1) What are the advantages of Variable Costing and the Contribution Approach? Ex
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Question
1) What are the advantages of Variable Costing and the Contribution Approach? Explain each and provide examples.
2) Absorption Costing meets the requirement Matching Principal; explain how and compare this concept to Variable Costing.
3) In what ways does management find Variable Costing more useful?
4) In large manufacturing environments, labor costs are insignificant and fixed overhead costs are huge, such as IBM. In such cases, how can increase of production affect profit? Explain using each of the two methods of costing system:
A) Variable Costing
B) Absorption Costing
Explanation / Answer
Answer:1 There are a number of advantages to using variable costing (and the contribution approach) in internal reports and analysis.
1. More useful for CVP analysis.
Variable costing statements provide data that are immediatelyuseful for CVP analysis since they categorize costs on the basis of their behavior. In contrast, itis often difficult to rework absorption costing data so that they can be used in CVP analysis andin decisions.
2. Income is not affected by changes in production volume.
Under absorption costing,reported net operating income is affected by changes in production since fixed costs are spreadacross more or fewer units. This can distort income and may even result in income moving in anopposite direction from sales. This does not occur under variable costing.
3. Avoids misunderstandings concerning unit product costs.
Absorption costing unit productcosts can be easily misinterpreted as variable costs since they are stated on a per unit basis. Sucha misperception can lead to serious errors in making decisions. Variable costing avoids this problem since unit costs include only variable costs.
4. Fixed costs are more visible.
The impact of fixed costs on profits is emphasized because thetotal amount of such costs for the period appears separately and is highlighted in the incomestatement rather than being buried in cost of goods sold and ending inventory.
5. Understandability.
Managers should find it easier to understand variable costing reports because data are organized by behavior and because variable costing is much closer to cash flow.
6. Control is facilitated.
Variable costing ties in with cost control methods such as flexible budgets.
7. Incremental analysis is more straight-forward.
Variable cost corresponds closely with thecurrent out-of-pocket expenditure necessary to produce and sell products and services and cantherefore be used more readily in incremental analysis than absorption costing data. And sincevariable costing net operating income is closer to net cash flow than absorption costing netoperating income, it is likely to be more useful to companies that have cash flow problems.However, variable costing is not generally accepted by auditors for external financial reports andis not permitted by the IRS in the United States and by tax authorities in many other countries for income tax calculations. There is some question about whether variable costing is actually prohibited in the United States by official pronouncements and some companies do use someform of variable costing in their external reports, but absorption costing must be considered themost generally accepted practice.
Answer:2 Absorption costing advocates believe that absorption costing does a better job of matching costs with revenues than variable costing. They argue that all manufacturing costs must be assigned to products to properly match the costs of producing units of product with the revenues from the units when they are sold. They believe that no distinction should be made between variable and fixed manufacturing costs for the purposes of matching costs and revenues.
The only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead. Using absorption costing, fixed manufacturing overhead is reported as a product cost. Using variable costing, fixed manufacturing overhead is reported as a period cost.
Answer:3 Variable costing provides managers with the information necessary to prepare a contribution margin income statement, which leads to more effective cost-volume-profit (CVP) analysis. By separating variable and fixed costs, managers are able to determine contribution margin ratios, break-even points, and target profit points, and to perform sensitivity analysis. Conversely, absorption costing meets the requirements of U.S. GAAP, but is not as useful for internal decision-making purposes.
Another advantage of using variable costing internally is that it prevents managers from increasing production solely for the purpose of inflating profit. For example, assume the manager at Bullard Company will receive a bonus for reaching a certain profit target but expects to be $15,000 short of the target. The company uses absorption costing, and the manager realizes increasing production (and therefore increasing inventory levels) will increase profit. The manager decides to produce 20,000 units in month 4, even though only 10,000 units will be sold. Half of the $40,000 in fixed production cost ($20,000) will be included in inventory at the end of the period, thereby lowering expenses on the income statement and increasing profit by $20,000. At some point, this will catch up to the manager because the company will have excess or obsolete inventory in future months. However, in the short run, the manager will increase profit by increasing production. This strategy does not work with variable costing because all fixed manufacturing overhead costs are expensed as incurred, regardless of the level of sales.
Answer:4) A) Variable Costing: Variable costing requires that all variable production costs be included in inventory, and all fixed production costs (fixed manufacturing overhead) be reported as period costs. Thus all fixed production costs are expensed as incurred.
B) Absorption Costing: Since absorption costing includes fixed manufacturing overhead as a product cost, all products that remain in ending inventory (i.e., are unsold at the end of the period) include a portion of fixed manufacturing overhead costs as an asset on the balance sheet. Since variable costing treats fixed manufacturing overhead costs as period costs, all fixed manufacturing overhead costs are expensed on the income statement when incurred. Thus if the quantity of units produced exceeds the quantity of units sold, absorption costing will result in higher profit.
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