Absorption Costing vs. Variable Costing: A Report

The account issue addressed in this case study was whether to continue with the existing costing method for each product line or implement a activity-based costing method. The ABC method allows for an organization to allocate direct and indirect costs to products and obtain an accurate level of costs and profit for each unit produced, thus allowing the company to improve their overall operational effectiveness. ABC does differ from the existing costing method described in the case as the old method does not account for volume related overhead costs which must be allocated to the specific ODD and TGC products.

Now you add that to the cost per unit manufactured on Table 1 ($48) to get a total of $60 per unit manufactured. When the company only produced 25,000 units the cost was $72 per unit. ((600,000/25,000) + $48 = $72). Now the excess fixed manufacturing costs are rolled into inventory for the next quarter. As shown in the less ending inventory in Table 3 ($1,500,000), because 25,000 units of the units manufactured were not sold. Contribution margin or variable costing does not break up the fixed manufacturing costs, instead it puts in the entire amount of $600,000 into the quarter and does not roll over the fixed costs into inventory. (As shown in the line fixed manufacturing overhead below the contribution margin.) However, in variable costing, $48 of manufacturing cost per unit is rolled over in the inventory. Because variable costing accounts for the fixed costs entirely it is the better option for knowing where your company stands.

The gross profit margin for each product produced based on the ABC data can be determined by the selling price minus the ABC cost per unit multiplied by the units produced (Edmonds, Tsay, & Olds, 2011). Product GS-157, selling price per unit $19.30 minus ABC cost per unit $12.50 equals $6.80 multiplied by the units produced 120,000 equals the ABC gross profit margin $816,000 (Edmonds, Tsay, & Olds, 2011). Product HS-241, selling price per unit $17.50 minus ABC cost per unit $11.67 equals $5.83 multiplied by the units produced 90,000 equals the ABC gross profit margin $525,000 (Edmonds, Tsay, & Olds, 2011). Product OS-367. Selling price per unit $15.10 minus ABC cost per unit $13.75 equals $1.35 multiplied by the units produced 40,000 equals

In the case, it is more advantageous to use absorption costing than the variable costing because it is a simpler method of providing accurate record for the external reporting for a highly unstable manufacturing volume in the manufacturing company. More importantly, the absorption costing provides more accurate picture of cash flow of an organization since the organization will add unsold product to the sale mount of the next fiscal year. (Walther, 2013).With the absorption costing, the organization will be able to transfer the cost of inventory to the costs of goods sold making the organization to reduce the gross profit. The rational behind using the absorption costing is that firms will be able to measure the products as complete costs. (Noreen, E.W. Brewer, P.C. Garrison, R.H. (2013).

In absorption costing, all manufacturing costs, both fixed and variable, are assigned to units of product. Units are said to fully absorb manufacturing costs. Most countries require some form of absorption costing for both external financial reports and for tax reports. Also, most companies across the world use absorption costing in their management reports. It is the most common approach to product costing throughout the world. It is also known as Job-Order Costing.

2. Using budget data, what was the total expected cost per unit if all manufacturing and

The relevant cost for materials already in inventory (11.00/kg) and used regularly would be the purchase (12.50/kg replacement price).

Marginal cost is the change in the total cost that arises when the quantity produced has an increment by unit. That is, it is the cost of producing one more unit of a good. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit.

The reasons for these changes are that, with a system of variable costing, profit is a function of sales volume only, when the selling price and cost structure remain unchanged. The principles of marginal costing denotes that since fixed costs relate to a period of time and does not fluctuates in sales volume, it is misleading to charge units of sale with a share of profits. However, with absorption costing, profit is a function of both sales volume and production volume. Absorption costing argues that fixed manufacturing costs are product costs. It assumes fixed costs expire with the passage of time regardless of production activity and that these costs are incurred for the benefit of operations during a given period of time. This benefit is unchanged by the actual level of operations during the period, and the benefit expires at the end of the period.

profit. However, by using the ABC method to analyze and allocate "other operating costs" to each of the market segments the

Product costs can be used both as “cost of goods manufactured” when the companies are incurring goods and as a “Cost of goods Sold” when the companies are selling the goods. Direct material cost includes all the cost that are used in the manufacturing of product; direct labor cost includes the cost of the labor that are physically in touch with product manufacturing and manufacturing overhead includes the cost other than direct material and labor cost like indirect materials, indirect labor, factory equipment depreciation. In manufacturing company’s balance sheet current assets of inventory includes cost of raw materials, work in progress and finished goods. Period Costs in manufacturing companies will include sales commissions, advertising costs, office salaries, property taxes, research and development, insurance, depreciation, selling

For internal reporting purposes, absorption or variable costing approaches can be used. Absorption costing can be used to save additional costs of preparing reports since absorption costing must be used for external reporting purposes. For short-term planning, it is more appropriate to use variable costing approach because fixed costs do not change within a relevant range as a result of short-term

There are a couple of differences between the two methods that give us the different results. The first is that under absorption, the manufacturing expenses (fixed and variable) are included in the calculation of the gross profit. The selling expenses are then calculated after that. Under the contribution method the structure is to include the variable expenses in cost of goods sold (contribution margin) and then take out the fixed costs.

On the other hand, Absorption costing is the financial accounting statements. It is the method of product costing in which fixed cost together with variable cost forms the total cost of production. Thus in absorption costing total cost of product is made up of fixed and variable cost. In short, absorption costing is a cost technique where fixed as well as variable cost are allocated to cost units (products).

For a company making regular production and sales, with equal quantity of units each period, absorption costing will show the real cost of goods sold. If the production and sales are irregular, this approach will reflect that variable costs and fixed overheads change according to the sales. The fixed overhead costs won’t have any effect due to the level of production or sales but, variable costs will be affected by the level of production or sales. For a company having fluctuations in the level of sales and production, variable costs provide a better picture of costs to be incurred in order to run a business unit.