statement as part of the cost of goods sold. When units are produced and not sold, fixed overhead stays in finished goods inventory. Under variable costing, reported operating income is driven by the unit level of sales. Under absorption costing, reported operating income is driven by the unit level of production as well as by the unit level of sales. Under variable costing, Fixed overhead is a period expense assigned to the income statement periodically regardless of the number of units sold.

Effect on Income Measurement

If units produced is equal to units sold, then no difference between absorption costing and variable costing net income. Production equals sales (no change in inventories). under both costing methods all of the current fixed manufacturing overhead will flow through to the income statement as an expense.
If units produced is greater than units sold, then absorption costing net income is greater than variable costing net income. When Production exceeds sales inventories increases so the net operating income reported under absorption costing will be greater than the net operating income reported under ...

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Effect on Income Measurement

If units produced is equal to units sold, then no difference between absorption costing and variable costing net income. Production equals sales (no change in inventories). under both costing methods all of the current fixed manufacturing overhead will flow through to the income statement as an expense.
If units produced is greater than units sold, then absorption costing net income is greater than variable costing net income. When Production exceeds sales inventories increases so the net operating income reported under absorption costing will be greater than the net operating income reported under variable costing.
If units produced is less than units sold, absorption costing net income is less than variable costing net income. Sales is greater than production, inventories decrease. Since only the current fixed manufacturing overhead costs are expensed under variable costing, the net operating income reported under absorption costing will be less than the net operating income reported under variable costing.
if beginning & ending inventory levels are equal: absorption costing profit = variable costing profit

In conclusion The difference between the two types of costing lies exclusively in the treatment of the fixed portion of manufacturing overhead. Under absorption costing, changes in operating income are tied to both sales and production while Under variable costing method, changes in reported operating income are tied only to sales. Absorption costing is the method required by tax regulation. “Marginal costing net profit reacts to changes in saes volume only : absorption costing net profit react to changes both in sales and in stock volumes” (Alan Upchurch, 2002. P.336). The difference between the two income-measurement approaches is essentially the difference in the timing of the charge to expense for fixed factory-overhead cost. Operating income is a function of both sales and production.

Question (ii)

Although tax regulations require manufacturing companies to use an absorption costing system, I agree the most appropriate method is variable costing. it is easier to understand variable costing reports For internal reporting and control purposes, because data are organized by behaviour and variable costing is closer to net cash flow than absorption costing net operating income. Variable costing does not allow the capitalization of fixed overheads on stocks that cannot be sold.

A more practical approach - If Units produced = 2,000, units sold = 1,800, contribution margin ratio is 37%, fixed S & A expenses are €90,000, Fixed mfg, Expenses are €80,200 hence net income greater under absorption costing than variable costing by €8,020 (bogus figure). It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate. Variable costing facilitates C-V-P analysis because it uses a “contribution” approach. variable costing can be used to assist in decision making in the following circumstances: product mix, acceptance of a special order, dropping a product, make or buy decision.

In conclusion Variable costing mitigates the effects of earnings management because fixed manufacturing costs are not inventoried. Thus, merely increasing production volume relative to sales will not boost net income. use internally to calculate the number of units needed to be sold to break even. Variable costing is most useful in inventory valuation and income determination; relevant cost analysis, margin of safety, Break-Even and Cost-Volume-Profit Analyses; and short-term decision-making.

Question 2

Market Competition is not the single most important Variable in pricing decision. The final price for a product may be influenced by many factors, These factors can be categorized as internal and external.

Internal factors influencing price decision - company objectives and strategies (with an emphasis on integration); costs and classification (including fixed and variable costs); economies of scale; experience effects; price escalation; and the cost of implementing various pricing schemes.

External factors influencing price decision - demand and sales volume. The channel environment, legal environment, consumer pricing regulations and the international setting are also key issues in the determination of price. Selling prices are not easy to determine in practice because of the difficulty in estimating a product demand curve Colin 1996, p.337

The supply and demand illustrate market interaction between prospective sellers and buyers of a goods and services . The supply and demand determines price and quantity sold in the market. Excess demand puts upward pressure on price and Excess supply puts downward pressure on price, the demand, supply and prices are the outcome of the decision of people. Law of demand and supply states that , other things being equal, the demand for a commodity or service will decline if the price is raised and will rise if the price is reduced(IPA, 2004, economics stage 2, p.17...)

For example the price for Heinz bake beans is higher than other Baked beans such as Tesco, dunes and lidl, despite the competition with these other products, Heinz manage to keep its price high due to the quality of the food. With regard to Heinz baked beans, competition is not the only variable in pricing decision

Pricing is essential to the overall profitability of the organization. Effective pricing, however, requires a systematic approach starting with a review of the objectives of the company, you’re the product or service will have a significant impact on Price decisions, Understanding the characteristics of the marketplace is an essential factor in establishing a price, characteristics of the product will influence the price also environmental factors .

References

PA, 2004, economics stage 2, p.17 Bachelor/ Diploma in Business Studies, undergraduate text.

IPA, 2004, cost accounting, Chapter 16, stage 2, Bachelor/ Diploma in Business Studies, undergraduate text.

Colin Drury, 1996, Management and Cost Accounting, p.337, 4th edition

Alan Upchurch, 2002, Cost Accounting principles and practice, P.336 , Pearson education

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