Full Costing and Variable Costing - Essay Example

?Full Costing and Variable Costing Contents Full Costing and Variable Costing Instructor 1 Date 1 Contents 2 Executive Summary 3 Main Findings 4 Direct Costs 5 Indirect Costs 6 Full Costing 6 Variable Costing 7 Summary of Full Costing and Variable Costing Components 8 Making a choice between the two 9 Conclusion and Recommendations 10 References 12 Accounting for Management, 2011. Advantages and Disadvantages of Absorption Costing System. [online] Available at < http://www.accountingformanagement.com/advantages_and_disadvantages_of_absorption_costing.htm > [Accessed 25 December 2011] 12 Charles T. Horngren, Srikant M. Datar, George Foster, 2007. Cost Accounting: A 12 Managerial Emphasis. 12th ed. Prentice Hall. 12 Elliott Taylor, 2011. Full-Costing Income Statement vs. Variable-Costing Income Statement. [online] Available at < http://smallbusiness.chron.com/fullcosting-income-statement-vs-variablecosting-income-statement-20350.html > [Accessed 25 December 2011] 13 Jae Shim, Joe Seigel, 2011. Schaum's Outline of Managerial Accounting. 2nd ed. McGraw-Hill. 13 John Simms, 2008. The Variable Costing Income Statement for External Reporting. VDM Verlag. 13 Noah P. Barsky, Anthony H. Catanach, 2004. Management Accounting: A Business Planning Approach. South-Western College Pub. 14 Steven M. Bragg, 2011. Cost Accounting Fundamentals: Essential Concepts and Examples. 2nd ed. Accounting Tools. 14 Executive Summary Full Costing and Variable Costing are two common approaches to cost keeping employed at the management accounting level in various firms across the globe. Both approaches have their pros and cons and making a choice between the two is solely dependent upon the practices of the firm, its approach to create shareholder value and the mindset of its employees. In terms of the treatment of different types of cost, there is only one difference between the two approaches under consideration. The Manufacturing Overhead component of cost is treated in a different manner under both the approaches. The fixed component of the Manufacturing Overhead is absorbed by the product as it is treated as a product cost in Full Costing approach while the same component is treated as a period cost under the Variable Costing approach. This different treatment of the Fixed Manufacturing Cost, poses a positive effect on the bottom line of the company in the Full Costing Approach, as the cost incurred on the goods not sold is not deducted from the revenues generated during the relevant period. When it comes to Variable Costing, the costs incurred over the manufacturing of all the produced items are deducted from the revenues of the relevant period. This tends to shrink the company bottom-line for the immediate period. These two approaches thus influence the mindset of the shareholders and stakeholders of the company. The type of approach to costing adopted by the company shall also depend on the industry that it operates in and the shareholder anticipations as well. Introduction The ultimate objective of the commencement of any business is to generate profits. A simple equation that generates the bottom line of any business entails the deduction of costs from revenues of the company. Revenue calculation is not a Herculean task, and thus there are not a lot of distinguished approaches that can be used to calculate the revenue of the company. However costing is a much more complex and complicated component of the formerly mentioned equation. There are various approaches utilized by management accountants and financial analysts across the globe for the computation of the cost components. Each component has its own justification and rationale and this paper will be specifically aimed at discussing two of the most utilized approaches to costing namely Full Costing and Variable Costing (Garrison, Noreen, Brewer, 2009). Main Findings In general, no matter whichever approach to accounting is used by the accountants for the treatment of the cost factors in the financial statements, some aspects remain the same. The cost can be differentiated into two main types depending on the function that it serves and the aspect on which it is spent. These two types of cost components include Direct Cost and Indirect Cost. Direct cost refers to the cost that is incurred on purposes linked directly to the production of the final product itself. In other words these are the costs that are incurred on the product directly, while manufacturing. Direct Costs are in turn bifurcated into two main categories, Direct Material and Direct Labor (Simms, 2008). Direct Costs Direct Material refers to the cost that is incurred for the purchase of materials related to the manufacturing of the product directly. For instance, a company manufacturing orange juices purchases orange pulp for $100,000/= and gloves worth $700/= for the workers handling the pulp at various stages of the production process. In the books, the company has spent a total of $100,700/= but from an accounting perspective $100,000/= is the amount that will be debited to Direct Materials. This is simply because the purchase of gloves is not directly related to the manufacturing of orange juice, the final product of the company (Madhav, Datar, Hongren, 2011). Similarly, Direct Labor refers to the cost incurred on the labor employed by the company for the sole purpose of manufacturing the product. In other