Comparing Full and Variable Costing - Research Paper Example

executive summary This research report analyzes two important costing approaches; variable costing and full costing and determines which costing system is more appropriate and should be used by the management. The report compares the two costing approaches used by organisations around the world and analyses the strengths and weaknesses of each costing approach. Also implications of these approaches in the real world along with the use of variable and full costing approach in product and service organisations has also been discussed. In the end, the report provides recommendations to have proper and more effective costing method. introduction Identifying and accurately calculating product cost is one of the important aspects of any business because the management cannot determine the selling price of the product unless they know about its cost (Cooper and Kaplan, 1988). Cost of the product is important for any business because if an organisation is able to produce a product at a lower cost in comparison to others then it will be able to gain competitive advantage over others but if the product cost is not accurately calculated then it can distort the financial statements and profitability of the firm and the firm might be selling the product even at lower price than its production cost. Therefore calculating accurately the cost of product is an important aspect for any organisation and management takes keen interest in knowing the product cost (Startton, Desroches, Lawson, and Hatch, 2009). The product cost is also important because the management analyses the cost of each product that the firm manufactures and then takes action to reduce the cost so that the profitability can be enhanced or the selling price can be reduced or it can be done to increase sales of the company by lowering the selling price or improve profitability by producing at a lower cost (Elliot, & Elliot, 2004). Costing method is important for firms that manufacture more than one product as well as it helps the firm to analyse the profitability of each product and then decisions can be taken accordingly by the management (Turney, 1991). By determining the cost of each product accurately the firm is able to identify the cost of production and the profitability that each product is making to the organisation. Cost of product is important in decision making as well since the management uses the cost of product in making decisions whether the firm should carry on manufacturing the product or not, whether the firm should produce more product or not, whether the firm should modify the price in order to change the supply and demand situation in the market and several other decisions are made only on the basis of cost of product (Banker & Hansen, 2002). findings Comparing full and variable costing The costing method can be divided into two broad approaches; full costing and variable costing. In fixed costing, product cost includes the fixed as well as variable costs whereas in variable costing, variable cost of the product is used to determine the price of the product (Roodhooft, & Konings, 1997). Regardless of the importance of product cost, managers and accountants around the world have been finding the best approach or method that should be adopted for costing purpose. Full costing, which is also known as absorption costing method, includes all manufacturing costs; both variable as well as fixed manufacturing overheads along with direct labour and direct material. In absorption costing method, inventory cost is transferred to the cost of goods sold as the products are sold which would mean that the gross profit is decreased by total manufacturing cost. However, period expense which mainly includes selling and administrative expense are excluded in this cost (Kaplan, and Atkinson, 1998). Because many analysts believe that some costs included in the product cost should not be included in full costing. This is the reason why many analysts prefer using variable costing in order to mitigate the shortages in the full costing method (Brimson, 1991). In variable costing, only variable cost of the product is used to calculate the cost of product and this variable cost is assigned to inventory and cost of goods sold. Direct material, direct labour and variable manufacturing overheads are included in this variable cost. However, period cost includes fixed manufacturing overheads, selling and administrative expenses. implications of full and variable costing Because analysts believe that fixed cost would be incurred whether the organisation produces any product or not therefore including fixed manufacturing overheads in the product cost is not a good idea and inclusion of fixed manufacturing overheads in the product cost analysis could distort the analysis and lead to several wrong decisions. Hornger and Foster (1991) claimed that there are two main purposes for using variable costing: 1. The first purpose is for financial accounting in order to allocate the manufacturing cost that has been incurred throughout the period between cost of goods sold and inventories. 2. The other reason for using variable costing is for decision making as it provides more in-depth analysis of the product cost. Product cost is of vital importance for the management as it has been found that organisations tend to use the product cost in making important decisions like whether the company should continue or discontinue manufacturing of product, at what price the product should be sold in the market (Mikovcová, 2008). It has also been found that management use product cost to determine how much effort the organisation should put in promoting and marketing of products (Cagwin, Bouwman, 2002). Theory states that decisions should be taken on costs that are avoidable and this is the reason why different scholars emphasise on taking decisions on the basis of variable costing (Piper and Walley, 1991). However this reflects that scholars focus on the short term and believe that the fixed cost would remain fixed in the long run but it is important if decisions are to be taken considering the long run then fixed costs should also be included. According to Cooper and Kaplan (1988), management believes manufacturing of product as a long term commitment and when an organisation decides or evaluates whether they should manufacture a product or not then they determine the long term feasibility of the product rather than short term. Strengths and Weaknesses of two approaches Strengths of Variable Costing 1. One of the main strengths of variable costing is that it can be understand by everyone easily and it provides more in-depth information about the product cost. 2. Additional sales or profitability from additional sales can be easily traced and analysed with variable costing. 