We will examine the given data from the case and compare the unit costs from the company’s current costing system (traditional costing) and from activity-based costing. We will also highlight other qualitative data in consideration with the numerical factors that may result to a significant change on our recommendation.
The author was able to provide a detailed aspect of variable costing with clear emphasis on the importance of variable costing. According to the author, differentiating between fixed and variable costs is the first step in controlling costs. The article is helpful in understanding cost relationship and its correlation to cost absorption in manufacturing
The management then uses information about cost behavior to understand how future costs might change and affect profitability as operations changes (Scott & Demand Media, n.d). In any case, when reviewing and reporting, understanding variable costing supports decision-making since cost behavior affects profitability. The management also reports about the operating income to help determine the best alternative. Product pricing and budgeting are elements of decision making that impact sales revenue, net income and hence profitability.
According to this method, every unit of the product is assigned all direct, fixed, and variable costs. This method includes the cost of direct materials and labor as well as a portion of the overhead costs associated with it in the final costing of every unit of the product.
Mixed costs consist of a fixed component and a variable component. Understanding the mix of these essentials of a cost, one can predict how costs will change with different levels of activity. As the level of usage of a mixed cost item increases, the fixed component of the cost will not change, while the variable cost component will
Cost behavior refers to the relationship between a given cost item and the quantity of it 's related cost driver. It explains how the total amount for various costs respond to changes in volume. When volume is zero, variable costs equal zero. If there are no lab tests being performed, there are no variable costs incurred. Fixed costs on the other hand do not change in response to a change in volume. The monthly cost to rent a clinic would stay constant whether they had 50 or 100 lab tests, because that is a fixed cost.
For external reporting, production costs must be assigned to products for both income and asset reporting purposes. For operational cost control, strategic decision making, and performance measurement purposes, however, many organizations also capture and assign costs from the other functions in the internal value chain. What methods are used to measure costs and profits across the value chain, and does their usage vary by function? We identified the most frequently used types of methods as: x Actual costing, x Normal costing, x Standard costing, and x Activity-based costing.
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.
All the costs by a company can be broken into two categories, fixed costs and variable costs. Costs that are independent of output are called fixed costs. Fixed costs remain constant throughout the relevant range and are usually considered sunk for the relevant range. Buildings and machinery are included inputs that cannot be adjusted in the short term. They are only fixed in relation to the quantity of production for a certain time period. The cost of all inputs is variable, in the long run.
One of the basic parts of cost accounting is to gauge the cost of tangible or intangible product or service. All costing models are attempting to discover the "correct" cost 1.e actual cost without any cost variances for all cost objects, for example, product, profit, segment, and division. costing methodologies all over the world apportion overhead by utilizing volume- driven measure, for example, unit transformed to first gauge a foreordained overhead rate then assign overhead by applying this normal overhead rate to the cost object. Requisition of such models is authentic for offices generating goods with less differing qualities. In any case, as manufactured goods differ, the wide averaging methodology prompts severe cost variations
Besides the problems with absorption costing listed above, it considers fixed manufacturing overhead as product cost which shows a higher cost per unit than variable costing. As a result, it does not help management decide the selling price of a product. In the example above table 3 shows $72 and $60 per unit sold, while table 4, the variable cost per unit sold is $55. Also absorption costing can make the bottom line look better than it is by removing product costs from the income statement
Lewis Company has been using absorption costing to assess the cost of the modules they manufacture. The use of a variable income statement may allow the firm to make better decision regarding pricing as it will allow for increased transparency and easier calculation of the number of units which will need to be solid to break even. The first stage is to convert the income statement into a contribution statement.
There are different costs that respond to the different activities like variable costs are directly associated with the products sold. The cost behavior patterns of selling, general, administrative, and other operating expenses are determined, and these expenses are budgeted accordingly. For example, sales commissions will be a function of the forecast of either sales dollars or units. The historical pattern of some expenses will be affected by changes in strategy that management may plan for the budget period. In a participative budgeting system, the manager of each department or cost responsibility center will submit the anticipated cost of the department 's planned activities, along with descriptions of the activities and explanations of significant differences from past experience. After review by higher levels of management, and perhaps negotiation, a final budget will be established. Because of the necessity to recognize cost behavior patterns for planning and control purposes, overhead costs will be classified as variable or fixed.
Application of fixed costs can be misleading: Product costing comprising allocation of costs from activity centers to products and computing a products cost per unit. The major disadvantage of this method is that fixed costs are frequently large portion of the overhead costs being allocated for example, building and machinery, depreciation and supervisor salaries. Fixed costs are costs that doesn’t change in total but activity
Under the new cost system, two broad sources of costs were identified: manufacturing and SM&A. All costs within these categories were reclassified as either volume driven or order driven. Hence, four cost pools were set up.