words, Direct Labor is the component of the entire labor that comes in direct physical contact with the product, before, during and after manufacturing (Much Tutorials, 2011). . For instance, if we continue with the example of orange juice manufacturing then Direct Labor will not include security guards, sweepers, Supervisor’s Secretary or the telephone operator. Direct Labor will only include the Supervisor and his team members who were involved in the process of producing the final packed product (Bragg, 2011). Indirect Costs Indirect Costs are those costs which are not directly related to the production or manufacturing of the product. Such costs include purchasing of staff supportive equipment such as stationery, furniture, office fittings and also wages paid to security and other administrative staff. In accounting terminology, Indirect Cost is also referred to as Overhead Cost or Manufacturing Overhead Cost. The treatment of Manufacturing Overhead costs prove to be the defining factor for the two main types of costing methods to be addressed in the following sections of this paper Full Costing Full costing is also known as Absorption Costing. The term refers to the approach used by firms and companies to evaluate their inventories by including all the costs involved in the production process into product costs, including the allocation of Manufacturing Overhead to cost object and its treatment as a cost incurred in the production (Kinney, Raiborn, 2010). Fixed Manufacturing Overhead refers to the costs incurred by the firm on a regular, periodic basis. These costs remain constant up to a certain level of production. The characteristic of remaining constant and thus independent of the volume of production to a certain extent, explain the term “fixed” used to define this component of Full Costing. Variable Manufacturing Overhead is the cost that varies with the level of output generated by the firm or by its labor to be precise. If the labor is required to work overtime to meet the elevated demand of the product in the market then the additional time spent by the labor and thus the additional units of the final product produced will influence the Variable Manufacturing Cost component of the Full Costing methodology (Barsky, Catanach, 2004). Management accountants allocate all the costs incurred for the production of the final product to the product cost stating that all these costs are directly or indirectly incurred for the sole objective of producing/manufacturing the product. Therefore all the costs must be taken into account while computing the total cost encountered per unit by the firm. At some instances, the distribution costs are also included in the product cost by the company under Full Costing methodology (Shim, Seigel, 2011). This method is carried out with strict surveillance and supervision and is audited on a regular basis to ensure transparency and company integrity is taken care of at all points in time (Taylor, 2011). Variable Costing Variable Costing is another approach that is utilized by firms and management accountants to keep an account of the inventory costs or product costs incurred by the company over a period of time. Variable costing treats the Manufacturing Overhead component of the cost function in a different manner. Manufacturing Overhead can be easily fragmented into two broad categories: Fixed Manufacturing Overhead and Variable Manufacturing Overhead. Now this is where Variable Costing differs from Full Costing. Here, only the Variable Manufacturing Overhead Component of the Total Manufacturing Overhead is treated as product cost and is thus involved in computing the total cost of production for each unit (Horngren, Datar, Foster, 2007). Since Variable Costing does not include Fixed Overhead costs in the production cost, therefore it assists the managers in keeping a stern eye over the exact costs of production incurred. The marginal increase in the costs is easy to be monitored by the management and any variance in the actual numbers reached from the forecasted ones can be noticed and corrected instantaneously. This method provides advantage to the top level management in terms of keeping an eye over the accountants of the company as each penny spent on the production/manufacturing of goods will be observable and there will be no easy escapes for the managers with the accountability (Apostolis, 2011). Summary of Full Costing and Variable Costing Components Making a choice between the two Both the methods that have been discussed in this paper along with their respective and distinguished components have their own pros and cons. The proponents of one method have arguments glorifying their approach and same goes with the other side of the coin as well. In this section, both sides of the story will be considered (Accounting Explanation, 2011). As discussed in the former sections of this paper, Fixed Costs are also added to the product costs in the Full Costing method. This methodology proves to be beneficial in case the company ends up with a finished goods inventory resulting from the remains of sales made. So, while constructing the income statement, costs will only include expenses that have been incurred on the goods that were sold, ignoring the costs incurred on the goods that were not sold. In this case, the losses are understated and the company may have a healthy bottom line to show to the shareholders and