3. As the fixed cost is not considered in variable costing, so the management is able to determine the exact cost of a product. 4. The other strength of using variable costing is that illogical fixed overheads are not included in the stock valuation 5. Because management knows the exact cost of an additional product, therefore decisions like discounts, promotional sales, and production policies can be taken more easily and management will be in a better position to analyse the profitability (Friedlob, & Plewa, 1996). 6. Variable costing method is helpful in short term planning for the management as this allows management to do breakeven analysis and profitability analysis. Also this method allows the management to compare the profitability or performance of different products or decisions easily which is helpful for decision making (Gosselin, 1997). Weaknesses of Variable Costing Weaknesses of variable and full costing approach are as follows: 1. One of the major weaknesses of using variable costing is that it is difficult to separate fixed and variable costs and at times it could give misleading results. 2. Using variable costing, the value of work in progress and stocks are undervalued and thus, the actual profitability of the firm is not stated as fixed costs from inventories are excluded. 3. Fixed overheads are estimated figures and might not be the same as expected and therefore it may under value or over value the final profitability. 4. Inclusion of fixed cost is important to determine the profitability of the firm and excluding fixed costs might not give the actual results thus it is important to consider fixed costs as it is an important part of the overall cost of the organisation. 5. In order to make the accounting or costing system effective, fixed cost should be considered as it holds a major portion of the overall cost. 6. In reality, selling price, fixed cost and variable cost may vary therefore assuming fixed cost to remain fixed might not give realistic results. Strengths of Full Costing 1. As fixed cost is included in the income statement therefore it does not give an in-depth analysis of product cost but better reflects overall cost. 2. The advantage of using full costing is that it helps in determining total cost per unit which is more important to determine profitability. 3. In full costing fixed overheads are included so it gives more accurate total cost. 4. In full costing, management is able to determine total cost and net profit of the firm thus they can take decisions accordingly. 5. In full costing several profitability analysis methods can be performed as management is able to calculate exact net profit of the organisation. 6. Total cost can be easily calculated as one does not have to segregate fixed and variable costs (Kaplan, & Anderson, 2007). Weakness of Full Costing 1. When full costing is used, management is not able to determine the cost of an additional product. 2. Several decisions like discounts, promotional campaigns and other decisions are taken only when management knows the cost of an additional product thus with full costing management is not able to take such decisions correctly (Armstrong, 2002). Comparing two approaches to product and service costing As it has been found that variable costing is more appropriate for managers to analyse and take important decisions however full costing is important for the firm in the long run to determine how profitable the product or service is for the organisation and there are advantages and disadvantages of using both the products (Atkinson, Kaplan, Matsumura, & Young, 2007). Full costing has to be done as organisations have to follow the principles of Generally Accepted Accounting Principles (GAAP) and thus it is mandatory for organisations to prepare cost of goods sold using absorption costing whereas organisations use variable costing as a base to take important decisions (Hicks, 1992). Different scholars and researchers have reviewed and analysed which costing method or approach firms should use. One of the researches on this subject was conducted by Drury and Tayles (1994) in which they studied and analysed 260 manufacturing companies in United Kingdom. Their findings suggested that almost 60% of the organisations often or always use total manufacturing cost for decision making purpose and one major reason for using this has been the simplicity in the approach. It has also been found that almost 84% of the organisations use full costing in order to analyse the profitability. Because manufacturing organisations earn revenue by producing an additional unit of product whereas in service organisation there is no manufacturing or production therefore manufacturing organisations or organisations that offer products generally use variable costing approach in order to analyse the cost per unit whereas organisations that offer services use full costing to calculate their profitability (Atkinson, Banker, Kaplan, and Young, 2011). Because there is no as such manufacturing or production cost in a service organisation, and they do not have inventory and they do not use absorption costing or full costing to allocate fixed costs and thus service organisations do not show manufacturing margin in their income statement (Warren, Reeve, & Duchac) conclusion Costing is an important part of any organisation and variable and full costing are the two most extensively used costing approaches by management around the world. It depends on the type of organisation which approach they should use as both have their own strengths and weaknesses however full costing have to do regardless of any kind of organisation according to GAAP. recommendations Several organisations have been using both variable costing and full costing approach to take advantage of both the methods; variable costing has been used for decision making purposes and fixed costing has been used to calculate net profit. But it is important for the management to come up with a comprehensive costing system that incorporates long term costs particularly variable costs and it should offer the management basis for decision making related to pricing and discounting. Reference list Armstrong, P 2002, ‘The Cost of Activity Based Management’, Accounting, Organizations and Society, vol. 27, pp. 99 – 120. Atkinson, A, Banker, R, Kaplan, R, and Young, M 2011, Management Accounting, Prentice-Hall, New Jersey. 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