stakeholders of the company (Lanen, Anderson, Maher, 2007). Such an approach proves to be of great value to the company as it shows a positive picture of the company to the outside world. Though this is very fruitful for the company on the one hand but on the other, this could be misleading as well. The company managers shall take advantage of this reduced cost and its impact on the company bottom-line and shall demand bonuses. The misleading picture shall also veil the critical performance of employees of the company and management shall not identify the adversity of the situation at the right time (Accounting Coach, 2011). In case of variable costing, the company understates profits by deducting all the expenses from the statement that have been incurred over the relevant period of time. This enables the company to monitor the costs closely and to keep them in check on a regular basis. Under this approach company accounts for those expenses too for which it has not sold the produced products (Value Based Management, 2003). Where on one hand, this method gives an advantage by showing a healthy bottom line the next time round, where preciously unsold units would be sold without accounting for additional fixed costs being incurred; the disadvantage lies on the immediate impact that it produces. With variable costing approach to costing employed, the company, in other words overstates its costs for the period. This could be an alarming situation for the shareholders and stakeholders of the company, as they may not be very comfortable with a wobbling bottom-line of the company (12 Manage, 2011). Conclusion and Recommendations Having discussed both the costing approaches in detail, one may say that this discussion is inconclusive as both sides have strong pros and cons that can neither be denied nor ignored. The type of approach that a company adopts, out of the two, depends on the mindset of the management and the comfort zone of the management accountants. A company which plays the business game with a conservative approach shall go for variable costing while a company that aspires to attract more and more investors shall favor a full costing approach. However one fact cannot be denied that management accountants and employees may abuse each of the approaches to manipulate the scenario in their favor and shall claim for undeserving bonuses and incentives (Hansen, Mowen, 2010). Bearing in mind the entire discussion, it is recommended that companies shall consider the following aspects while deciding upon the type of approach to be adopted: Type of industry that the company is part of Mindset of the Shareholders of the company Mindset of the potential investors Mindset of the employees Company’s approach to profit making Norms in the Industry References 12 Manage, 2011. Absorption Costing. [online] Available at < http://www.12manage.com/methods_absorption_costing.html> [Accessed 25 December 2011] Accounting Coach, 2011. What is Absorption Costing? [online] Available at < http://blog.accountingcoach.com/absorption-costing/> [Accessed 26th December 2011] Accounting Explaination, 2011. Variable Costing vs Absorption costing. [online] Available at [Accessed 25 december 2011] Accounting for Management, 2011. Advantages and Disadvantages of Absorption Costing System. [online] Available at < http://www.accountingformanagement.com/advantages_and_disadvantages_of_absorption_costing.htm > [Accessed 25 December 2011] Charles T. Horngren, Srikant M. Datar, George Foster, 2007. Cost Accounting: A Managerial Emphasis. 12th ed. Prentice Hall. Collin Drury, 2007. Management and Cost Accounting. 7th ed. Cengage Lrng Business Press. Don Hansen, Maryanne M. Mowen, 2010. Cornerstones of Cost Accounting. South-Western College Pub. Dismus Reinald Apostolis, 2011. Efficiency Based Absorption Costing. Dic Press. Elliott Taylor, 2011. Full-Costing Income Statement vs. Variable-Costing Income Statement. [online] Available at < http://smallbusiness.chron.com/fullcosting-income-statement-vs-variablecosting-income-statement-20350.html > [Accessed 25 December 2011] Jae Shim, Joe Seigel, 2011. Schaum's Outline of Managerial Accounting. 2nd ed. McGraw-Hill. John Simms, 2008. The Variable Costing Income Statement for External Reporting. VDM Verlag. Micheal R. Kinney, Ciciley A. Raiborn, 2010. Cost Accounting: Foundations and Evolutions. 8th ed. South Western College Pub. Much Tutorials, 2011. Absorption Costing vs Variable Costing. [online] Available at < http://muchtutorials.com/tutorials-on-financial-cost-management-accounting-ifrss/cost-accounting-tutorials-tutorials-on-financial-cost-management-accounting-ifrss/absorption-costing-vs-variable-costing.html> [Accessed 25 December 2011] Noah P. Barsky, Anthony H. Catanach, 2004. Management Accounting: A Business Planning Approach. South-Western College Pub. Ray Garrison, Eric Noreen, Peter Brewer, 2009. Managerial Accounting. 13th ed. McGraw-Hill/Irwin. R. Madhav, Srikanth M. Datar, Charles T. Hongren, 2011. Cost Accounting.14th ed. Prentice Hall. Steven M. Bragg, 2011. Cost Accounting Fundamentals: Essential Concepts and Examples. 2nd ed. Accounting Tools. Value Based Management, 2003. Absorption Costing. [online] Available at < http://www.valuebasedmanagement.net/methods_absorption_costing.html> [Accessed 25 December 2011] William Lanen, Shanon Anderson, Michael Maher, 2007. Fundamentals of cost Accounting. 2nd ed. McGraw-Hill/Irwin. Read More